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Situation Of GST Compensation Shortfall Explained

by Tavaga Invest
GST: Tiff Between States And Centre

By: Tavaga Research

The Union Government abolished numerous indirect taxes and assumed sole control of the tax regime in the country with the implementation of Goods and Services Tax (GST) in 2017. One of the ways they persuaded the State Governments to get on board was by offering 14% annualized growth on revenues attributable to states from tax collection. This offer came with a cherry on top when the States were guaranteed their share, even in a situation where the new regime did not perform as the old tax system would have. The Union Government would compensate the states for any shortfall in the collections through compensation cess levied on certain luxury and sin products for five years to facilitate the transition. Post GST implementation, the States handed in their taxation rights, except for taxes on petroleum, alcohol, and stamp duty. 

This week, the State administrations were stunned when the Centre announced that the void in GST collections attributable to the States will have to be filled by the States itself. The gap is worth Rs 3 lakh crores. Of the total amount, Rs 1.5 lakh crores are the shortfall in the first four months of this financial year. 22% of the shortfall will be met by the compensation cess, leaving Rs. 2.35 lakh crores to be payable by the State Governments. These shortfalls in the revenue collection have been cascading in nature for the past 12 months and were fulfilled by delayed and distressed payments by the Centre but back then, the economic slowdown was in the backdrop of the discussed shortfalls. 

Although the promised 14% annual growth seemed like a stretch even in 2017, the decision was taken to put the implementation of a unified tax system on the fast track. In hindsight, the growth in tax collections should have been linked to an economic activity metric, such as GDP, which would reduce the pressure of compounding on the Centre.

The main reason behind the pressure on States stems from the reality that the Centre is already burdened with borrowings to sustain the economy in the wake of the Covid-19 pandemic. The Union Finance Secretary, in his letter to the States and UTs, dismissed the option of the Centre borrowing funds as it would influence the yields on central Government securities (G-secs) and will have macro-economic repercussions. The reluctance of State Governments to borrow is based on the fact that borrowing by States will incur a higher interest as compared to the Centre. The reluctance is also because the States were of the impression that they will let the Central Government take the fall for the failures in transition and reap the benefits if they come into existence at all.

GST Collection vs Target
Source: Tavaga Research

As per the estimates of the Government, of the Rs 2.35 Lakh crores, Rs 97,000 crores shortfall is due to the GST rollout, the remainder is the result of the adverse impact of Covid-19. Now, the Centre has proposed two options in the light of higher interest cost, and state administrations are free to choose from them:

  1. Should the State decide to fill just the gap of Rs 97,000 crore due to GST implementation, within a prescribed window, the interest cost will be pegged at or around the yield of G-secs. The interest on this borrowing will be paid out of the compensation cess and will not be treated as a debt of the State.
  2. The States can decide to service the entire shortfall of Rs 2.35 lakh crores, which will be borrowed by states through the issue of market debt. In this debt structure, the interest will be paid by the States from their resources, and the principal amount will be paid through the proceeds of compensation cess. Again, Rs 97,000 crore will not be treated as a debt of the States. 

Despite the given options, the State Governments are not convinced as their finances continue to be insufficiently striving to keep up with these strenuous times. 

GST Month-Wise Collection
Source: PIB, Tavaga Research

*Breakups for the month of April and May still awaited

What has gone wrong with the new tax regime?

GST was brought into implementation to establish a consumption-based tax system as opposed to a predominantly manufacturing-based tax system. However, to the Central Government’s dismay, the economy has been undergoing a period of muted growth for a year or so. The pandemic has accentuated the economic issues and put them under immense scrutiny.

The multiplicity of rates in the tax system was to cater to the various interest groups which have made GST a complex system to implement. The Government has given numerous deadlines extensions for filing returns deferring the revenues to a certain extent. Moreover, it is fair to assume that there are bodies and entities still evading tax, and bringing the hammer down on them might boost the revenues. However, that is easier said than done.

Another reason for the shortfall in GST rates for certain products and processes may have come down post-implementation. That is where the concept of compensation cess would materialize. However, with the pandemic breathing down the neck of the economy, the level of consumption is not putting the collections where they ideally should be.

Alternative options to make up for the shortfall?

Economists at SBI suggested some ways by which the gap can be bridged:

  1. The central bank, RBI, which is a banker to all the State Governments can monetize the debt by purchasing Government securities to the extent of the debt and raising enough funds to service the shortfall in revenue collections.
  2. By Ways and Means Advances (WMA), the Government can raise loans to fix the mismatch between revenue and expenditure. However, WMA is short-term in nature and cannot be treated as permanently viable.
  3. Thirdly, a Special Purpose Vehicle (SPV) can be formed to provide an independent source of finance by taking recourse to the National Small Savings Fund (NSSF). Essentially, this method will mobilize savings through post offices and banks against non-tradable securities of the states. For the States to be able to consider this option, the recourse should be made available at concessional rates.

Recent Developments

During the 42nd GST Council meeting held on Oct 05, the finance minister of the Union cabinet decided to extend the levy of compensation cess beyond 2022. The extension comes against the initially decided five-year transition period following GST implementation. The period to be extended beyond 2022 will depend on the needs to meet the revenue gap.

As for the two borrowing options proposed by the Centre to the states, as many as 21 states stood firm till mid-September on the first option to borrow Rs 97,000 crore within the special window.  However, some of the states are still conflicted between availing the options and appealing for the original compensation. 10 states have placed their demand to be compensated in full as per the initial agreement. The GST council is set to meet on Oct 12 to deliberate on conflict resolution.

The Centre also disbursed a payment of Rs 20,000 crore to the states on account of the compensation cess collections. The total compensation cess collected this financial year is at least Rs 35,000 crore. The opposition parties are appealing for the disbursal of the entire compensation cess collected so far. Furthermore, the states are also demanding additional Rs 11,000 crore as the state’s portion of IGST collections.

The ministry is also working on the structural inconsistency related to the distribution of IGST collections. Presently, there is no formula for the distribution of IGST between the Centre and the states.

As for the issues more macro in nature relating to GST, time is going to be the healer. GST rates on some items cannot be rationalized unless the collections start showing revival. The collection revenue is a factor of economic progress. To witness the bright side of this unified tax system, we need to outlive the economic slowdown cycle. Meanwhile, the Government should consider incentivizing higher business turnover by increasing the tax threshold of non-salaried class to ensure that reported incomes agree with the turnover.

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