Finance ministers of eight Opposition-ruled states huddled here on Wednesday, just ahead of the start of the two-day Goods and Service Tax (GST) Council meeting, and decided to seek compensation for the “revenue loss” likely to be incurred by them, on account of the proposed GST slabs rejig.
On August 21, when the Group of Ministers on GST rate rationsalistion met here to review the Union government’s proposals to reform the tax, some states had expressed similar concerns. They proposed continuation of the “compensation cess “ (which will outlive its purpose by October) or any other suitable mechanism to offset the states’ potential revenue shortfall. One southern state even sought the leeway to impose a state-specific cess, and a revision of the revenue-sharing ratio, between the Centre and states from 50:50 now to 60:40 in favour of the states.
Have states gained or lost under GST?
Have states been better off under the GST system compared to the previous regime of value added tax (VAT)? The answer is both yes and no. A study by Tushar Chakrabaorty and Tanvi Vipra, published by PRS Legislative Research in October 2023, showed that at least until 20222-23, the final year of the compensation scheme for the states, their direct revenue from GST (state GST receipts) were lagging the receipts from taxes subsumed in GST, primarily VAT, in the previous five years.
However, the cess receipts (14% revenue guarantee) were included, states reaped richer dividends from the GST regime (see chart).Sine 2022-23, the gross GST collections (including cess proceeds) as a fraction of the GDP were constant at 6.7%. So the situation for the states may not have improved at the aggregate level, though some states may have performed better in comparison to others. Given the revenue guarantee ceased to exist from July 2023, states might actually have been worse off since.
The fact is GST hasn’t yet produced the incremental revenue productivity it was supposed to. Structural issues lie behind this. Even an extra impost (cess) on sin, demerit and luxury goods weren’t enough to keep the promise of 5-year revenue guarantee for states, and the Centre had to take loans in the final two years of the period to make up for the shortfall.
The road ahead for GST reforms
NR Bhanumurthy, director at Madras School of Economics says: “While cess on GST would end soon, we may have to rework guaranteed growth for states With the average nominal GDP growth since GST implementation is about 10.4%, as worked out for GST compensation in 2017, guaranteed growth could be lower than 14%. The Council may also revisit the current sharing formula of 50:50. Or it may work on both guaranteed growth as well as on sharing formula.”
There are also concerns about the distribution of integrated GST or I-GST applied on imports and inter- state transactions by the Centre among states. While the Place of Supply rules prescribe that the revenue must go to the state where the relevant good or service is consumed, the system of allocation hasn’t been transparent enough, and delays are reported. The proposed implementation of pre-filled returns may help in this regard.
Rahul Renavikar, managing director at Acuris Advisors, says: “While the CGST is paid directly to the Central Government’s exchequer and the SGST in the respective state’s exchequer, the I-GST is paid to the Central Govt’s exchequer first and then through the settlement mechanism it is appropriated to the consumption state. This results in a time gap and hence the states prefer businesses to undertake within state transactions for faster realisation of S-GST in the state’s exchequer.”
States are up in arms for revenue compensation because they have more at stake if GST revenues stagnate. State GST (S-GST) accounts for roughly 40% of the states’ own tax revenue (OTR). For the Centre, the Central GST (C-GST) receipts are CGST just 23% of its gross tax receipts and 35% of the net receipts after mandatory transfers to the states (FY26BE).
Finance minister Nirmala Sitharaman has sought to refute some states’ view that GST hasn’t been a gainful bargain for them. In a post on X in May last year, she said: “It is a myth that all GST collections are pocketed by the Centre. GST contributes significantly to state revenues – States receive 100% of S-GST collected in that state, approx. 50%of IGST (i.e. on inter-state trade). A significant portion of CGST, i.e., 42 percent, is devolved to the states based on the Finance Commission’s recommendations.”
She has a point, but this is true of all taxes that are part of the divisible pool, and it is a constitutionally supported policy. States would cite the “vertical fiscal imbalance” between the taxing powers and expenditure obligations of the Union government and the states. The guarantee of 14% annual revenue growth was accorded to states as a grand bargain. This is what helped to secure their consent for GST even amid fears of reduced fiscal autonomy; they also gave up the demand for 60:40 revenue split on the strength of this guarantee. In that sense, it is natural for some of them to demand restoration of the revenue compensation, when the GST reforms could result in a temporary dip in revenues.
According to Bhanumurthy, the concern there could be a loss of revenues is misplaced, at least in the medium to long term. “ As was seen in direct taxes, even in indirect taxes, tax rates and the GDP growth are negatively related while it is positively related with tax compliance,” he notes.
Of course, the Centre must be credited for moving towards a more benign average GST rate. This, coupled with the correction of inverted duty structures, would help broaden the tax base. As former finance secretary Vijay kelkar said, the practice of setting tax rates “largely with the objective to maintain revenue neutrality” is irrational and counter-productive. High rates would make it lucrative for the fraudsters to evade taxes. “Reducing rates with only two slabs should act as a fiscal stimulus to the economy that is facing demand constraints,” adds Bhanumurthy.
The Centre’s commitment to ensure that the overall tax incidence on sin goods remains unchanged even after the current reforms must encourage states. With this principle, it is possible to find a solution to the revenue concerns of states. States would also do well to maximise their revenue effort.
According to Renavikar,, with the advent of e-invoices and digitisation, having one single PAN based GST number for the entire country can resolve these issues around I-GST distribution once and for all. The idea is where the GST is collected as one tax from the taxpayers and then at the back end is equally apportioned between the Centre and the consumption states, based on the Place of Supply rules.
According to Rajiv Memani, president, Confederation of Indian Industry, during the past few years, the settlement system has been streamlined to take care of the states’ issues, and automation has helped in bringing transparency. “The Centre has been transferring I-GST to the respective states on a regular basis. Further, the process is subject to monitoring and audit by the Comptroller and Auditor General, which provides an additional safeguard for transparency and timely settlement,” he says. Memani, however, added that it would be useful to institute a fully automated, real-time refund system with minimal manual intervention. “This would not only speed up processing but also enhance transparency and reduce disputes. Additionally, a mechanism for automatic payment of interest in cases of delay, as in the case of Income Tax, would create accountability.”
