Goods & Services Tax: The compensation conundrum

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September 1, 2020 6:40 AM

There was no reference to “Act of God” in the GST agreement, nor was it provided that the states will have to borrow & pay interest on the compensation loans.

The FM had assured that compensation to the states shall be paid in full for the five years within the stipulated period.

The GST Compensation Act requires compensating the states for a shortfall in their revenue collections because of GST implementation every two months. The states had joined the GST regime in 2017 on the agreement that they will receive compensation equivalent to the difference between the revenue from the taxes subsumed in GST in 2015-16, increased at 14% every year, and the actual revenue collection from the tax. Of course, it was optimistic to take a high growth rate, but that was a part of the “grand bargain”, a lure for the states to join the reform. With a sharp decline in revenue collections due to the pandemic, the Union finance ministry has put forward two alternative proposals in the meeting of the GST Council, held specifically to discuss the issue. The states have been asked to decide on the proposals within seven working days.

Even as the fine print of the two proposals is unfolding, there is considerable consternation among states on the recommendations. They are vexed with the solutions offered as an abrogation of the agreement. The entire episode brings out the fact that despite eulogising “cooperative federalism”, ultimately, it is the relative bargaining power and not the spirit of the agreement that decides the solutions. Even if the states feel that they have been given the short-shrift, there is very little they can do. They cannot go back to the pre-GST regime, nor is there a dispute resolution mechanism. Although Clause 11 of Article 279A of the Constitution provides for the creation of an adjudication mechanism by the GST Council, it has not been done so far.

The states were persuaded to forgo their fiscal autonomy in favour of tax harmonisation only after assuring that their revenue interests will be safeguarded for five years. The compensation amount was to be estimated as discussed above, and to finance this, a provision was made to enable the Centre to levy compensation as cess on some ‘luxury’ items and ‘demerit’ goods. The proceeds were to be deposited in the compensation fund to be kept in public accounts. The GST Compensation Act states that if there is excess in the fund on the expiry of five years, 50% of the excess will be transferred to the Consolidated Fund of India and remaining to the states.

However, there is no mention in the Act about what should be done when there is a shortfall. However, according to the minutes of the 7th and 8th GST Council meetings, the FM had assured that compensation to the states shall be paid in full for the five years within the stipulated period. And, in case of a shortfall, the GST Council shall decide the mode of raising additional resources including borrowing from the market, which could be repaid by collecting the cess in subsequent years. In the prevailing situation, the states were hoping that the Union government would borrow the required funds, which could be repaid from the collections from the cess in future.

The GST reform was hailed as a great experiment in “cooperative federalism” with all the states and UTs with legislatures joining the Centre in the reform to harmonise domestic trade taxes. But, the real test of cooperative federalism comes in a crunch situation. Faced with significant erosion of their own revenues and substantial decline in the tax devolution from the Centre and faced with sharp increases in their liabilities on account of fighting the pandemic, providing livelihoods to the people and reviving the economy, they were hoping that the Centre, armed with greater strength and borrowing powers, would help them tide over the difficulties.

The two proposals put forward is akin to choosing between ‘rock and a hard place’. According to the available reports, the total revenue to the states is estimated at Rs 3 trillion. After adjusting for the estimated revenue collection from the cess of Rs 0.65 trillion, the loss to the states works out to Rs 2.35 trillion. After adjusting for the loss on account of Covid-19, which is termed as an “Act of God”, the loss is estimated at Rs 0.97 trillion. In the first proposal, the states can borrow Rs 0.97 trillion, and the Centre would arrange with RBI to open a special window at a lower interest rate.

The servicing and repayment of this loan will be done by the future cess collections, and this will not be counted in their liabilities. In the second, the states can borrow the entire shortfall of Rs 2.35 trillion from the market and pay the interest, though the repayment will be made from future cess collections and this borrowing will be counted as states’ liability. The states are disappointed. There was no reference to the “Act of God” in the agreement, nor was there a provision that the states will have to borrow and pay interest on the compensation loans.

The proposals raise a number of issues. First, the projections and adjustments made to account for the “Act of God” are contestable. The world over, GST is considered as the “money machine”. However, in India, even after three years, the GSTN failed to stabilise the technology platform, and with no mechanism to match invoices to monitor input tax credit, compliance has fallen. In the first two years, the revenue from compensation cess exceeded payments, but in the third year, this fell short, and a major reason for this has to be found in the poor compliance. If the GSTN has failed to stabilise the platform to match invoices and validate input tax credit claims, should the states be penalised?

Second, nowhere in the GST Compensation Act, or the relevant Rules, the “Act of God” finds a place. Third, considering the fact that the entire repayment of the loans will be made from the proceeds of the cess collections in future years, it would have been better for the Union government to borrow. The credit rating agencies would not have taken this negatively as this liability would not burden the Consolidated Fund of India. Fourth, we do not know the details of the special window to be opened by RBI and how the interest rates will be kept at a rate lower than the market rate. In any case, considering the fact that the net financial saving of the household sector is just a little over 7%, and with the Centre’s and states’ aggregate borrowing for the year estimated at about 12% of GDP, this loan may have to be financed either directly or indirectly by monetising the deficit.

Many states are naturally disappointed, and some have openly expressed their disagreement on any of the two proposals. Even in this late hour, the Union government can take the decision to take the loan to compensate the states, which may be serviced and repaid in later years from the proceeds of the compensation cess in the spirit of the agreement and foster the spirit of cooperative federalism.

Chief Economic Adviser, Brickwork Ratings, and former member, 14th Finance Commission 
Views are personal

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