GST Compensation: State govts staring at a fiscal cliff

An extension of GST compensation beyond the original five-year period would be prudent, to avoid a structural shock to state finances

The daily average for the first 19 days of September was 21.24 lakh, almost at par with the daily average (21.26 lakh) for August.
The daily average for the first 19 days of September was 21.24 lakh, almost at par with the daily average (21.26 lakh) for August.

GST compensation has turned out to be a significant portion of many states’ overall revenue receipts over the recent years. Such compensation was meant to be provided for a period of five years after the transition to the regime, and ends on June 30, 2022. However, with the pandemic battering state finances over the last two years, an extension of GST compensation beyond the original five-year period would be prudent, to avoid a structural shock to state finances, as the Indian economy rebuilds itself. The state GST (SGST) collections accounted for around two-fifths of the aggregate own tax revenues (SOTR) of the state governments and around a fifth of their total revenue receipts during FY2019-FY2021 (based on their FY2021 RE).

Under the provisions laid down in the GST (Compensation to States) Act, 2017, a shortfall in the SGST collections below the protected level is to be compensated by the Centre for the first five years after the transition to the GST regime. The protected revenues of the state governments are arrived at by expanding the revenues subsumed into GST in FY2016, at an annual rate of 14%. The GST compensation was meant to be funded by levying a cess on the supply of specified products, including sin products (pan masala and tobacco), luxury goods (motor vehicles), coal and aerated water.

With SGST revenues falling well short of the protected amount, the GST compensation amount has burgeoned in the recent years. Moreover, cess collections have proved inadequate to meet the compensation requirement since FY2020.

FY2021 was particularly challenging. Even as protected revenues rose to Rs 7.2 lakh crore in FY2021 from Rs 6.3 lakh crore in FY2020, the aggregate SGST collections contracted by 5%, to Rs 4.7 lakh crore from Rs 4.9 lakh crore, respectively, based on data available on the Rajya Sabha website. Moreover, cess collections declined to Rs 0.8 lakh crore in FY2021 from nearly Rs 1.0 lakh crore in FY2020.

In addition to transferring Rs 1.5 lakh crore through grants, the GoI undertook market borrowings of Rs 1.1 lakh crore and on-lent the proceeds to the state governments and Union Territories (UTs) as a back-to-back loan, to fund a portion of the GST compensation requirement for FY2021. With this, GST compensation actually transferred during FY2021 through these two routes ended up exceeding 9% of the total state revenue receipts in that year (based on the RE; note: back-to-back loans don’t form part of revenue receipts). This was particularly acute for Punjab, Karnataka, Gujarat, etc.

In FY2022, GST compensation is planned to be funded in a similar fashion; Rs 1.0 lakh crore through the GST compensation cess to be garnered in FY2022, and Rs 1.58 lakh crore through back-to-back loans to be raised by the GoI. Out of the latter, a generous Rs 75,000 crore was provided to the states in a single tranche in July 2021, easing cash flows considerably.

How have SGST collections themselves performed in FY2022 so far? Despite the second wave of Covid-19, the aggregate SGST collections of the state governments in Q1 FY2022 were similar to the pre-Covid-19 level of Q1 FY2020, benefitting from the record high collections of April 2021 that reflected activity in the previous month. With the easing of state-wise restrictions, the headline GST collections for July-August 2021 stood at a healthy Rs 2.3 lakh crore, 14% higher than the inflows in July-August 2019.

Looking at the recent trends, we project the SGST collections in FY2022 to rise to ~Rs 5.7 lakh crore from the Rajya Sabha estimate of `4.7 lakh crore in FY2021, ~17% higher than the pre-Covid level of FY2020. With economic recovery expected to intensify, SGST collections could grow by 15% to `6.6 lakh crore next year, an increment of Rs 0.9 lakh crore.

However, as compared to the compensation of Rs 2.5-2.6 lakh crore each for FY2021-FY2022, compensation is currently intended to be provide for just Q1 of FY2023. The looming step-down in the combined SGST and GST compensation funds is surely going to be a tough fiscal cliff for the states to navigate in FY2023.

The unfortunate victim could be state capex, at a time when the economy needs to rebuild its vitality. This would be especially worrying given the substantial 40% share of the National Infrastructure Pipeline’s funding expected to be provided by the states.

The cess to finance GST compensation will be continued beyond June 30, 2021, in order to service the back-to-back loans of Rs 1.1 lakh crore raised in FY2021 and Rs 1.58 lakh crore planned for FY2022. There is a case for extending the period of compensation to the states as well, beyond the original five-year transition period.

The author is Chief economist, ICRA

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