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How the Centre and States Are Dealing With GST Compensation Issue?

Oct 17, 2020 10:58 AM 3 min read

One may assume that when the economy gets hit - the government for one would be united?! 

Unless ‘competitive federalism’ hits back! 

The ongoing borrowing tug-of-war between the Centre and States, thanks to the poster child of competitive federalism i.e. GST, represents the perfect case-in-point..  

Yesterday: Another meeting of the GST Council ended in an impasse. 

Breakthrough: The Centre allowed 20 states to borrow an additional ₹68,825cr ($9.4bn) through Open Market Operations (OMOs) to make up for the GST-compensation shortage. 

A Quick Recap of Events

28 States have been aggrieved due to depletion of their coffers on account of two reasons:

  1. Shortfall in GST compensation owed by the Centre.
  2. Excesses borne due to unplanned spending amidst the pandemic.

So, on August 27th 2020, the Centre offered two outs.

Option 1: - Borrow whatever we (the Centre) owe you (the State) via Reason No. 1 and we will (i.e. The Centre) take care of repayments (principal + interest) by adjusting your share in the GST Compensation Fund.

Option 2: Borrow the entire amount you lost (Reason No. 1 + Reason No. 2) and pay the interest costs. We will only repay your principal amount from the Fund. (Click here for a detailed explainer on the options).


What Did The States Choose?

20 States picked the first option because not only does it make sense to grasp at whatever straws available with minimum borrowing, it is also in the interest of federal solidarity.


How Do They Plan To Execute Option 1?

The option to raise ₹1.1trn ($15bn) (earlier) + ₹68,825cr ($9.4bn) (now added as a sweetener and representing 0.5 percentage point of their respective Gross State Domestic Products) will be exercised through OMOs.

An OMO is the process by which RBI either 

  • sells or buys Government bonds in the open market or 
  • enters into a repo or secured lending transaction with a commercial bank

To give liquidity to the banks.

These banks will effectively bring liquidity to the market and the states.

However, eight states have still deterred from exercising either option and are firm in their demand for the Centre to step in as the borrower and compensate them in full for both GST-shortfalls as well as COVID-related exigencies. 


What Happens If The Centre Borrows?


In the unitary spirit of the nation, it may be a good idea for the Centre to take over in a big-brother capacity and arrive at the States' rescue. But, as is evident, there appear to be significant variables in the "cons" column suggesting otherwise. 

In addition, with an outstanding debt of ₹12Lcr ($163.8bn) - already surpassed target of ₹7.96Lcr ($108.7bn) - the Centre is inordinately leveraged. Is it a good idea to pile on?



The "Act of God" narrative that was conferred by the Centre may sound convenient but is not unwarranted from the prism of grave fiscal turmoil that's gripping governments worldwide. 

Suspending fiscal rules by the Centre to help States cope is a good strategy that has been adopted in some measures in India (removing borrowing caps, easing OMOs, extending borrowing-calendar etc.). 

In addition, aiding with revenues is also a possible avenue to ease burden (boosting cess with the recent cess increases in luxury items, "sin" and "demerit" goods).

In the future, fiscal equalisation formulae for fiscal consolidation as suggested by OECD in the event of a rainy day might come in handy. 

These are unprecedented times with the power to set many precedents for the future...


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