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The Centre-States GST Compensation Rift, Explained

Sep 12, 2020 4:36 AM 4 min read

The Centre and States are at loggerheads.

The issue is the “promised” GST compensation “owed” by the former to the latter...

Last month, terming COVID-19 as an act of god, Finance Minister Nirmala Sitharamn announced that the Centre would be unable to pay the amount due in the present financial year.

States, as expected, felt livid and betrayed, considering this promise was part of the reason States agreed on adopting GST within our federal structure in the first place.

To understand what’s happening, let’s begin at the beginning...

What is the GST Compensation?

Rewinding to 2017 when GST began to be implemented. This involved replacing multiple Central and State indirect taxes with a single framework.

FYI: States procure revenue, broadly speaking, from (1) tax sources and (2) non-tax sources. The former is further divided into the State’s “Own Tax Revenue” and its share in Central taxes. 

Initially, many States were reluctant to board the GST train because it would prohibit their power to impose indirect taxes outside its realm, potentially leading to a drop in revenues. To pacify the States’ concerns, the Centre assured that it would create a Compensation Fund composed of a cess levied on the 28% GST bucket items.

Estimated revenue loss of States would be compensated by the Centre for a period of five years (till 2022) through this fund.

The assumption was that States would see a 14% rise in revenues irrespective of GST. Any shortfall would be deemed as a revenue loss and hence be compensated.

An agreement was reached, and thus GST came into effect. The system worked well for three years. Before the pandemic.


What’s Happening Now?

The lockdown has caused sharp drops in GST collections. Lower collections mean smaller Compensation Fund. The coffers of both the Centre and States are depleted.

For FY 2020-21, the revenue loss for States (i.e. Amount below the 14% expected growth) is around ₹3Lcr ($40.9bn).

Centre says only ₹65,000cr ($8.9bn) can be covered by the current Compensation Fund, meaning a compensation shortfall of ₹2.35Lcr ($32bn) at the end of FY21.

The Centre now argues that of this shortfall only ₹97,000cr ($13.2bn) can be accounted for due to the GST implementation. The rest i.e. ₹1.38Lcr ($18.8bn) is due to the pandemic for which it cannot be blamed..



What Options Do States Have?

So the Centre and States need money but don’t have any. What’s the logical corollary? One of them needs to borrow the required money.

At the 41st GST Council Meeting two weeks ago, many States’ Finance Ministers called on the Centre to finance the shortfall by borrowing more. Instead, the Government put the onus of borrowing on the States, proposing two options to bridge the shortfall.

Option #1

States can borrow ₹97,000cr directly from the RBI at a concessional rate. The principal + interest can be repaid after June 2022 from the Compensation Fund (hence no additional burden).

Option #2

States can borrow the entire shortfall amount - i.e. ₹2.35Lcr. But they would have to bear the interest cost (on their books); only the principal would be repaid from the Compensation Fund.

Another important distinction between these two options involves States’ fiscal deficits. If States opt for Option #1, a 0.5% relaxation in their borrowing limit would be provided. No such relaxation has been announced for Option #2 (yet).

FYI: Under the Fiscal Responsibility and Budget Management (FRBM) framework, States are required to keep their fiscal deficit to gross state domestic product (GSDP) ratio under 3%. This limit was raised to 5% in May on account of the worsening economic situation.

Needless to say, States aren’t happy with the way things have turned out. This is particularly true for non-NDA ruled States, whose Finance Ministers have been more vocal about voicing their concerns. Punjab said borrowing at such a scale right now would be akin to “mortgaging of the future to live for the present”. Kerala wants the FRBM limit to be raised by 1.5 percentage points to borrow the entire shortfall amount. Delhi called it the “biggest betrayal” in the history of Indian federalism.

To be fair, both the Centre and the States’ concerns can be empathised with. The pandemic was bound to test the limits of the Indian economy, there was no avoiding that.

And both can do more. States have borrowed only 1.25% of GSDP so far this year; the Centre meanwhile breached its full-year fiscal deficit target in only four months. The former is evidently better positioned to borrow (which is not to say that it’s a bad idea for the Centre to borrow more).

At the same time, the Centre’s invoking of an “act of god” force majeure clause to get out of its commitment is likely to hamper Centre-State relations and damage the Centre’s commitment to meeting its obligations. Major reforms like the GST are made possible by federal amity; reneging on promises unilaterally could hurt other major reforms down the lane.

Moreover, in the end, no matter who borrows - the Centre or the States - the overall debt burden of the economy will rise regardless.

Meanwhile, the economic situation remains bleak. Q1 FY21 saw GDP growth contract by a record 23.4% YoY, and the economy faces a recession this fiscal. The hopeless macro conditions demand that the Centre and States resolve their GST differences at the earliest.


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