GST Compensation
The mechanism of a nationwide Goods and Services Tax (GST) came into existence with the Constitution (One Hundred and First Amendment) Act 2016. As per the Act, the central government is required to compensate states for their loss of revenue arising out of the implementation of GST. When the GST was implemented on July 1, 2017, the multiple taxes prevailing at the time were subsumed under the GST with the states receiving the SGST (State GST) component of the GST, and a share of the Integrated GST (IGST, which is levied on the supply of goods and/or services either during inter-state trade or import of goods and services into India).
Implementation of GST became possible because states gave up their powers to impose local-level indirect taxes. It changed the principle of indirect taxation for many goods and services from origin based to destination based, i.e., the goods and services produced in origin states (where they are produced) began to be taxed in destination states (where they are consumed). This shift caused concern among some states which was addressed through the GST (Compensation to states) Act, 2017 on the recommendation of the GST Council. The act provides for an annual growth rate of 14 per cent in GST revenue of the states for a period of five years from 2017-2022. As per Section 4 of the act, financial year 2015–16 was taken as the base year for calculating compensation amount payble to states for loss of revenue during the transition period. Thus, if there is less than 14 per cent growth in GST revenue of a state, then the Centre provides GST compensation grant to the state. In order to meet this gap in revenue, the Centre levies a GST compensation cess on certain luxury items and goods (like tobacco products, cigarettes, etc.) which is credited into a separate compensation fund. The compensation to states is paid out of this fund.
Shortfall in Compensation
The issue of compensation shortfall arose in 2019 when payments due for August–September 2019 were delayed because of insufficient funds with the Centre for the purpose. As a result of economic slowdown, the Centre could not garner enough funds by levying a compensation cess, as the sale of some goods on which such cess is levied was affected. In the year 2019–20, cess collections had a growth of just 0.4 per cent, while the compensation requirement of states went up by 104 per cent resulting in a shortfall of funds of nearly ` 70,000 crore.
Therefore, since August–September 2019, all subsequent payments had been delayed. The GST compensation payments to states have been pending since April 2020. The pending amount for April–July was about ` 1.5 lakh crore.
How is Compensation Calculated?
The compensation granted to states is calculated on the basis of the difference between the states’ current GST revenue and the protected revenue after estimating the annual 14 per cent growth rate from base year of 2015–16. The high rate of 14 per cent has been compounding since 2015–16 and, as such, the GST compensation shortfall stands at around ` 3 lakh crore for FY 2020–21, while the cess ollection was estimated to generate only ` 65,000. So, the compensation shortfall in estimated to be 2.35 lakh crore. As per the recent estimation of the Centre, out of this 2.35 lakh crore, ` 97,000 crore is the deficit arising out of GST implementation collection, while the remaining deficit of ` 1.38 lakh crore arose due to Covid-19 pandemic.
Meeting the Shortfall
The union finance minister in her budget speech in February 2020 stated that transfers to the compensation fund would be limited only to collections of the GST compensation cess. It is so because as per the GST (Compensation to States) Act, 2017, the Centre can provide compensation to states only through the money available in the compensation fund, but if there is a shortfull in the availability of money in the compensation fund, there is a constitutional obligation on the Centre to fulfil the compensation requirement of states for a period of five years (from July 2017–June 2022).
So, regardless of the cause of shortfall, the Centre has to compensate the states for GST loss. When the shortfall cannot be met through compensation cess, the GST Council is empowered to recommend other funding mechanism/amounts to settle the issue.
Options Given by the Centre
In order to resolve the compensation issue, the union finance minister in the 41st GST Council meeting, held on August 27, 2020, gave two borrowing options to states: (i) borrow ` 97,000 crore (the shortfall due to GST implementation) to fill the gap in GST compensation through a special window facilitated by the RBI or (ii) borrow from the open market the entire amount of ` 2.35 lakh crore (including ` 1.38 lakh crore deficit caused by the COVID-19 pandemic). These amounts of ` 97,000 crore and ` 1.38 lakh crore were later revised to ` 1.10 lakh crore and ` 1.8 lakh crore, respectively.
Under option 1, the states are required to sell debt securities in the market to raise ` 97,000 crore. The interest cost on these borrowings will be kept at or close to the yield on G-Sec (Government securities), which are the bonds issued by the Government of India. If the interest costs are higher, the Centre will grant a subsidy on it to lessen the burden on states’ finances.
It also entails that this additional borrowing by the states will not come under the category of states’ debt for the purpose of calculating a state’s overall debt. The repayment of the principal and interest on these borrowings will be met through the compensation fund by extending the period of cess collections beyond 2022. As per option 2, the states can raise the entire amount of ` 2.35 lakh crore shortfall by selling debt in the market. Under it, the states will have to bear the interest cost with only the principal being provided through the compensation fund.
States’ Response to Centre’s Proposals
Initially, 20 state governments and one union territory (Puducherry) chose option 1 and agreed to borrow ` 1.10 lakh crore. However, states like Jharkhand, Kerala, Maharashtra, Punjab, Rajasthan, Tamil Nadu, Telangana, West Bengal, and Delhi had rejected both the options. They contended that the Centre should borrow the entire GST shortfall, compensate states in totality, and pay off the debt from the compensation cess fund.
The 42nd GST Council meeting was convened on October 5, 2020 to resolve the issue, but no solution could be reached and it was decided that the council would meet again on October 12, 2020 to sort out the differences between the Centre and states over GST compensation transfer. However, in the meanwhile the Centre decided to release ` 20,000 crore collected as cess to the states and transfer the pending GST of ` 24,000 crore to the states. The GST Council also extended the transition period of five years for levy of compensation cess beyond June, 2022.
The 43rd GST Council meeting, held on October 12, 2020, also ended without a consensus between the Centre and opposing states. The 20 states who had agreed to option 1 were allowed to borrow ` 68,825 crore through open market to meet the GST compensation shortfall.
On October 15, 2020, to break the impasse between the Centre and states, the central government agreed to undertake market borrowings to meet the ` 1.10 lakh crore of GST compensation shortfall. The Government of India decided to undertake the required borrowings in tranches (security that can be split-up) and pass them on to the states as ‘back-to-back’ loans. The arrangement is such that it will not reflect in the fiscal deficit of the Centre and will come under the capital receipts of the state governments. The back-to-back loan to be provided under the arrangement are similar to the way in which the Centre borrows from multi-lateral institutions, such as the World Bank and the Asian Development Bank, and lends to states.
Settlement of the Issue
By December 2020, all states and three union territories (those with legislative assemblies) accepted the central government’s proposal in option 1. Besides this, the states are also entitled to get unconditional permission to borrow the final instalment of 0.50 per cent of gross state domestic product (GSDP) out of the 2 per cent additional borrowings allowed by the Government of India under Atma Nirbhar Bharat Abhiyaan.