Context:

• The Central government announced that it has released the Goods and Services Tax (GST) compensation dues to States for 2019-20.
• The total compensation was ₹1,65,302 crores while the compensation cess fund collected was ₹95,444 crores.
• The shortfall was made up by excess collections in earlier years as well as some of the balance of inter-State GST from earlier years. This raises the question of how the compensation will be made in the current year.

Background of the cess

• GST subsumed several taxes, including those, which were the preserve of the States, such as sales tax, and therefore required an amendment to the Constitution of India.
• In order to convince manufacturing States to agree to GST, a compensation formula was created.
• The Constitution Amendment Bill, introduced in 2014 and passed by the Lok Sabha had two provisions.
  • First, it provided for a 1% tax on inter-State trade, which would be assigned to the supplying State.
  • Second, it made provisions for a law to be passed by Parliament to provide compensation to States for loss of revenue for a period up to five years.
• However, a Select Committee of the Rajya Sabha recommended that the compensation be guaranteed for a period of five years.
• As tax receipts of manufacturing States had been protected by the guarantee, the provision of the 1% tax on inter-State trade was dropped.

The cess fund

• The GST (Compensation to States) Act, 2017 assumed that the GST revenue of each State would grow at 14% every year, from the amount collected in 2015-16, through all taxes subsumed by the GST.
• A State that had collected tax less than this amount in any year would be compensated for the shortfall.
• The amount would be paid every two months based on provisional accounts, and adjusted every year after the State’s accounts were audited by the Comptroller and Auditor General.
• A compensation cess fund was created from which States would be paid for any shortfall. An additional cess would be imposed on certain items and this cess would be used to pay compensation.
• The items are pan masala, cigarettes and tobacco products, aerated water, caffeinated beverages, coal and certain passenger motor vehicles.

Issue and possible resolution

• As indirect taxes are levied on the nominal value of transactions, this is likely to result in significant shortfall for States from the assured tax collection.
• A key source of the problem is that the 2017 Act guaranteed a tax growth rate of 14%, which is unachievable this year. Whereas no one could have foreseen the pandemic and its impact on the economy, the 14% target was too ambitious to start with.
• Given the government’s inflation target at 4%, this implied a real GDP growth plus tax buoyancy of 9%. That this was an unrealistic target is evident from the shortfall last financial year, when the lockdown was for less than two weeks.

Way Forward:

• First, the Constitution could be amended to reduce the period of guarantee to three years (thus ending June 2020). This would be difficult to do, as most States would be reluctant to agree to this proposal.
• Second, the Central government could fund this shortfall from its own revenue. States would be happy with this proposal. However, the Centre’s finances are stretched due to shortfall in its own tax collection combined with extra expenditure to manage the health and economic crisis.
• Third, the Centre could borrow on behalf of the cess fund. The tenure of the cess could be extended beyond five years until the cess collected is sufficient to pay off this debt and interest on it.
• Fourth, the Centre could convince States that the 14% growth target was always unrealistic. The target should have been linked to nominal GDP growth.

Reference:

https://www.thehindu.com/opinion/op-ed/making-up-for-shortfalls-in-gst-collection/article32319744.ece#:~:text=If%20the%20Centre%20can%20negotiate,be%20sufficient%20for%20this%20purpose.

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