Faced with dwindling tax revenue since last financial year 2019-20, the issue of ‘full’ and ‘timely’ compensation for the shortfall in states’ tax revenue (their own collection plus the amount received as their share in indirect tax collected by the Centre as per Finance Commission devolution formula) vis-à-vis a given benchmark has been a bone of contention between the central government and the states. It has acquired gargantuan dimensions during the current year with Corona pandemic forcing collapse of businesses cutting across almost all sectors (barring essential items) in turn, leading to steep fall in tax collection of both the Centre and states.
The compensation to states is intertwined with the Goods and Services Tax (GST) in vogue since July 1, 2017. In fact, the passage of the constitutional amendment bill (August, 2016) leading to the launch of GST was predicated on the Centre giving a legally binding commitment that it would compensate the states for the loss of revenue they would incur under GST vis-à-vis the revenue they would get under the subsisting dispensation of excise duty, sales tax or value added tax (VAT) plus other local taxes.
Accordingly, Modi – government enacted the GST Compensation Act (2017) to provide for compensation to the states for 5 years during 2017-18 to 2021-22 for the loss of revenue to be calculated as the difference between their actual collection (including transfer of their share in indirect tax collected by the Centre) and the amount they would have got with annual growth @14% over 2015-16 level under the erstwhile dispensation (read: sales tax/VAT/excise duty/service tax).
However, to ensure that the Centre has enough funds to pay for the shortfall faced by states, it also passed an amendment to GST Compensation Act (2018) to levy a cess on the supply of certain goods and services. The cess is levied on demerit goods (those which fall in the highest tax slab @28% – other slabs being 5%, 12% and 18% besides the exempt category) such as automobiles, tobacco, drinks etc with a proviso to use the proceeds for compensating states. The cess was to remain in force for 5 years in sync with Centre’s obligation to compensate states for that period.
The rationale behind keeping the these arrangements in place for 5 years was that at the end of this transition i.e. 2021-22, the GST dispensation would have acquired the much needed ‘vitality’ and ‘resilience’ to yield sufficient resources for the state governments to meet their budgetary requirements within prudential limit set under the Fiscal Responsibility and Budget Management Act [FRBM] thereby obviating the need for any extra support beyond 2021-22.
During the first two years (since launch of GST) viz. 2017-18/2018-19, the collection from cess was higher than the shortfall in tax revenue faced by states. Even after meeting the compensation requirement of the states, at the beginning of 2019-20, the Centre had a surplus of about Rs 47,000 crore in the cess pool. However, things reversed during 2019-20 when against the requirement of over Rs 165,000 crore, proceeds from the cess were just about Rs 95,000 crore leaving deficit of about Rs 70,000 crore.
As a result, even after utilizing the surplus from the previous year, the Centre faced substantial deficit of Rs 23,000 crore. This led to considerable delay by the Centre in releasing payment to states. For instance, the compensation for October/November, 2019 about Rs 34,000 crore was released in February/April, 2020. Besides, some states are yet to get their dues for that year.
The situation is going to be much worse during the current year. Against compensation requirement of over Rs 300,000 crore, proceeds from the cess are estimated to be just about Rs 65,000 crore leading to a whopping shortfall of Rs 235000 crore. In this backdrop and states unwilling to relent on their claim for compensation in full, the Centre is talking of what in legal jargon is termed as ‘force majeur’. Put simply, the latter may have expressed its inability to pay invoking an event beyond control or an ‘Act of God’ (read: Covid – 19).
The issue was discussed during a marathon meeting of the GST Council on August 27, 2020 wherein the Finance Minister, Nirmala Sitharaman indeed described Covid-19 as an extraordinary “Act of God” even as revenue secretary Ajay Bhushan Pandey informed that of the total shortfall Rs 235,000 crore, only about Rs 97,000 crore is attributable to the implementation of GST, while the rest was due to the Coronavirus pandemic. Ruling out hike in tax rates or the Centre making good the shortfall from either the Consolidated Fund of India (CFI) or borrowing against its balance sheet, Sitharaman presented two options for consideration by the states.
Under option – I, the Centre, in consultation with the Reserve Bank of India (RBI), will provide a ‘special window’ to States to borrow Rs 97,000 crore at a reasonable rate of interest. Under option – II, the States borrow the entire GST compensation gap of Rs 235,000 crore through the ‘special window’. The interest from borrowing would be repaid from the cess collected in the years beyond the first five years of GST implementation. The States have seven working days to decide and come up with their choice.
The GST Council also decided that ‘the above borrowing arrangement would be for the current fiscal and a review would be done at the beginning of the next financial year’.
The Centre’s offer has been opposed by states especially those where non-NDA government’s are in place. They argue that the union government is constitutionally duty bound to pay the compensation in amount full. They aver, the money should be released from the CFI, alternatively, the Centre should borrow and pay. The states’ demand is untenable in view of the following.
First, on legality, the two provisions in law viz. one relating to compensation and the other levy of cess (and collection thereof) have to be viewed in conjunction with each other. In other words, the discharge of the constitutional obligation to compensate states for the loss of revenue would be possible only when there are enough funds available in the cess pool. During 2020-21, money in the cess pool being short of the compensation requirement and considering that the two are inextricably linked, the Centre is under no obligation to pay (this position is even confirmed by the Attorney General).
By the same logic, there is no case for the Centre borrowing the amount on its balance sheet and pay to states. Even so, going for it will have catastrophic impact on its budgetary position.
Already, the Centre has increased its borrowing program for the current year by 50% to over Rs 1200,000 crore which factored in the impact of Aatma Nirbhar Bharat Abhiyan announced by FM during May 13 – 17, 2020. Including additional expenditure of Rs 90,000 crore (Rs 50,000 crore on employment scheme for migrant labor and Rs 40,000 crore additional allocation for MGNREGA) coming thereafter, the borrowings will have to be Rs 1290,000 crore. If, to this we add Rs 235,000 crore required to cover the deficit in the cess pool, the total borrowings will scale up to Rs 1525,000 crore or of 8% of GDP which is more than twice the budget estimate at 3.5%.
Apart from casting a shadow on India’s ability to protect its macro-economic fundamental and inviting the wrath of rating agencies by way of downgrade, borrowing by the Centre on such a mammoth scale will crowd the market, harden the yield and increase the cost of borrowing by states even for their normal borrowing program (apart from making things difficult for private sector).
In this backdrop, the proposal put by FM on the table makes sense. However, it makes no sense to make a distinction between shortfall arising from GST implementation or pandemic. Whatever may be the cause, the fact remains, there is deficit of Rs 235,000 crore in the cess pool and all of it needs to be addressed. Therefore, we need to focus only on option – II. The states will get to borrow from the ‘special window’ at low interest rate and there won’t be any burden on them as servicing of the loan will be from the cess collected from 2022-23 onward.
This presupposes that cess on demerit products will continue beyond 5 year period and will require further amendment to GST Compensation Act, 2018. It will also require that the states refrain from pursuing their demand (made before the 15th Finance Commission) for continuing with compensation for three more years (beyond 2021-22) as that will jeopardize the chances of servicing the loan taken to fund the deficit for 2020-21.