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GST Compensation Cess: Centre v/s State- Tug of War

Launched on 1st July 2017 Goods and Services Tax subsumed most of the indirect taxes collected by the states and the Union. It is a comprehensive, multi-stage, destination-based tax levied on every stage of value addition. Introduced as "One Nation, One Tax" this simplified version of tax proved to be much more complicated because lets be real, centralization has never worked for India. To persuade opposition states to be on board for the transition to the new tax regime, a compensation scheme was designed. Goods and Services Tax (Compensation to States) Act, 2017 was enacted as a compensation to the states for the loss of revenue arising on account of implementation of GST. To understand why this cess was needed let’s go back to the time where instead of GST we had Central Sales Tax for interstate trade and commerce. CST was an origin-based tax which implies that it benefited the producer state more than states with higher consumption. For instance, if textile manufactured in Tamil Nadu was consumed in Madhya Pradesh, Tamil Nadu collected taxes on them.


But since GST is a destination/consumption-based tax the tables turned and now the Madhya Pradesh government would collect taxes. This caused strong opposition from states like Tamil Nadu and they put forth valid reasoning that to incentivize manufacturing they allocated a lot of funds on infrastructural development of highways, roads, ports, etc and so they were entitled to recover the returns on the same. To accommodate their demands, the Central government agreed to compensate them for the loss of revenue for 5 years due to implementation of GST. This cess was levied on items such as pan masala, aerated water, tobacco & tobacco products, motor vehicles, coal, etc. The calculation of compensation payable for an FY was the gap between the actual and projected revenues of the state. The expected growth rate of revenue for the purpose of calculating compensation was decided as 14% p.a. taking FY 2015-16 as the base year, which is quite absurd, to begin with. This generous compensation enticed the states to trade their powers for tax collection for some hefty sum for 5 years. Fast forward a couple of years, due to the economic slowdown, the state revenues were nowhere near 14% and the GDP was worse than ever before. As if the situation wasn’t bad enough, the pandemic caused the economy to worsen. The Union Finance Minister, Nirmala Sitaraman raised hands and confessed that the Centre won’t be able to honor their side of the bargain further arguing that the pandemic was an “Act of God”.


In the current fiscal, the compensation requirement of states was estimated up to 3 lakh crore, of which 65,000 crores have been collected through GST compensation Cess. This leaves us with a shortfall of Rs. 2.35 lakh crore (1.38 lakh crore of which is attributable to covid). In the 41st GST Council Meet held on 27th August 2020 states were offered two options for bridging this gap. The first option involved raising Rs. 97,000 crore (excluding the impact of covid on GST) through a special window by RBI, the principal, and​ interest for which would be repaid by extending GST compensation cess beyond five years. The remaining Rs 1.38 lakh crore, however, would be given to states after the principal and interest are repaid by extending the levy of compensation cess in a staggered manner after the transition period of five years is completed. This option will ensure a steady flow of resources similar to the bi-monthly GST Compensation. ​ The second option involved borrowing the​ entire Rs 2.35 lakh crore, including the impact of Covid-19 on GST revenues, from the market at the prevailing market rates but states would have to pay the interest from their resources. In the 42nd GST Council meeting held on 5​th October, the Centre and the states could not draw consensus on the issue of borrowing to make up for the compensation shortfall though the finance minister proposed to increase borrowings to 1.1 lakh crores instead of the earlier decided 97,000 crores. About 10 opposition-ruled states wanted a group of ministers (GoM) to review their proposals and add relaxations in the terms of borrowing or get the council to consider a third option which involves the Centre and states sharing the burden of the borrowing proposed to bridge the deficit. BJP ruled states backed the first option and wanted the Centre to roll out the special borrowing mechanism to get the resources flowing. They were clearly against the setting up of GoM. Council met again on 12​th​ October to further deliberate on the issue but no fruitful conclusion could be drawn because the Council is not empowered to increase the borrowings beyond June 2020 and all the details of the borrowing need to be discussed with the Union expenditure department. The deadlock over borrowing options remains unresolved.


By Nidhi Puniyani

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