COMPENSATION FOR STATES FOR REVENUE LOSS FROM GST REFORMS

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Picture Courtesy:  THE HINDU

Context

The proposed GST reform to simplify the tax structure is expected to result a short-term drop in revenue for states, raising the demand for extending the compensation cess.

GST REFORM: SIGNIFICANCE, CHALLENGES AND WAY FORWARD

What is GST Compensation CESS?  

GST Compensation Cess, governed by the GST (Compensation to States) Act 2017, is a tax levied on specific goods and services to compensate states for revenue shortfalls resulting from the shift to the GST system.  

• Revenue from the Cess is deposited into the Goods and Services Tax Compensation Fund.

List of Products currently under the GST Compensation Cess

• Pan masala
• Tobacco, tobacco products, and tobacco substitutes
• Coal, briquettes, ovoids, and similar solid fuels manufactured from coal, also includes lignite and peat.
• Aerated waters
• All luxury cars and Motorcycles of engine capacity exceeding 350 cc.
• Other aircraft (e.g., helicopters, airplanes) for personal use.
• Yachts and other vessels for pleasure or sports.
• Some specified goods under the GST regime.

Compensation formula: State's tax revenue from the financial year 2015-16 serves as the benchmark.

• Central government assumes a 14% annual growth rate on the base revenue for each financial year.
• Actual GST revenue collected by a state is subtracted from its projected revenue.
• If the actual revenue is lower, the central government compensates the state for the shortfall.

Initially introduced for five years (ending June 2022), however, extended to March 2026, mainly to repay ₹2.69 lakh crore loans taken during the COVID-19 pandemic.

• Centre borrowed (₹1.1 lakh crore in FY 2020-21 and ₹1.59 lakh crore in FY 2021-22) and passed them to states as loans, covering revenue shortfalls during the COVID-19 pandemic.
• Government plan to end the cess collection, possibly by October 31, 2025, as pandemic-era loan repayments near completion.  

Recent GST Reform Proposal and its expected impact  

Rate Cut: Simplifying GST rate structure from its current multi-tier system to a two-tier structure of 5% and 18%, with a separate higher rate applicable only on a limited set of luxury or demerit goods.

Maintenance of Revenue (Long-Term Strategy)

• Higher rates (around 40%) on sin goods and luxury goods will help recover some revenue.
• Lower tax rates on essential goods and durables will increase consumption.
• Increased compliance and formal billing systems will reduce leakages.
• Growing compliance and increased demand will largely offset the initial revenue dip.
• Reforms also aim to attract more manufacturing and investment into India.

Lower Average Tax Rate: Average tax rate was around 15% before GST and reduced to about 11.5% after GST implementation and next rate cuts, is estimated to drop to 10% after these proposed cuts. (Source: The Hindu)

Challenges related to Recent Proposal

Revenue Loss from Rate Cuts: Proposed rate cuts will lead to a real short-term revenue impact. Estimates suggest a potential impact of ₹60,000 crore to ₹1,00,000 crore per year, about 0.2-0.3% of GDP. (Source: The Hindu)

Uneven Revenue Impact on States: GST revenue distribution is not equal among states, thus the impact of tax cuts.

• Manufacturing and service-heavy states with strong urban centers, like Maharashtra, Karnataka, and Tamil Nadu, will experience a visible hit to their immediate GST revenue collection
• States more dependent on agriculture, such as Bihar or Uttar Pradesh, may not experience revenue dent, as their consumption basket mainly includes essentials already exempted or in lower slabs.
• Smaller, less industrialized states receive a negligible share of total GST collections.

Expiry of Compensation Guarantee: Centre compensation guarantee for revenue losses has now ended. 

• Relying on regular compensation from the Centre for taxation losses is not a sustainable long-term option for a country like India.

Concern Regarding Reforms: States feel nervousness about the rate cuts and rationalization, however, they need to understand the long-term benefits of such tax reforms.

Potential Disagreements within the GST Council: PM announced GST consensus proposal, however GST council is still to discuss "rate and products" category, and compensation to state for loss.

• Disagreements might arise over products' slab classifications (e.g., 5% or 18%) or the effective date of the changes.

Way Forward

New Compensation Mechanism: Despite the end of the guarantee period, a mechanism to compensate states is necessary due to the unequal distribution of GST revenue, especially for smaller, less industrialized states.

• Alternatives include a mechanism within the Consolidated Fund of India, providing support through special packages.
• Creating a separate contingency fund where a part of GST could go, allowing the GST Council to allocate funds based on a state's specific situation.

Strengthen State Fiscal Autonomy: States must prioritize developing self-sufficient revenue generation systems.

• Improving internal tax administration, plugging leakages, broadening their tax base, and actively attracting investment.

Adopt "Next Gen GST" Reforms Strategically: Simplified two-slab GST structure (5% and 18%) aim to enhance affordability, boost consumption, reduce classification disputes, and improve ease of doing business.

• States must understand the long-term economic benefits and collaborate for successful implementation.

Ensure Equitable Revenue Distribution: GST Council must address the unequal impact of GST revenue distribution and rate changes across states. Future reforms and support mechanisms should ensure fairness and balanced development.

Source:  THE HINDU