The Political Fix: Will upcoming compensation battle prompt India to examine GST’s many flaws?

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The Big Story: Under-compensation

Unlike in the years when the Congress was in power, the Bharatiya Janata Party’s massive majority in Parliament since 2014 and its complete centralisation under Prime Minister Narendra Modi has meant that you rarely get news stories about disagreements between ministries or top officials.

Which is why this report, from last week, is worth paying attention to:

“Taking a grim view of the GST compensation issue snowballing into a major controversy with even BJP-ruled states expressing concerns over non-payment by the Centre, the Prime Minister’s Office has sought explanation from the finance ministry, sources said.”

Stories about the Prime Minister’s Office “seeking explanation” from ministries are usually a clear indication of backtracking without admitting to it – or a pretence of accountability.

The context here is the extremely complex problem of the Goods and Services Tax compensation, one that involves the worrisome condition of Indian federalism, the country’s tottering economy and uncomfortable truths about even the current government’s flagship reforms.

Here is the issue, simplified:

• In 2017, the Centre managed to get states to agree to a common, nationwide tax regime called the Goods and Services Tax – which the BJP had opposed before it came to power. It aimed to turn India into a single market rather than one where differing tax regimes in various states stood in the way of commerce.
• This involved states giving up their taxation powers, and handing them to a Goods and Services Tax Council, with representation from every state. One-third voting power was in the hands of the Centre.
• To convince states to take such a drastic move – altering their status within the Indian Union – the Centre promised that it would compensate each one for the gap in revenue between what they earned earlier and any notional losses incurred under the new GST regime.
• Needing a formula to calculate this gap, the GST Council after much discussion settled on a simple assumption that state revenue would grow by 14% every single year – and that the Centre would pay this compensation for five years until 2022, with a presumption that wrinkles in the new taxation system would be ironed out by then.
• This promise was then enshrined in law, the Goods and Services Tax (Compensation to States) Act, 2017.

Now take a look at two news stories from the last few weeks:

• “The Central government will not be able to pay the promised 14% GST compensation to states due to low tax collections, Finance Secretary Ajay Bhushan Pandey is said to have told a parliamentary panel.”
• “The Attorney General has opined that the Centre has no statutory obligation to make up from its coffers any shortfall in GST revenues of states, which may now have to look at market borrowings against future revenue mop-up, sources said.”

The combination of these two developments, both seeming to suggest that the Centre was going to renege on its promise, led to major pushback from the states.

Punjab Finance Minister Manpreet Singh Badal wrote to the Finance Minister Nirmala Sitharaman saying, “must take note of Centre’s innumerable assurances in the run up to the GST to provide for assured and unhindered compensation.” Kerala said it would move the Supreme Court.

“Government can not back-off from the constitutional commitment,” said Delhi Deputy Chief Minister Manish Sisodia. Even BJP-ruled states like Karnataka indicated that they would pressure the Centre to honour its commitment. Bihar, where elections are due later this year, is said to be complaining too.

So we now have a news report of the Prime Minister’s Office stepping in. Sitharaman had earlier promised a one-point GST Council meeting to discuss the issue, originally intended for July but now expected before the end of August.

Does that mean the government will now decide to pay the compensation amount to states in full? The fact is that the Centre simply does not have enough money to do so.

When it was rolled out, the BJP-led government had made grand promises of the GST reform raising India’s overall Gross Domestic Product by 2%. At the time it set up a cess, putting a sin tax on luxury and “vice” goods, whose revenues would be used to pay the compensation.

In the first two years, the Centre was happy to take the excess funds collected from this cess – once the compensation had been paid – and treat it as its own revenue, a move some have called illegal or at the very least improper. Meanwhile, tax collections under the new GST regime were extremely underwhelming, with the gap between estimates and actual collections becoming ever larger.

With the economy struggling well before Covid-19 hit, Finance Minister Nirmala Sitharaman announced in the 2020 Budget in February that compensation would only be paid out of the cess collections – meaning if these fell short, it would not pay. And it is, indeed, falling massively short.

“The source of funding the GST compensation is a cess levied on consumption of specific items, including automobiles, coal etc. Such collections are likely to halve to Rs 494 billion in FY2021. This, along with a paltry estimated balance of unutilised cess of the prior years of Rs 255 billion at end-March 2020, pales in comparison with the sum of around Rs 4.6 trillion needed towards the total GST compensation requirement for FY2020 that was pending at end-March 2020, and the projected fresh demand for FY2021.”

Over the previous year, in fact, the Centre had begun seriously delaying its compensation payments – which my colleague Shoaib Daniyal wrote about here.

So how can the Centre pay? Some of the options discussed have been:

• Raising GST rates – politically sensitive and likely to hurt the public in the midst of an economic, demand-side crisis.
• Having the GST Council itself borrow to fill the gap – no certainty that the Council has the legal, corporate personality to do so, and sets up certain problems in future years while servicing that debt.
• Having the Centre borrow to fill the gap – which the Modi government, already struggling with its own deficit, simply does not want to do.
• The Centre could also simply refuse to pay – as the news reports seem to suggest it was willing to consider – or attempt to renegotiate the 14% rate, citing the economic crunch caused by Covid-19 and a need to adjust.

While the government may indeed end up choosing the last option, any decision to go back on unequivocal promises made when GST was being negotiated risks a breakdown in trust between Centre and states, which may explain why the PMO has got involved.

In a paper that is a must-read for anyone interested in the topic, V Bhaskar and Vijay Kelkar draw out the many problems with the GST compensation design, which reflect the broader problems that have made the tax reform fall way short of its expectations from the very beginning.

The paper, for example, points out that

• The compensation cess should have been seen as a cushion to make up for uncertainty in the new regime, but was treated by the Centre as revenue.
• That the compensation design was vastly different from the model used during the Value Added Tax roll-out, which incentivised efficient tax collection from the states.
• That the 14% growth rate presumption had no basis in reality and so was flawed from the very beginning
• and that the lack of an independent GST Secretariat means the Council has in the past made decisions on tax rates with “no mention of the tax base, the tax elasticity of the commercially important goods, the loss anticipated by such reduction and the anticipated increase in buoyancy through such measures”.

While concluding that the Centre may not have a legal obligation to pay the compensation, Bhaskar and Kelkar argue that it does have a moral imperative to do so, moreover at the promised rate.

As importantly, the paper argues, “It must be remembered that the compensation cess was designed to be self-limiting. If state ‘losses’ on account of GST continue, it means that the GST model should be restructured, not that the compensation template should be reviewed.”

More than three years into Modi’s flagship reform, GST still has – according to the chairperson of the 15th Finance Commission in December 2019 – “a cluttered rate structure, enormous challenges of compliance, challenges of technology”. The chairman called for the government to “go back to the drawing board in spite of the fact that this may or may not be the appropriate time for it”.

The need to re-examine this, as well as many other aspects of GST, appear obvious. But is the government willing to have that conversation?

Flotsam and Jetsam

Here is a collection of links to read this week, including a number of key pieces on the Ram Temple in Ayodhya that we wrote about last week.

More than 2.1 million total Covid-19 cases have been registered in India, with over 43,000 deaths.

Congress leaders are still calling on the Congress to solve the Congress’ leadership problems. The Rajasthan Assembly is set to hold a floor test for the Ashok Gehlot government on August 14.

Manoj Sinha, a BJP politician, has been made the new Lieutenant-Governor for the Union Territory of Jammu and Kashmir. Defence Minister Rajnath Singh announced an import ban on 101 items related to the Indian military.

That’s all for today’s The Political Fix. Send feedback to rohan@scroll.in, and if you enjoy this newsletter please do share it.