With the Centre refusing to pay compensation to states, is GST nearing an end?

It fails every time – yet Indians love to imagine that centralisation is a solution to the country’s problems. It happened with Nehru’s Planning Commission, which went from being a consulting body to one that allowed New Delhi to dictate to the states. And it is now happening to Modi’s Goods and Services Tax. The “One Nation, One Tax” meant to simplify India’s federal taxation structure is now so complicated, some exasperated politicians are talking of returning back to the old system again.

Thursday saw GST receive a particularly significant blow, as the Union government made it clear that it would be reneging on the promise to pay states the compensation promised to them at the time India changed its taxation systems. Introduced in July 2017, the GST subsumed nearly all indirect taxes collected by states and the Union. To persuade states to move to the new regime, the Centre promised to cover the shortfall in their tax revenues for five years through a new GST compensation cess.

For 2020-’21, the gap between projected tax revenues and GST collections for all states is stunning: Rs 3 lakh crore. In comparison the GST compensation cess, meant to bridge this gap, is projected to generate only Rs 65,000 crore. This leaves the states short of Rs 2.35 lakh crore.

Evading its responsibility

Rather than step up and make up this shortfall, the Modi government has washed its hands off the matter. On Thursday, as part of the GST Council meeting, the Union suggested that states make up the shortfall by borrowing from the Reserve Bank of India. Currently, the exact details of how this borrowing would be facilitated have not been spelt out, with the Kerala Finance Minister complaining that the scheme proposed by the Centre actually stopped the states from borrowing the entire shortfall amount.

The Union government also made a distinction between the shortfall due to the introduction of GST and that caused by the Covid crisis. It put the former number at Rs 97,000 crore and that caused by both, it argued, was Rs 2.35 lakh crore. The Union finance minister Nirmala Sitharam called it an “act of God” thus arguing that it was not GST itself that was responsible for this massive shortfall.

Except this seems more an excuse than fact. It was clear in 2019, months before the first coronavirus case, that compensation would fall short, with the GST Council even discussing the matter in September. In fact, GST has struggled right from the start compared to the tax regime it replaced.

Why compensation

To understand why the Union government’s stand is so problematic, we need to go back to why the concept of compensation was introduced in the first place.

In theory, the GST would generate as much revenue as the previous tax regime. However, the new regime meant that consumption, not manufacturing, would be the point of tax – which meant manufacturing states would lose out. Tamil Nadu, for example, was vociferously against the very idea of a GST.

It was to assuage these states that the idea of compensation was mooted. To make this promise watertight, the idea of compensation was both written into the Constitution and its finer details passed by way of central legislation. It was assumed that state revenues would grow at a rate of 14% year-on-year on a base of the state’s tax revenue in 2015-’16. Any gap between this projection and actual GST revenue would be the compensation. This would be financed by way of a special compensation cess, levied over and above the GST on sin (for example, tobacco) or luxury goods (for example, SUVs).

That the rate of growth for the GST revenue projection was hard-wired rather than be linked to economic growth was unusual. While a proposal to link the rate of growth of projected GST revenue to GDP growth was discussed in the GST Council on October 2016, it was not eventually taken up. Assuming state revenues would grow by 14% was – even at the time – absurd. The GDP growth rate for 2015-’16 and 2016-’17, for example, was far short of that figure at 10.5% and 11.8%, respectively. Since then, things have become much worse with a growth of 4.2% in 2019-’20 and a significant GDP contraction expected in this financial year due to Covid-19.

A carrot for the states

So why was the GST compensation fixed so high? While it was called “compensation”, it actually served a dual purpose: it was so generous that it acted like an incentive for states to accept the GST.

While GST has been forcefully opposed by the states in the previous Manmohan Singh-led Union government – including by Gujarat chief minister Narendra Modi – this opposition melted away when cash-strapped states saw this juicy carrot dangled before their eyes. In effect, states were ready to barter their powers of taxation for the short-term promise of increased revenues. Given how sought after the power to tax is in modern politics, this was, to say the least, unusual. But with states cash-strapped, this gave parties ruling them a chance to spurge for the next election. Even Tamil Nadu – the most recalcitrant state when it came to GST – was happy with this windfall.

For the Centre, the payoff was clear. The structure of the GST council gave it significant powers to decide taxes for the entire Indian Union. It also helped the Bharatiya Janata Party politically, since it could claim that it had cut through a Gordian knot.

Maybe for the first time in world history, a new tax was introduced by the government as an achievement, with a special GST midnight ceremony of Parliament in 2017. “Historic” called it one newspaper: “from today India is finally one nation, one tax”. Captains of industry were similarly enthusiastic (if spectacularly off the mark). “There is absolutely no doubt the GST will boost GDP, as the new tax regime will remove hassles to trade,” Infosys founder NR Narayana Murthy said on the day the GST was launched.

Centre’s promise

Since then, of course the Union government has, so to speak, reneged on this deal. While it still maintains its expanded powers of taxation, the states have not got their revenue windfall. The Attorney General of India, the Union government’s legal advisor, has argued that there is no legal requirement for the Union to pay states compensation.

This might eventually not be borne out in court but it is noteworthy to remember that the GST Council did discuss an explicit legal clause requiring a compensation guarantee. In January 2017, Karnataka argued that the draft GST compensation law should be edited to guarantee the fact that full compensation would be paid within five years. To this, the Union government agreed, assuring that the agreed-on compensation would be paid even if the cess fell short. The council itself decided that the law should be amended.

This was, however, not done. When Telangana asked why it hadn’t in a GST council meeting in February 2017, the Union government assured the states that compensation was guaranteed and “the Central government could raise resources by other means for compensation and this could then be recouped by the continuation of the cess for more than five years”.

Moreover, at no time was linking compensation in any way to economic growth discussed. In fact, even when a proposal to that effect was raised in the GST council, it was rejected in favour of a hard-wired rate.

Thus, no matter the legal position, it is clear that states were guaranteed compensation by the Centre that was not linked in any way to economic performance. Without this generous compensation, in fact, it is unlikely that states would have agreed to GST in the first place.

Other options

On Thursday, the Centre gave the states an option where they could borrow from the Reserve Bank of India on the basis of future compensation cess. This would mean a compensation cess that lasts far beyond five years, with the Indian taxpayer footing the bill for this new tax regime. It would also mean a complete negation of the “one nation, one tax” promise with a cess – on top of multiple GST slabs – lasting for years, maybe even decades.

If states do not agree to the Centre’s offer, what other options could be explored?

In theory, states could agree to accept a lower rate of growth of compensation or a shorter time period. However, this seems unlikely given that it has been discussed and rejected by states. This is expected given how cash strapped they are in the wake of the pandemic, since in the Indian federal scheme, states are in charge of health.

Some people, such as Kerala finance minister Thomas Isaac, have suggested that the GST council itself should be allowed to borrow and the money repaid from the compensation cess. However, the legality of the council borrowing money is unclear – it isn’t a sovereign entity. In the end, the loan would have to be underwritten by the Union government, which of course makes it an unappealing proposition for New Delhi.

Ideally, since it was part of the initial GST dealmaking, the Centre should itself provide the money from either its own taxes or by borrowing from the market. New Delhi is, however, unwilling to do this given that its own fiscal situation is extremely precarious with measures such as demonetisation, Covid-19 and, ironically, GST itself, taking the wind out of the Indian economy’s sails.

The final, nuclear option is the end of GST, given that the initial deal that facilitated the tax now lies defunct. As of now Maharashtra, Chhattisgarh and Puducherry have proposed reverting to the older regime of allowing states to raise their own taxes.

However, reflecting the original divide at the time of the introduction of GST, poorer, consumption states such as Bihar or West Bengal would be less eager to change this system which still benefits them relatively. To add to this is the fact that India is expecting a long and protracted economic slowdown, which means tax collection would be poor, no matter which regime is in place.