In view of the dwindling tax revenue (courtesy, reduction in their own collection as well as their share in taxes collected by the Centre as per the Finance Commission devolution formula), even as the states are demanding full compensation for the shortfall from the union government, the latter has not only been making short payment but the amount is released after considerable time lag. For instance, the compensation for October/November, 2019 about Rs 34,000 crore was released in February/April, 2020. The economic devastation triggered by a prolonged lockdown has only made matters worse.
With states revenue virtually drying up during the first two months of current financial year (the trend is expected to continue through most of the year), while they have put up hefty demand for compensation, the Centre may be contemplating what in legal jargon is referred to as ‘force majeur’. In plain words, the latter may have indicated its inability to pay in view of an emergency situation beyond control or an ‘Act of God’ (read: Corona).
To understand the unfolding scenario, conflict of interest between the Centre and states and how best it can be resolved, it is necessary to check out a few basic facts.
The idea of introducing the Goods and Services Tax (GST) was mooted way back as 2006 by the then finance minister, P Chidambaram under the erstwhile UPA – government led by Dr Manmohan Singh but could not bring it to fruition. A major reason was its refusal to accede to the demand of the states for compensation of 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.
The demand for compensation was spearheaded by Narendra Modi who was the chief minister of Gujarat during that period. GST being a consumption oriented tax, major producing states such as Gujarat, Maharashtra, Tamil Nadu etc were worried about huge loss of revenue; hence, they pestered the Centre for compensation as a pre-condition for taking up a constitutional amendment bill on GST. But, the UPA – government refused to oblige.
On taking charge in 2014, NDA – government led by none other than Modi himself and having felt the pain (while sitting in the other chair as Gujarat CM) succeeded in bringing all states on board. In August, 2016, it passed a constitutional amendment bill leading to its launch from July 1, 2017. It also carried through the GST Compensation Act (2017) to provide for compensation to the states for 5 years i.e. till 2021-22 for the loss of revenue to be calculated as the difference between actual collection and the amount they would have got with annual growth @14% over 2015-16 level.
However, to ensure that the Centre got enough funds in its kitty 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%) such as automobiles, tobacco, drinks etc with a proviso to use the proceeds for compensating the states. The cess was to remain in force for 5 years in sync with Centre’s obligation to compensate states for the corresponding period.
The rationale behind dispensing with the compensation obligation as well as the levy on completion of 5 years is that by this time i.e. 2021-22, the GST dispensation would have acquired the much needed vitality and resilience to yield sufficient resources for the states 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.
Therefore, the two provisions in the law 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 the first two years viz. 2017-18/2018-19, the collection from cess was higher than the shortfall faced by states. For July 2017-March 2018, the cess collected was Rs 62,600 crore against Rs 41,150 crore needed for compensating the states. During 2018-19, the cess collection was Rs 95,000 crore against Rs 69,000 crore distributed among states as compensation. Thus, at the beginning of 2019-20, there was surplus of about Rs 47,000 crore in the pool.
However, the situation deteriorated during 2019-20. Against the requirement of over Rs 135,000 crore, proceeds from the cess were just about Rs 95,000 crore leaving deficit of about Rs 40,000 crore. During the current year, thanks to lockdown, proceeds from the cess are estimated to be less than 50% of monthly compensation requirement of over Rs 20,000 crore. For the whole year, this works out to deficit of around Rs 125,000 crore in the cess pool.
Going strictly by the spirit of the two constitutional amendments, when there is not enough money in cess pool, the compensation to states needs to be reduced to the balance the two. But, the states are unwilling. They insist that Centre must fully compensate them even if the amount in the cess pool is less. If, the latter concedes, its fragile finances (due to likely shortfall tax collection: about Rs 400,000 crore, ballooning expenses on health infrastructure and welfare measures such as PM Garib Kalyan Yojna: Rs 170,000 crore; additional allocation for MGNREGA: Rs 40,000 crore; employment scheme for migrant labor: Rs 50,000 crore etc) could reach a tipping point.
True, the Centre has the option of additional borrowings or even asking the Reserve Bank of India (RBI) to print more currency. But, both are prone to serious risk. Already, it has increased its borrowing program for the current year by 50% to over Rs 1200,000 crore. Increasing the borrowings further will crowd the bond market and increase interest rates. On the other hand, monetizing the deficit has inflationary implications; besides, it sends a wrong message to stakeholders especially rating agencies, about India’s ability to protect its macro-economic fundamentals.
What then is the way forward? How can the states and the Centre come out of the crisis situation without undermining India’s economic fundamentals?
The states should avoid taking a legalistic position and works closely with the Centre – in the spirit of cooperative federalism – to address the issue. A way out could be to continue the cess on demerit products beyond the 5 year period by further amending the GST Compensation Act (2018). Meanwhile, the deficit in the cess pool may be met from additional borrowings to be serviced from the cess collection during the extended period starting from 2022-23.
The states have made a submission before the 15th Finance Commission for continuing with compensation scheme even beyond 2021-22. They should refrain from pursuing it as the scheme was only meant to be a temporary arrangement till such time the GST acquires ‘robustness’ and ‘resilience’ to yield the desired revenue. Indeed, 5 year period is long enough to enable full stabilization of the new regime and achieve its full potential. Unfortunately, things are not unfolding the manner in which they ought to be.
There is widespread evasion and fraudulent transactions causing huge loss of revenue. According to a statement by minister of state for finance, Anurag Thakur in reply to a question in Rajya Sabha, loss to the exchequer due to frauds under GST (including bogus claims of input tax credit) was about Rs 45,500 crore since the roll out of the tax reform on July 1, 2017 (according to Dr Amit Mitra, finance minister, West Bengal, this could even touch the Rs 100,000 crore mark). Unless this is fixed by undertaking complete overhauling of the administrative machinery to prevent frauds and plug leakages, we won’t get to a system which is self-sustaining.
To conclude, the GST Council may offer an olive branch via continuing the cess beyond 2021-22 to service the loans to be taken now for plugging the current deficit in the cess pool. Further, the states need to plug all loopholes in the administration of GST and also tighten their belt amidst Covid – 19 crisis which will help rein in their deficit in turn, moderating their demand for compensation. The Council should galvanize them on this broader point.
It may brainstorm on both these points in its next meeting.