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The debate on Goods and Services Tax compensation for states, earlier discussed in hushed tones, has now assumed centerstage. It was expected that current economic strain would impact GST collections and in turn take a toll on the Government of India’s resources, especially on account of having to compensate states for revenue loss. Having been confronted by select state finance ministers publicly, the central government sought opinion of the Attorney General, with a view to resolve it amicably, including options for raising finances to meet the shortfall.

The moot question that emerges is shaping the way forward with respect to the centre’s obligation to compensate the states in respect to GST.

It is interesting to note that when the models were being constructed for a grand bargain of the Goods and Services Tax, as a centre-state conjointly implemented fiscal measure, the 2009 taskforce on GST recommended that the centre should not be obliged to compensate states which fail to adhere to the roadmap for implementation of GST “to establish a mechanism whereby the defaulting state is made liable to pay for the negative externalities”. Essentially, a carrot-and-stick model was envisaged where the availability of compensation to the states was tied down to steps towards GST implementation.

The political bargain and then circumstances, at the time of 2016 constitutional amendment, however, ensured that final design was a one-way obligation upon the centre where the states carried a statutory right and constitutional assurance of compensation. The assured compensation was predicated on the assumption that states would be able to secure the GDP growth on account of the GST implementation, which assumption, however, has not fructified due to slow-down in past ten quarters.

The Covid-induced crisis has merely worsened the situation. As things stand, there are no caveats in the GST compensation law and the centre is legally mandated to compensate any shortfall in the GST revenues of each of the states, so as to achieve a 14% increase in state GST revenue year-on-year.

The obligation commenced in July 2017 and the three years of its implementation reveal that it has been by and large dutifully abided; there may have been delays but no denials. 

Hence, the spirit of cooperation and the cooperative federal ideal has, thus, been achieved without demur. The states must be complimented for adhering to the GST design and implementation without deviations.

But the compensation requirement has been steadily climbing, even earlier, with the situation becoming precarious in Covid-19 months since April. Analysis of the July 2020 data offers a true assessment of the situation.

Total GST collection in July stood at Rs 87,422 crore, less than Rs 90,917 crore collected in June 2020, which was a catch-up month.

The State GST component for July is Rs 21,418 crore, as against Integrated GST of Rs 42,592 crore – leaving the balance Central GST of Rs 16,147 crore and Compensation Cess of Rs 7,265 crore, which is clearly not sufficient to defray the shortfall to states.

It’s fair to assume that the collection trends for rest of this fiscal year and possibly 2021-22 will continue to be subdued unless there is pick up in the last two quarters.

As per the centre’s statement, the total GST compensation paid to states for FY 2019-20 was Rs 1,65,302 crore whereas the GST Compensation Cess collected was only Rs 95,444 crore.

In other words, for the first time in three years the GST Compensation Cess collected was not sufficient and significantly dug into the coffers of the union even in a normal year.

To be sure, the centre was able to pay this from surplus Compensation Cess amounts collected in the previous two years.

The present circumstances are a test of character for the stakeholders and the response shaped now institute itself as a crisis-resolution benchmark for times to come. And hence, a calibrated designed response to the importune moment cannot be overemphasised.

Bridging The Gap

It appears that various options are being discussed, including legal, given that the states are vehemently opposed to any dilution of the compensation obligation, particularly in these times when state finances are equally, if not more stressed. 

It must, however, be noted that the central point of all options is contingent upon the GST Council. Article 18 of the GST Constitutional Amendment postulates the Government of India’s compensation obligation upon recommendations of the GST Council. In other words, the underlying legal tenets of the Compensation Law can indeed be rewritten, though upon GST Council’s recommendation. Given the decision-making modalities of the GST Council, this implies that no unilateral change can ensue, and the states must agree before the compensation obligation can be rewritten.

Review of compensation mechanism as an option holds vital clues on the possible scenarios. In our view, an ideal solution is one which is acceptable amicably to the centre and the states.

There cannot be hint of doubt that the current situation is temporary which requires solutions and not a revisit of the design and hence, deferment appears to be the best compromise.

This will provide the necessary breather to the centre to divert its resources for upliftment of the economy to address the growth trajectory. Simultaneously, in a deferment, the states would not lose the unpaid compensation entitlement which would stand restored once the GST Council, of which the states are an integral part, assesses resumption of normalcy. The advantage with temporary deferment is that the states may, through their common voice at the GST Council, impress upon the centre for an extension beyond the balance two years, or find other ways to ensure that the temporary loss is recouped.


The other options being discussed include the central government raising additional resources, including by borrowings from the market and collection of cess beyond the fifth year. 

If market borrowing is decided as the way forward, the centre will be pushed to approach the market multiple times for raising resources to compensate the states suggesting a further rise in the debt-GDP ratio, impacting market sentiment, and sovereign-ratings with interest-burden taking away funds needed for growth revival. hough, one school of thought believes growth revival is paramount and slippage in the debt to GDP is not a priority, the centre borrowing to pay states sounds like, robbing Peter to pay Paul! In principle, this seems like subsidising the states without any matching commitments by the latter to invigorate economic activity. Given the juncture where the economy stands, the centre can ill-afford to exercise an option of raising debt to meet its compensation obligation.

Irrespective of the choice, being technically right does not automatically translate into being morally right. This applies equally to the central government and the states, who may insist upon their entitlements. he spirit of bonhomie which underlies the functioning of the GST Council has been achieved by extraordinary commitment and sacrifice by all stakeholders. A strain in ties due to trust breakdown will shake the spirit of the GST design. Wriggling out of the obligations by taking recourse to the fine-print of the law is bound to create an impasse in actions of the GST Council, which both sides can ill-afford given the fragile balance and decision-making mechanism of the Council. Health-crises is an extraordinary situation which occasioned with economic-crisis must be met resolutely and cohesively by all actors.

State Reforms
The states on their part, will do well to relax their insistence on continuation of the existing regime and instead borrow on either their own strength (not all states could possibly) and/or backed by central government’s guarantee to focus on economic revival, a shared responsibility.

If the states are not inclined to borrow or have exhausted their borrowing capacity, perhaps it is time to undertake overdue reforms.
The fact remains that the entire tax-reforms agenda has been driven by the centre. A closer look at List II of the Constitution’s Seventh Schedule reveals the wide ambit of the states’ taxing powers which have remained unaffected by subsumation exercise of GST. The states have done little to use tax-reforms in these spheres as an avenue for boosting growth and subsequently raising resources. Undoubtedly, these would be dubbed as non-popular, but aren’t these reforms due? Instead the reliance is on traditional measures, for illustration, the states’ decision to make use of the Covid crisis to raise tax on petroleum products. Rationalisation of states’ other revenue garnering measures, such as stamp-duties, alcohol, tolls, professional taxes, and a host of constitution-delineated taxes could contribute towards the states’ coffers.

Furthermore, the laws relating to agricultural taxation and land revenue, which are within the exclusive fold of the states, have not been revisited since independence. The changes in the economic realities, rich-farmers, contract farming, bumper harvests, etc. are good reasons for states to adopt a differential parameter so as to share the proceeds of their efforts in improving agricultural productivity. These choices require political-will but indeed offer long-term solutions and overcoming their dependence upon central resources.

Let the states’ reforms be of such magnitude that the next Finance Commission would not find a reason to recommend sharing of Government of India’s tax revenue because the states themselves have outgrown their dependence on the centre.

Mukesh Butani and Tarun Jain are Partners, at BMR Legal Advocates. The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.

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