The Goods and Services Tax (GST) Council meeting this week did not extend the revenue compensation period for states beyond five years, overriding a demand by several states. The rationale behind the compensation was to offset the cost of transitioning to a new tax system. When tax rates were harmonised across the country, some states benefited and some suffered a temporary loss of revenues due to pre-GST differentials in tax rates and base. The compensation was to protect states in the process of transition to the new regime. In a federal system, compensation is a transitional cost of fiscal harmonisation.
However, the pandemic complicated the transition process. Apart from economic contraction, it created unprecedented disruption in fiscal management. The amount of borrowing needed to finance GST compensation ( ₹1.1 lakh crore in 2020-21 and ₹1.59 lakh crore in 2021-22) itself is an example of one of the dimensions of such disruption.
Going forward, the fiscal stance is likely to remain expansionary and public expenditure will continue to remain high. The withdrawal of fiscal support to the economy may have adverse consequences. Thus, from the perspective of pandemic management, the demand for an extension of the compensation period by the states is not surprising.
However, the revenue needs at the state level cannot be seen through the SGST lens alone. GST revenue at the state level constituted around 41% of taxes (as per 2019-20 accounts); 59% was collected from other sources, including excise, petroleum, and other taxes. The collection of taxes from these sources was also affected by Covid-19.
The aggregate own tax revenue of states during the pandemic contracted. As per the data available from state budgets, in 2019-20 (pre-Covid-19), all states own tax revenue collection was ₹11,75,576 crore and in 2020-21, (during-Covid-19), it was ₹11,31,058 crore. Thus, the aggregate shortfall was was ₹44,518 crore. The SGST revenue contracted by was ₹37,887 crore between 2019-20 and 2020-21. As per Reserve Bank of India’s study on state finances, the volume of compensation received by states and Union Territories in 2020-21 (RE) was ₹1,13,110.11 crore. This amounted to 298.54% of the SGST revenue shortfall that year.
More than 298% revenue support through compensation against the actual revenue shortfall of ₹37,887 crore in 2020-21 was due to the very high rate of compensation (at 14% decided by the GST Council while introducing GST) and the revenue contraction due to the pandemic. The own tax revenue growth before the pandemic, between 2015-16 and 2019-20, at the state level, was 9.7%. This also implies that the estimate of loss — based on a growth rate significantly higher than the actual growth rate of taxes — has increased the cost of tax harmonisation way above the normal rate of growth of GST.
This has both equity and efficiency implications. This compensation mechanism rewards states whose tax growth performance is below 14% and penalises states growing above 14% per annum undermining efficiency. If revenue compensation has to continue, it needs to be redesigned to factor in the actual tax performance of states post GST. A numerically fixed growth of revenue, uniform across states, doesn’t have an inbuilt mechanism to incentivise revenue collection and is also fiscally regressive as it does not take into consideration state-specific challenges concerning tax collection.
The optimal time horizon of compensation to support tax reform in the federal system is also an issue. We should note the introduction of value-added tax (VAT) was supported by a compensation mechanism for three years. The reduction and eventual elimination of the central sales tax (CST) rate was again supported by a compensation mechanism, though the compensation requirement was much lower.
In the case of VAT, the compensation for the first year was 100%, for the second 75% per cent and for the third year, 50%. The GST constitutional amendment accommodated the full five-year compensation as a part of the GST constitutional amendment. A temporary provision such as compensation, for a specified period, became part of the constitutional amendment to assure states about its certainty and to enhance trust in the federal system.
Going forward, to understand the challenges of fiscal space at the state level, one needs to take an aggregate view of the revenue shock, including revenue transfers to the states. It is also important to note that there is a significant post-Covid-19 recovery of own tax revenue at the state level and on a month-on-month basis. GST revenue has shown an increase in growth between November 2000 and May 2022. At the same time, the GST design issues remain very important. As observed by the Fifteenth Finance Commission, there are structural issues due to changes in the tax structure from the origin-based taxation regime to the destination-based GST regime. The commission stressed the need for resolution of such structural issues “to minimise the fiscal and economic impact of GST”.
Finally, the impact of Covid-19 is asymmetric across states. The state-level growth and revenue recovery are also asymmetric. A uniform compensation rule is unfair to states that managed Covid-19 better and recovered faster. Maybe it is time to think of a state-specific fiscal support programme if necessary, not linked to GST, especially when expenditure needs differentials across states due to Covid is different. If compensation needs to continue, it should devise a design that incentivises revenue collection and brings down the fiscal cost of tax harmonisation significantly.