Prepare For A Double Whammy On GST Compensation Cess

GST compensation cess, a central government tax on select ‘sin goods’, may see a rate increase and be levied for longer than the promised five years, BloombergQuint learnt from government officials in the know.

The revenue collected from this cess—in FY19 it was Rs 95,081 crore—is paid by the centre to the states to compensate for revenue lost due to the implementation of the goods and services tax rolled out in 2017. In subsuming a host of indirect taxes, the GST took away the right of states to levy indirect taxes and thereby deprived them of being able to control their revenue. In return, the central government promised to compensate states by paying them the lost revenue, for five years starting 2017-18, and assuming a 14 percent increase in that revenue every year. The compensation cess collected is to be paid to states every two months.

Except that with a slowing economy, India’s GDP growth rate is down to 5 percent and nominal growth at 7.5 percent, the compensation cess collections are lower than needed to pay states the promised amount. The unavailability of funds led to delayed compensation payments to states for August-September. The states, in a joint statement issued to reporters, had then complained that they are facing acute pressure on finances.

The problem of insufficient collections persists, but the law requires the central government to pay up, leaving it with only a few options.

OPTION 1
Ditch the 14 percent promise. But, as per the GST constitutional amendment, that will need GST Council’s approval. That is, approval from the states. Which will be tough as lower revenue hurts states’ ability to spend on their own social and economic programs. A confrontational approach may also seriously fracture the consensus on which GST has been built so far.

OPTION 2
Raise funds from elsewhere to make up for the shortfall in GST compensation cess collections.

Interestingly, while finalising the GST (Compensation to States) Act, the GST Council had decided that if the amount in the compensation fund falls short the council will decide on a mode of raising additional resources, including borrowing from the market, which could be repaid by collection of cess in the sixth year or further subsequent year. This was recorded in the minutes of the meeting.

But, at a time of rising deficits, the centre is unlikely to want to borrow more to pay the states.

OPTION 3
Raise the compensation cess rates to collect more tax. But at a time consumption is at multi-year lows, that may not necessarily boost revenue collection as consumers may postpone purchases.

OPTION 4
Extend the period of cess collection. This means while the centre is committed to compensate states only for five years, it can levy the cess for more years to collect revenue and make up for any shortfall in the previous five years.

The last two of the four choices seem easier to implement, and that’s what the centre will push, said two government officials on the condition of anonymity. Extending the period of the cess, beyond five years, is most likely they say as it’s not clear if increasing rates in a slowing economy will help garner adequate revenue.

But, Will States Agree?

If the compensation is delayed till the sixth year, every state’s budget will get affected, and their expenditures will suffer, TS Singh Deo, minister for commercial tax, Chhattisgarh, told BloombergQuint. If the centre deviates from its promise to compensate states at 14 percent growth rate every year, the states, after consultation, may end up challenging this, and move court, Deo, who’s also a GST Council member, added.

Denying adequate compensation to states will be breaching a contract when states agreed to forego their rights to taxation, Deo pointed out.

A resource-rich, but less-developed state like Chhattisgarh agreed to give up its right to tax minerals, and these revenues now go to the central government’s kitty, according to Deo. Despite this, if states are not adequately compensated, this would be ‘completely unfair’ for less-developed states like Jharkhand, Chhattisgarh and Odisha.

However, Tripura Deputy Chief Minister and Finance Minister Jishnu Dev Varma expects there won’t be any "great" impact on states’ finances if GST compensation is delayed till the sixth year. State governments should themselves take steps to increase GST collections, and improve compliance in their respective states, Varma told BloombergQuint.

Varma also said that he expects GST revenue collections and compensation cess collections to increase.

The Budget Clue

It’s not as if the Narendra Modi-led government is unaware that states may oppose any change to the bi-monthly compensation payment and expected amount. And yet, recent events indicate the centre has made up its mind.

The first clue to a shift in the centre’s stand was the presentation of the Union Budget 2020 on Feb. 1. In that, Finance Minister Nirmala Sitharaman made a comment that on the face of it seemed unnecessary.

“It is decided to transfer to the GST Compensation Fund balances due out of collection of the years 2016-17 and 2017-18, in two installments. Hereinafter, transfers to the fund would be limited only to collection by way of GST compensation cess,” she said.

In the first part she stated how excess cess collections in previous years had then been transferred to the Consolidated Fund of India and are now being transferred back to the GST Compensation Cess Fund. But the last bit—hereinafter, transfers to the fund would be limited only to collection by way of GST compensation cess—was puzzling. After all, that is what the law laid down in 2017 when GST was introduced. So what prompted the minister to reiterate that?

It effectively closed the door on any borrowing to meet the shortfall.

Also, in the days after the budget, at a finance ministry and industry interaction in Chennai, Revenue Secretary Ajay Bhushan Pandey said that 14 percent promised compensation was based on the presumption that economy will grow at the rate of 12-13 percent and therefore the collections would also grow at that level. “But we have seen during the last few months the actual economic growth has been lesser to some extent, and accordingly this would also get impacted. Whatever is getting collected in the fund, it will be paid (to states),” Pandey said.

Together, these two indicate the central government’s determination on this issue. That the centre will not dip into its own resources or borrow to compensate states.

Instead, as the government official told BloombergQuint, it is considering to extend the cess levy by at least a year. Any shortfall in the bi-monthly compensation to states this year, and in the next three years, will be compensated via cess collections in year six onwards, another government official said.

L Badri Narayanan, a partner at law firm Lakshmikumaran & Sridharan Attorneys said that the GST (Compensation to States) Act allows the central government to make adjustments to compensation payments in the subsequent year. But, this would be till the sixth year, at the end of transition, he said. The Act states that a shortfall in collection of cess in fund to pay compensation must be paid by the central government, Badri Narayanan emphasised.

He also noted that the law would need amending if the collection of cess is to be extended beyond five years.

That may not be difficult for the government to accomplish, given the BJP’s majority in the Lok Sabha. But the states are unlikely to give up without a fight. This may cause the first big fracture in the GST Council since it first met.