GST Compensation: Defer Centre’s Outgo, Don’t Deny States Their Due - Drabu
State Finance Ministers at the 14th GST Council meeting in Srinagar, on May 18, 2017. (Photograph: Arun Jaitley/Twitter)

GST Compensation: Defer Centre’s Outgo, Don’t Deny States Their Due - Drabu


The GST Council’s meeting on the compensation issue went along expected lines. Not only is it unlikely to be resolved in a hurry, but it will also test the effectiveness of the GST Council as a federal institution. Indeed, it looks like the consensus-based approach which has been the DNA of the Council will undergo a change. Rather sad, especially for someone who was a part of it in the formative stages, to see states being forced to reach out to the judiciary. Courts shouldn’t be asked to decide between adversaries what the Council should have done between partners.

Actually, the last GST Council meeting started on the wrong note. In order to build a consensus on the compensation matter, the Finance Minister should have started with the unambiguous assurance that the Centre is bound to honour its commitment to compensate states as it has done so far. Had that been done, the Chair would have heard a huge collective sigh of relief in the room! Far from doing so, a case for wriggling out of the commitment was sought to be built by tabling the opinion of the Attorney General. It should not have been made into a ‘centre versus states’ issue; it is not.

It is the travesty of times that the sovereign is behaving like an insurance company invoking an “Act of God” to renege from its obligation to compensate states for a revenue shortfall.

How The Deal Was Reached

The principle of compensation, its means of financing, and modalities of distribution have all been agreed by the Union Finance Minister with the State Finance Ministers and then passed by the GST Council, got included as a part of the GST Act and incorporated in the Constitution as amended by Parliament. Then the legislative assemblies of all the states and union territories approved it. It is not a bilateral deal between two ministries or an executive decision.

Also, to be sure, compensation was the basis of the final acceptance of the GST by states. It was loud and clear in the GST Council meetings; no compensation, no GST. If there is any backtracking on it, not only will the assiduously built consensus on GST break, it will breach the fiscal federal edifice of India.

The compensation scheme was not designed as an ‘insurance’ but as a ‘minimum guarantee’ of 14% annual growth. This number, in the absence of an empirical basis and analytical rationale, is open to question.

I had articulated my serious concerns in the GST Council in 2016-17 on what I had then called an “open-ended compensation scheme”—this is recorded in the minutes if the GST Council—on the grounds that it covers generic revenue shortfall and not specific revenue shortfall.

But the “sense of the house” – a term on which the sagacious Arun Jaitley decided everything – was that it is the price that the Union has to pay for realising its “One Nation, One Tax” dream.

Then Union Finance Minister Arun Jaitley with J&K FM Haseeb Drabu,  MoS Finance Santosh Gangwar, and Revenue Secretary Hasmukh Adhia, on May 19, 2017. (Photograph: Arun Jaitley/Twitter)
Then Union Finance Minister Arun Jaitley with J&K FM Haseeb Drabu, MoS Finance Santosh Gangwar, and Revenue Secretary Hasmukh Adhia, on May 19, 2017. (Photograph: Arun Jaitley/Twitter)

Compensation Not Predicated On Cess

There is some talk of compensation being deferred on grounds of ‘force majeure’ which is built into any contract. While that is correct, the point is that this is not a commercial contract notarised by a revenue official. It is a sovereign commitment with legislative backing.

The real problem with the two options presented by the centre is that corpus of the compensation fund is now being restricted to what is being erroneously referred to as “compensation cesses”. These cesses were not imposed to fund the compensation fund.

By linking the two, the centre is trying to limit or restricting the size of the fund to the revenues from these cesses.

This is important to understand.

It may be useful to recall that while the GST rate structure was being designed, all types of cesses and individual rates were getting collapsed into five rate bands. There was no provision for cesses. The cesses made a backdoor entry when the Ministry of Finance made a case that they cannot fund the compensation entirely from its coffers.

The reason, a very valid one, being that the centre passes on to the states 43% of its own collection of GST, so they will need some additional revenues to finance the compensation fund. It is then the cardinal five rate structure of GST was diluted and cesses, which are not otherwise shareable, added to the rates. As such, cesses earmarked for the compensation fund. The fund, it is clear, was not restricted to this mode of financing.

While in normal times, the centre shares 43% of its revenues, in a bad time like this, the centre is sharing 43% of its losses with the states who are already reeling under their own revenue loss. Hence the criticality of compensation.

The Way Out Of This Logjam

Given this understanding of the evolution of compensation, the ideal way to address the issue is:

First, unambiguously own up the liability; not the number of Rs 97,000 crore based on an arbitrary 10% tax growth instead of the agreed 14%. The GST compensation requirement for FY21 is said to be Rs 3 lakh crore, while the compensation cess collection is expected to be around Rs 65,000 crore, resulting in a shortfall of Rs 2,35,000 crores. This hole needs to be filled by the centre – not as a ‘centre versus states’ issue which is what it has become today, but a joint issue.

Second, in terms of approach, the GST Council should find creative ways to ‘defer’ not ‘deny’ the compensation liability. To defer would be to postpone the cash outgo from the centre’s own coffers. This can be structured with a three-year timeframe to weather the ongoing storm and recoup the kitty by the time, hopefully, the economy will be back on track.

On this basis, it should not be difficult to put in place a bridge finance type of a facility for financing the compensation fund.

It would, of course, have a sovereign guarantee. This done, it really doesn’t matter who raises the debt, though in the current macroeconomic environment it is better for the centre not to do it. State governments can be authorised to contract the loans to cover their compensation needs. The debt servicing – interest payments for the next three or five years with a terminal-year bullet repayment will be done by the union government. After three years, when the compensation fund will go back into a surplus, the centre can dip into it to recoup what states raised on their behalf from the market. With Rs 5-lakh crore being parked with the RBI on a daily basis, bankers will see this as an opportunity to cover their cost of funds with zero-risk.

The current exceptionally exceptional situation has exposed the cracks in the design of the compensation scheme. Let it not escalate to become fault lines in the fiscal federal system and erode the status and stature of the GST Council.

Tail Piece

After the principle of compensation by the centre was agreed to, the GST Council secretariat put up a draft, wherein it was said, “…the Union “may” compensate the states in the event of a revenue shortfall…” West Bengal Finance Minister, Amit Mitra, objected, discussed, lobbied, cajoled, and threatened to ensure that compensation to states was made mandatory by replacing “may” with “shall”. And, in this, he had the backing of every single state, irrespective of the party in power.

The issue then became the rate of growth of taxes at which the compensation would kick in. Clearly, this wasn’t given enough thought. Every state was keen to protect its own trend rate of growth; so numbers started coming in thick and fast. With the biggies like Maharashtra, Gujarat growing at 7-8%; smaller states like Himachal, Jammu & Kashmir, Goa, Manipur were showing closer to 20%. Suddenly, a number on which all seemed to agree, came up and it was 14%. This mistake happened in the medley!

Haseeb Drabu is a former Finance Minister of Jammu & Kashmir (2015-2018). He was Chairman & CEO of J&K Bank, and previously a consultant to the Tenth Finance Commission and the Economic Advisory Council to the Prime Minister.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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