[Burning Issue] GST Compensation

During this pandemic, one significant area of loss of revenue to both the Centre and the states is GST. The states need all the funds they can get to ramp up the country’s rundown health system. The Compensation Act mandates compensating the states for revenue loss on GST implementation from the Compensation Fund.

The Goods and Services Tax

  • GST launched in India on 1 July 2017 is a comprehensive indirect tax for the entire country.
  • It is charged at the time of supply and depends on the destination of consumption.
  • For instance, if a good is manufactured in state A but consumed in state B, then the revenue generated through GST collection is credited to the state of consumption (state B) and not to the state of production (state A).
  • GST, being a consumption-based tax, would result in loss of revenue for manufacturing-heavy states.

Tap to read more about GST

Compensation under GST regime

The adoption of the GST was made possible by the States ceding almost all their powers to impose local-level indirect taxes and agreeing to let the prevailing multiplicity of imposts be subsumed under the GST.

While the States would receive the SGST (State GST) component of the GST, and a share of the IGST (Integrated GST), it was agreed that revenue shortfalls arising from the transition to the new indirect taxes regime would be made good from a pooled GST Compensation Fund for a period of five years that is set to end in 2022.

This corpus in turn is funded through a compensation cess that is levied on so-called ‘demerit’ goods.  This GST Compensation Cess or GST Cess is levied on five products considered to be ‘sin’ or luxury as mentioned in the GST (Compensation to States) Act, 2017 and includes items such as- Pan Masala, Tobacco, and Automobiles etc.

Distributing GST compensation

  • The compensation cess payable to states is calculated based on the methodology specified in the GST (Compensation to States) Act, 2017.
  • The compensation fund so collected is released to the states every 2 months.
  • Any unused money from the compensation fund at the end of the transition period shall be distributed between the states and the centre as per any applicable formula.

Issues with compensation

  • As the economy battles a pandemic and recession, the tax collection has dropped significantly.
  • At the same time, expenditure needs are sharply higher at the State level.
  • Using an equivalent of the Force Majeure clause in commercial contracts, the Centre is abdicating its responsibility of making up for the shortfall in 14% growth in GST revenues to the states.

Why is the compensation necessary?

  • States no longer possess taxation rights after most taxes, barring those on petroleum, alcohol, and stamp duty were subsumed under GST.
  • GST accounts for almost 42% of states’ own tax revenues, and tax revenues account for around 60% of states’ total revenues.
  • Finances of over a dozen states are under severe strain, resulting in delays in salary payments and sharp cuts in capital expenditure outlay amid the pandemic-induced lockdowns and the need to spend on healthcare.

What alternative has the Centre offered?

  • At the last meeting of the GST Council, states were offered two borrowing options to cover either the revenue losses due to GST implementation or the entire shortfall, including the effect of the pandemic.
  • The options involved states borrowing either under a special RBI window or from the market under different terms. The total compensation due from the Centre is ₹2.35 trillion.

Why are the States resented?

  • Several States, including West Bengal, Kerala, Punjab and Tamil Nadu, have rejected the options and made clear that the onus is on the Centre to borrow from the market to make good any shortfall in the Compensation Fund.
  • This is because any additional borrowing by states would have deleterious macro-economic consequences.

Alternatives to prevent losses

  • The input tax credit can help a producer by partially reducing GST liability by only paying the difference between the tax already paid on the raw materials of a particular good and that on the final product.
  • In other words, the taxes paid on purchase (input tax) can be subtracted from the taxes paid on the final product (output tax) to reduce the final GST liability.

Way Forward

(1) Reforming the regime

  • GST is a destination-based consumption tax, which must include all goods and services with very few exceptions.
  • That widening of the tax base itself will allow us to go back to the original recommendation of a standard rate of 12%, to be fixed for at least a five-year period.
  • Some extra elbow room for the States’ revenue autonomy could be allowed by States non-VATable surcharges on a small list of “sin” goods.
  • We must recognise the increasing importance of the third tier of government. After 28 years of the 73rd and 74th Amendments, the local governments do not have the promised transfer of funds, functions and functionaries.
  • Of the 12% GST, 10% should be equally shared between the States and the Centre, and 2% must be earmarked exclusively for the urban and rural local bodies.
  • The fresh approach also calls for an overhaul of the interstate GST and the administration of the e-way bill.

(2) Raising the funds

  • Additional resources could be raised by increasing the tax or the cess but in the present difficult times it would not be advisable to raise the burden of either the tax or the cess.
  • The only way out of this difficult situation is borrowings.  The Centre should borrow in view of its higher borrowing and debt-servicing capacity and its ability to borrow at lower rates.
  • The borrowing capacity of the states, too, is not very inferior. A/c to the RBI, the states are consistently borrowing less than they can borrow (legally and financially), which makes sound financial sense. Thus it makes sense for the states to borrow.

 (3) Other measures

  • The Centre can offer to fully compensate states without any borrowing by the latter provided opposition-ruled states agree to amend laws that prevent the privatization of nationalized companies, including many banks.
  • The Centre would then use the proceeds from privatization and land and asset sales to compensate states from its own immediate borrowings.
  • The compensation cess and privatization proceeds can be used to honour the Centre’s promises to states.
  • The Centre should offer this deal along with another sweetener: all future privatization proceeds will be shared upto 20 per cent with the states in which those undertakings are located.
  • States can also be promised a share of other asset sales, too, including land leased by states to central entities.


GST is a crucial and long-term structural reform that can address the fiscal needs of the future, strike the right and desired balance to achieve co-operative federalism and also lead to enhanced economic growth. At present, what states need is hard cash. Only the central government has multiple options and the flexibility to raise the resources and pay the shortfall in GST compensation to the states. Some way forward can surely go a long way.








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