Goods and Services Tax (GST)

Extending GST compensation as a reform catalyst


From UPSC perspective, the following things are important :

Prelims level : Tax buoyancy

Mains level : Paper 3- GST and issues


In 2020-21, the compensation payment episode plunged the Union-State relationship to a new low, creating humongous mistrust.

Background of the compensation to the States

  • To allay the fears of States of possible revenue loss by implementing GST in the short term, the Union government promised to pay compensation for any loss of revenue in the evolutionary phase of five years.
  • This was estimated by taking the revenue from the merged taxes in 2015-16 as the base and applying the growth rate of 14% every year.
  •  To finance the compensation requirements, a GST compensation cess was levied on certain items such as tobacco products, automobiles.
  • Period of five years: The agreement to pay compensation for the loss of revenue was for a period of five years which will come to an end by June 2022.
  • Mistrust between Centre and the State: In 2020-21, due to the most severe lockdown following the novel coronavirus pandemic, the loss of revenue to States was estimated at ₹3 lakh-crore of which ₹65,000 crore was expected to accrue from the compensation cess.
  • Of the remaining ₹2.35 lakh-crore, the Union government decided to pay ₹1.1 lakh-crore by borrowing from the Reserve Bank of India.
  • The entire compensation payment episode plunged the Union-State relationship to a new low, creating humongous mistrust.

GST reform is still in transition

  • Misuse of input tax credit: The technology platform could not be firmed up for a long time due to which the initially planned returns could not be filed.
  • This led to large-scale misuse of input tax credit using fake invoices.
  • Revenue uncertainty faced by the States: This is the only major source of revenue for the States.
  • Considering their increased spending commitments to protect the lives and livelihoods of people, they would like to mitigate revenue uncertainty to the extent they can.
  • They have no means to cushion this uncertainty for the Finance Commission which is supposed to take into account the States’ capacities and needs in its recommendations has already submitted its recommendations.
  • Changes needed: More importantly, the structure of GST needs significant changes and the cooperation of States is necessary to carry out the required reforms.

Changes needed in GST structure

  • Reducing exemption items: Almost 50% of the consumption items included in the consumer price index are in the exemption list; broadening the base of the tax requires significant pruning of these items.
  • Bringing petroleum products, real estate etc under GST: Sooner or later, it is necessary to bring petroleum products, real estate, alcohol for human consumption and electricity into the GST fold.
  • Single rate: The present structure is far too complicated with four main rates (5%, 12%, 18% and 28%).
  • This is in addition to special rates on precious and semi-precious stones and metals and cess on ‘demerit’ and luxury items at rates varying from 15% to 96% of the tax rate applicable which have complicated the tax enormously.
  •  Multiple rates complicate the tax system, cause administrative and compliance problems, create inverted duty structure and lead to classification disputes.

Way forward

  • Extending the compensation period: Reforming the structure to unify the rates is imperative and this cannot be done without the cooperation of States.
  • Thus, extending the compensation payment for the next five years is necessary not only because the transition to GST is still underway but also to provide comfort to States to partake in the reform.
  • Reforming the structure is important not only to enhance the buoyancy of the tax in the medium term but also to reduce administrative and compliance costs to improve ease of doing business and minimise distortions.
  • New rate of compensation: It has been pointed out by many including the Fifteenth Finance Commission that the compensation scheme of applying 14% growth on the base year revenue provided for the first five years was far too generous.
  • The issue can be revisited and the rate of growth of reference revenue for calculating compensation can be linked to the growth of GSDP in States.


The transition to GST is still in progress and an extension will provide comfort to States to help roll out crucial changes.

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