Goods and Services Tax (GST)

GST reforms and compensation issue


From UPSC perspective, the following things are important :

Prelims level : GST

Mains level : Paper 3- GST compensation issue and reforms needed

The GST compensation issue raises the need for reform in the system. The article discusses this issue and suggests reform.


  • Three years ago, the Centre and the States of the Union of India struck a grand bargain resulting in GST.
  • The States gave up their right to collect sales tax and sundry taxes, and the Centre gave up excise and services tax. 

Issue of compensation

  • Consent of the states was secured by a promise of reimbursing any shortfall in tax revenues for a period of five years.
  • This reimbursement was to be funded by a special cess called the GST compensation cess. 
  • The promised reimbursement was to fill the gap for an assured 14% year on year tax growth for five years.

Why is the Centre denying GST 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 Central government is wrong in denying the compensation

  •  1) The States do not have recourse to multiple options that the Centre has.[like sovereign bond or a loan against public sector unit shares from the Reserve Bank of India]
  • 2) The Centre can get loans at lower rates of borrowing from the markets as compared to the States.
  • 3) In terms of aggregate public sector borrowing, it does not matter for the debt markets, nor the rating agencies, whether it is the States or the Centre that is increasing their indebtedness.
  • 4) Fighting this recession through increased fiscal stimulus is basically the job of macroeconomic stabilisation, which is the Centre’s domain.
  • 5) Using the alibi of the COVID-19 pandemic causes a serious dent in the trust built up between the Centre and States.
  • It will weaken the foundation of cooperative federalism.

Reforms needed

  • 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.
  • In the long term there are many changes in consumption patterns, production configurations and locations, which cannot be anticipated and hence a static concept of Revenue Neutral Rate cannot be reference.
  • The commitment to a low and stable rate is a must.
  • 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.
  • Fresh approach also calls for an overhaul of the interstate GST and the administration of the e-way bill.

Consider the question “Discuss the issue related to GST compensation to the States by the Central government. Suggest the measures changes in the GST regime to deal with flaws.”


GST is a crucial and long-term structural reform which 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. The current design and implementation has failed to deliver on that promise. A new grand bargain is needed.

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