MC EXCLUSIVE Centre unlikely to extend 'compensation-cess framework' to make up for revenue loss to states

On Friday, eight opposition-ruled states sought compensation for the likely revenue loss once GST rate cuts are enforced

Several states agree with the Centre’s GST-rate-rationalisation proposal, and are willing to take a short-term revenue hit as a consequence, two government officials told Moneycontrol.

The Centre is of course mulling ways to allay their revenue-loss concerns, but the "compensation-cess framework" is unlikely to be extended or re-introduced, they said. The GST Council is meeting on September 3-4 to discuss the issues related to rate rationalisation.

"Many states are on board, barring a few. There’s a high chance the Centre’s GST rate-revamp proposal in the upcoming GST Council meeting will be accepted," said one of the official.

Bihar deputy chief minister Samrat Choudhary said on August 21 that the Group of Ministers (GoM), of the Council, has accepted the proposal to scrap the existing 12 percent and 28 percent tax rates and move towards a dual structure of 5 percent and 18 percent.

Some states are, however, asking for an additional levy on sin and luxury goods, over and above the proposed 40 percent rate, to maintain the current effective tax incidence, which goes as high as 80 percent for some products. They say that the proceeds of this levy should be fully distributed among the states as a necessary measure to safeguard states’ revenues.

The officials said that the Central government is exploring ways to make up for revenue loss to states for short-term by imposing an additional levy on sin goods, such as tobacco. "But there will be no legal guarantee given by Centre for compensation" said the second official.

The compensation cess, introduced in July 2017, was designed to make up for state revenue losses during the initial five years of GST implementation. The GST (Compensation to States) Act, 2017 was enacted to ensure that the Centre should provide compensation to states—for a period of five years from the implementation of GST (July 1, 2017)—to make sure that each state's tax revenue grow by 14 percent annually over a base year of 2015-16.

The legal window for compensation ended in June 2022, the levy was extended until March 2026 to service loans raised during the pandemic years when revenues sharply declined. "There’s no possibility of extending this framework further," the person added.

During COVID-19, the Centre provided states Rs 1.1 lakh crore in FY 2020-21 and Rs 1.59 lakh crore in the next year as loan to cover the shortfall in GST compensation due to pandemic-related revenue losses. This sum of Rs 2.69 lakh crore was borrowed by the Centre on behalf of the states and then passed on to them as loans to help manage their finances.

On Friday, eight opposition-ruled states--Himachal Pradesh, Jharkhand, Karnataka, Kerala, Punjab, Tamil Nadu, Telangana and West Bengal—sought compensation for the likely revenue loss once GST rate cuts are enforced. In a joint statement, these states projected revenue loss of between Rs 85,000-2 lakh crore a year, and said the loss should be compensated for minimum five years.

“Should there be a deficit even after the imposition of the proposed additional levy, the Union Government should raise loans secured against the future receipts of the additional levy,” the statement said.

Moneycontrol had reported last week that the Council may consider a proposal to either impose a fresh cess on sin goods to compensate states or amend the law to raise the maximum GST rate above 40 percent, to keep the tax incidence on products such as tobacco unchanged.

Tobacco currently attracts an overall incidence of about 52 percent through a mix of GST and cess, but the GST law caps the headline rate at 40 percent. As the current GST laws permit a maximum rate of 40 percent, any move to alter the ceiling would need consensus in the Council and Parliamentary approval for legislative changes.

“The Council is likely to examine options to ensure states do not face a revenue shock once GST shifts to two rates. There will be a substantial revenue loss for both Centre and states. Since states’ revenues are heavily dependent on SGST, the option of a compensatory cess (new levy) may be discussed. One route is a cess on tobacco; another is raising the statutory rate ceiling above 40 percent so that tobacco’s tax incidence can be maintained,” an official had told Moneycontrol earlier.

Experts say that the government is looking at a consumption boost given that the GST rationalization will put substantial more money in the hands of consumers and this should make up for the loss in revenues projected on account of rate rationalization. "Any shortfall in revenue will be transient and may need to be settled on an ad-hoc basis without changing the tax structure or introducing a long term compensation mechanism," Bipin Sapra, Partner, EY India said.

Pratik Jain, Partner, Price Waterhouse & Co said: " There is often no direct relation between GST rate cuts and loss in revenue.  GST rate cuts would boost consumption, widen tax base, and promote 'ease of doing' business resulting in increased investments."

Rahul Shekhar, Partner-Indirect Tax at Nangia Andersen, however, says that states are apprehensive about the revenue loss that they may have to bear owing to the proposed reforms.  "The Centre may compensate from the additional cess/ levy that could be collected over and above the GST levied on the goods and services," he said.