GST compensation uncertainties pose key risk to fiscal health of states

The state governments, which are at the frontline of addressing the COVID-19 pandemic, are facing a severe revenue shock, which could be exacerbated by delays in receipt of adequate Goods and Services Tax (GST) compensation.

The states’ own tax revenues (SOTR), which form the bedrock of the revenue receipts of most states, are dominated by indirect taxes, such as State Goods and Services Tax (SGST). We expect consumption of discretionary goods and services to have been squeezed during the lockdowns, and recover gradually thereafter, eroding the revenues of the states and the Government of India (GoI) in FY2021.

Specifically, the ICRA expects the states’ SGST revenues to contract by a considerable 30 percent to Rs 3.5 trillion in FY2021 from Rs 5 trillion in FY2020.

However, under the GST (Compensation to States) Act, 2017, the gap between the state governments’ actual SGST collections and the so-called protected revenues, is required to be released bi-monthly by the GoI to the states in the form of GST compensation up to June 2022. The protected revenues are calculated based on a 14 percent annual growth of the base year (FY2016) revenues subsumed into the GST.

With the protected revenues of all states being estimated at Rs 7.7 trillion for FY2021 and given the expected shortfall in SGST collections, we project their GST compensation requirement at a massive Rs 4.1 trillion for the current fiscal.

The source of funding the GST compensation is a cess levied on consumption of specific items, including automobiles, coal etc. Such collections are likely to halve to Rs 494 billion in FY2021. This, along with a paltry estimated balance of unutilised cess of the prior years of Rs 255 billion at end-March 2020, pales in comparison with the sum of around Rs 4.6 trillion needed towards the total GST compensation requirement for FY2020 that was pending at end-March 2020, and the projected fresh demand for FY2021.

So how will the GST compensation be funded? The options include the provision of some funds by the GoI from its own sources, GoI-guaranteed borrowings to be raised by the GST council (the legal dispensation for which are unclear) or some other eligible entity, etc. Until clarity emerges, the magnitude and timing of the release of GST compensation by the GoI will pose a major revenue risk to the state governments.

Other sources of the SOTR would also suffer, especially motor vehicles tax, and stamps and registration collections. The hikes in sales tax/VAT on fuels initiated by many states would only partly absorb the losses related to the low consumption of these items in Q1 FY2021.

A quarter of the states’ revenues is made up of central tax devolution, based on the recommendations of the prevailing finance commission. Provisional data pegged the GoI’s gross tax revenues at Rs 1.5 trillion lower than its revised estimates for FY2020. Accordingly, we estimate that the actual central tax devolution in FY2020 was Rs 484 billion higher than warranted, which would be adjusted in FY2021.

Moreover, given the expected curtailment in non-discretionary consumption, and the pandemic’s impact on corporate profitability, job losses and income levels, we project the GoI’s gross tax revenues to be 30 percent lower than the FY2021 Budget Estimates. Overall, the devolution to states will shrink to Rs 5.5 trillion in FY2021 from Rs 6.5 trillion in FY2020.

Simultaneously, the state governments’ expenditure on health and social security would rise during the crisis. With multiple extensions to the lockdown, the GoI has enhanced the net borrowing limit of the state governments for FY2021 from 3 percent to 5 percent of the gross state domestic product (GSDP). However, the unconditional increase is limited to 0.5 percent of the GSDP only, which we estimate at a modest Rs 1 trillion.

The borrowing limit of the state governments poses a soft constraint to the size of their fiscal deficits. Ultimately, capital expenditure would have to be cut or deferred, for many of the states to remain within their fiscal deficit/borrowing threshold for FY2021. Those states whose fiscal profile has supported a revenue surplus over the recent years, may be relatively better off, in terms of the amount of capital expenditure that they will be able to incur, without breaching the fiscal norm.

However, the states that are having to impose localised lockdowns even in Q2 FY2021, may witness an extended revenue compression, and have to further slash capex to remain within the fiscal threshold.