GST Compensation revives bitter memory of Centre-state tussle over VAT

Under the VAT system, the compensation mechanism linked to the cut in central sales tax from 4% to zero had created bad blood between the union govt and the states

Bitten by their experience over compensation under the VAT regime, states were not keen to join the then proposed goods and services tax (GST) system in a hurry unless there was a guarantee to compensate them.

Under the VAT system, the compensation for revenue loss to states was to be 100 per cent in the first year of the implementation of the levy, 75 per cent in the second year and 50 per cent in the third year. 

However, there was another compensation mechanism linked to the cut in central sales tax (CST) from four per cent to zero, which created bad blood between the Centre and the states. The central and state governments had agreed in 2006 to cut CST by one per cent every year from April 1, 2007 and eliminate it by April 1, 2010 to coincide with launch of the GST as was envisaged then. However, delay in implementation of GST due to lack of unanimity over its structure, and the global financial crisis led to a pause in the phase-out plan.

CST, a tax on inter-state movement of goods, was reduced from four per cent to three per cent in 2007-08, and further to two per cent in 2008-09 after the introduction of Value Added Tax (VAT). There was no reduction after that. Although CST was levied by the Centre, the revenue would go to the state from which movement of goods commenced. 

After compensation was not paid by 2009-10, states demanded Rs 19,000 crore in 2010-11. However, they got only Rs 6,393 crore that year.

The government had budgeted Rs 12,000 compensation for 2011-12 but according to revised estimates paid out only Rs 4,173 crore. In 2012-13, the then finance minister Pranab Mukherjee provided only Rs 300 crore, leading to further hardening of positions on GST.

That time Bihar deputy chief minister and chairman of the empowered committee of state finance ministers, Sushil Modi, had said states were suffering losses after reduction in CST rate to two per cent from four per cent and should be compensated as promised by the Union government.

Modi has asserted that if there was a trust deficit at the beginning of GST, the states would find it difficult to believe that the Centre would compensate them once GST was implemented. "if the CST compensation issue is not resolved there would be difficulties in implementation of GST," he had said.

Later, then finance minister P Chidambaram and the empowered committee of state finance ministers had, in April 2013, reached an agreement that states will get Rs 34,000 crore more as compensation for reduction in CST for three years beginning 2010-11.

States had agreed to receive the compensation in a staggered manner in view of the Centre’s fiscal’s constraints. The compensation would be limited to 100 per cent claims in 2010-11, 75 per cent in 2011-12 and 50 per cent in 2012-13, according to the recommendations of the sub-group.

However, the Narendra Modi government which assumed the power a year later, was to provide this compensation to the states. Its Cabinet had approved the compensation for 2010-11, 2011-12 and 2012-13 to be released in phases in 2014-15, 2015-16 and 2016-17.

Learning from past experience, states bargained hard with the Centre over the compensation mechanism for revenue loss under GST. That prolonged the discussions over GST between the Centre and states. Various models were suggested by the Centre, including staggered payment such as 100 per cent compensation for revenue loss in the first year, then 75 per cent and 50 per cent in the following two years, respectively, along the lines of VAT system.

However, states wanted constitutional guarantee from the Centre. So, the solution came in the form of the Compensation Act, which guarantees the states full compensation for the first five years of the roll-out.  The revenue loss would be taken if states do not record 14 per cent growth in their GST revenues on the base year of 2015-16.

However, the Act binds the compensation to the compensation cess collected. And there was a catch here which did not raise many eyebrows atthat time. The cess was imposed on luxury and sin products such as cigarettes, auto, aerated drinks over the peak 28 per cent GST rate.

After a smooth journey in the first two years of the GST roll-out on this count, the problems came when the cess remained muted in 2019-20 and the Centre had to dip into the excess cess collected in the previous two years and also in the first few months of the current financial year. The cess collection was Rs 95,000 crore in 2019-20 but the states were given Rs 1.65 trillion.

Now, the issue has become all the more acute as compensation cess is estimated to be yielding only Rs 65,000 crore in the current financial year and the states are staring at Rs three trillion compensation requirement. This would leave a gap of Rs 2.35 trillion.

However, the Centre estimated that out of this gap only Rs 97,000 crore is due to the GST system and the rest is due to Covid-19 or an Act of God, as finance minister Nirmala Sitharaman termed it.

As such, the union government offered two solutions to the state governments.

The first is that states take a Rs 97,000 crore window, to be worked out with the Reserve Bank of India, or borrow Rs 2.35 trillion from the markets to be facilitated by the central bank. The amounts will be paid by the compensation cess which will be extended beyond June 30, 2022.

However, states will have to bear the interest burden if they decide to borrow the entire Rs 2.35 trillion shortfall.

Under the second option, the proposed extension of cess will be used for paying only the principal amount, not interest.

While in the first case, borrowing under the Special Window will not be treated as debt raised by states, in case of second option, only the amount up to Rs 97,000 crore, which is the shortfall arising due to GST implementation, will not be treated as debt.

Also, the Centre assured that the states will be compensated fully even if they opt for the Rs 97,000 crore window by giving them revenues for the remaining sum -- Rs 1.38 trillion -- by extending cess.

The states were given time till Tuesday to send their feedback to the Centre, after which the GST Council meeting will be called to take up the matter.

Reaction from states to the Centre's offer came broadly along party lines. While Opposition-ruled states attacked the Centre for reneging on its promise, some BJP-ruled ones went for the first option. For instance, West Bengal chief minister Mamata Banerjee reminded Prime Minister Narendra Modi that he, as Gujarat chief minister, had objected to implementation of GST on various grounds including apprehensions that the Centre would not compensate states for losses under the GST regime.

On the other hand, Bihar and Karnataka, both ruled by BJP and alliance partners, opted for the first option.

In fact, Punjab, Delhi, West Bengal, Chhattisgarh, Telangana and Kerala wanted the Centre to borrow. However, sources said the union finance ministry ruled out borrowing by the Centre, saying that compensation is linked to compensation cess which is owned by the states. The Centre cannot borrow on resources that it does not own, they said. Besides, any such huge borrowings by the Centre over and above additional Rs 4.2 trillion that it had already announced would crowd out resources for the private sector and jack up bond yields at a time when the economy is crying for growth, they said. 

The acrimony between the opposition-ruled states and the Centre over the issue may not allow a consensus on the issue, which was a point of trust between the union government and states when they agreed on implementation of GST. It became quite clear when Kerala finance minister Thomas Isaac said that voting will be inevitable if the Centre sticks to its stand on two options and asks the states to borrow.