GST cess as an opportunity

India's economy should benefit from an early termination of the compensation cess

The performance of the goods and services tax (GST) regime has looked up in the last couple of years. In 2018-19, a year after its launch in July 2017, GST collections were estimated at about 6.22 per cent of India’s gross domestic product (GDP). After weathering the headwinds of two rounds of politically-induced rate cuts without any rationalisation or reduction in the multiplicity of rates and the Covid pandemic, GST collections in 2021-22 rose to 6.3 per cent of GDP. A year later, it was further up at 6.6 per cent. And in the first half of 2023-24, GST collections have been estimated at almost 7 per cent of GDP.

Indeed, the pace of recovery in GST collections has been faster than that of India’s overall tax revenues. The combined tax collections of the Centre and the states were estimated at 17.35 per cent of GDP in 2018-19. Four years later, this share was yet to cross that level, hovering at around 17.13 per cent in 2022-23. In contrast, GST collections last year exceeded what they were four years ago. If the GST regime has done better than other taxes, it is clearly not just because of economic growth, but also because of the improved efficiency in collection with the use of digital tracking of taxpayers and a widening of the tax base.

Of course, as Arvind Subramanian and his co-authors argued on this page on January 1, the actual collections on average are less than the total revenues under this head by 0.6-0.7 per cent of GDP, primarily because of refunds. These refunds take place because exports under the GST regime are zero-rated and hence any GST paid on products or services, which are eventually exported, is refunded.

This is a significant aspect of India’s GST structure, and the issues around such refunds need to be resolved soon, even though they do not detract from GST’s overall healthy performance. Similarly, key pending reforms like rate rationalisation should also be expedited. But it is equally important to assess how the different components of the indirect tax have fared in this period of about four years, and whether any gaps in the system need to be fixed.

Note that there are four heads under which GST is collected — the central goods and services tax or CGST, the state goods and services tax or SGST, compensation cess, and integrated goods and services tax or IGST, which has two components — one levied on imports and the other on inter-state sales.

Going by the full-year’s data for 2022-23, a little more than half of total GST revenues, or 52 per cent, is collected through the IGST. Almost 23 per cent is collected through SGST, levied at the state-level, and another 18 per cent is collected through CGST, levied at the central level. The remaining approximately 7 per cent comes from the compensation cess. Importantly, the share of the various components of GST has remained largely the same in the last few years.

The trend in performance of different components of GST during this period has at least three takeaways, underlining the need for policy imperatives in each of those areas. One, the puzzle over the consistently better performance of SGST collections compared to that of CGST needs to be resolved. In the normal course, CGST and SGST collections should be the same during a year, if not every month. However, there seem to be delays and gaps in the process of input tax credit adjustments for IGST collections. Thus, apart from the input tax credit refunds on exports, the adjustments on account of IGST paid on inter-state transfers also need to be quick and smooth. To begin with, the GST Network can make data on export refunds and adjustments for input tax credits on inter-state sales available, so that the extent of the problem could be gauged and corrective action taken.

The second takeaway arises from the recent trend in collections of IGST on imports. After contracting for two successive years in 2019-20 and 2020-21, collections of IGST on imports jumped by over 62 per cent in 2021-22 and again by 25 per cent in 2022-23. But this growth slowed down to less than 2.5 per cent in the first nine months of 2023-24. During the same period, IGST collections on inter-state sales have risen sharply. In the early years of the new indirect taxes regime, the growth in GST collections was fueled largely by IGST on imports. Now, a reduced dependence on IGST on imports is a welcome sign of GST’s intrinsic buoyancy.

The most significant takeaway arises from the steady 7 per cent share of compensation cess in total GST collections, underlining the need for the GST Council to make an early decision on how this levy should be handled after its withdrawal from April 2026. At Rs 1.26 trillion, collected in 2022-23 from the sale of so-called demerit goods including motor vehicles, aerated water, coal, and pan masala, the compensation cess offers an opportunity for policymakers.

Should the cess be discontinued or subsumed in the existing structure? A discontinuation would result in a major tax relief for products that now attract the cess and could act as a demand stimulus for these price-sensitive sectors. Alternatively, the cess could be subsumed in the existing tax structure and the revenue could be used for financing climate transition schemes. Either way, the Indian economy will benefit if an early decision is made.

The original objective of the cess, enforced for only five years till June 2022, was to compensate the states, whose annual revenue growth failed to exceed 14 per cent over the base that prevailed in 2015-16. However, thanks to the Covid pandemic, cess collections were not adequate to compensate the states in 2020-21 and 2021-22, and the Centre formalised a special arrangement with the Reserve Bank of India to borrow about Rs 2.7 trillion in two tranches.

This money was used for meeting the states’ compensation shortfall till June 2022, after which the compensation mechanism came to an end. However, the compensation cess was extended till March 2026 and it was agreed that the amount to be collected from July 2022 would be used by the Centre to repay the loan.

Total compensation cess collections between July 2022 and December 2023 were estimated at about Rs 2 trillion. At the current rate, these collections from January 2024 to March 2026 should yield another Rs 3.24 trillion. This implies that the Centre’s loan repayment liability should be over several months before March 2026, providing the GST Council an option to remove the cess much earlier. This is yet another reason why the Council should take a quick decision on whether the cess should be discontinued or subsumed.