GST system overhaul needed as compensation cess repayment nears 2026

The pandemic delayed a significant decision in administering goods and services tax (GST). The tax came into being in 2017 with a promise to compensate state governments for revenue losses during the first five years. The funds to compensate the states were raised by imposing a compensation cess on certain items in the highest GST bracket. In normal circumstances, the compensation cess would have ended in 2022. However, during the pandemic, which significantly affected tax collection, it was decided states would be compensated for the revenue loss through borrowing, and cess collection would be extended to repay the debt raised on this account, along with interest. Thus, the cess is being collected to repay Rs 2.7 trillion raised during the pandemic. According to estimates, repayment will be completed by January 2026. Thus, it is important to decide the future course and necessary legal changes in time.

A group of ministers (GoM) has been formed to suggest the path on this. As reported by this newspaper last week, state governments suggested merging the compensation cess with the GST rate. From a pure revenue perspective, merging the cess with the highest rate will keep revenue collection and the load on the taxpayer stable. The revenue collected as cess can be divided between the Union and the states as usual GST collection after the merger. Collection from cess was nearly Rs 1.45 trillion in 2023-24.
 

However, things are unlikely to be as simple and the GoM, which is expected to submit its report by December 31, will need to look at various possible consequences. For instance, cess was imposed for a limited period and then extended in exceptional circumstances. Thus, would it be justified to permanently impose much higher taxes on consumers of certain products, which was not in the original design of GST? Further, the level of cess on different items differs. Subsuming the cess in the base rate might end up increasing the number of slabs in the GST system. It is now well accepted that the multiplicity of rates creates complications for both businesses and the tax authorities, and there is a need to reduce the number of slabs. In fact, another GoM is looking at rate rationalisation. In its meeting last week, this GoM decided to recommend changes in GST on items like packaged drinking water, bicycles, wristwatches, and shoes. The GoM needs to go beyond tinkering at the margins and look for ways to make a structural shift. It will be important that the GoMs coordinate and align their recommendations to aid the GST Council in making decisions.
 

The objective of the Council should be to reduce the number of slabs to three at best — a lower rate for some essential items and a higher rate for selected goods. All other items can be taxed at a middle rate with minimal exception. In the context of cess, it can be subsumed at the highest rate only in limited items. Overall, the idea should be to take the GST structure to the revenue-neutral level. Collection in 2023-24, including the cess, as a percentage of gross domestic product was roughly the same as collection from equivalent taxes in the pre-GST period. Without the cess, collection would drop materially. Therefore, there is a need to overhaul the GST system to make it simpler and help boost revenue collection.