Compensating States for Revenue Loss: History Lessons for GST

By Anit Mukherjee —

Dakshinapan Shopping Complex -a shopping center with mostly government emporiums in Kolkata, India. Source: Eric.Parker's flickr photostream, used under a creative commons license.

Dakshinapan Shopping Complex, a shopping center with mostly government emporiums in Kolkata, India. Source: Eric.Parker’s flickr photostream, used under a creative commons license.

The Goods and Service Tax (GST) has been billed as India’s biggest tax reform in a generation. It will finally lead to an integration of the country under a homogenous tax structure with all states signing on to level the playing field, reduce distortions, and improve tax administration and compliance. States have negotiated a hard bargain in exchange for giving up their constitutionally mandated taxation powers. The GST is therefore a compromise between one that is technically perfect and one that is politically feasible, with an outcome that is acceptable to all.

Compensation for revenue loss incurred while moving to the new GST structure remains a core issue that is yet to be resolved. The GST Act stipulates that the center must compensate the states for any revenue loss for a period of five years from the date of implementation. A series of estimates have thrown up numbers varying from 15 to nearly 30 percent, depending on what assumptions are made regarding the tax base, efficiency of tax collection, and exemptions or zero rating of goods and services. It has been a source of intense negotiation both at the Empowered Committee of the State Finance Ministers (EC) and the recently constituted GST Council, with states fighting their corner on how they would be compensated.

From the center’s perspective, a low GST rate would lead to demands for higher compensation. This may not be fiscally sustainable in the context of the Fiscal Responsibility and Budget Management (FRBM) Act limiting government borrowing. On the other hand, a GST rate in the upper range will reduce the revenue loss for nearly all states and therefore is the preferred option for the states. However, it will have a potentially negative impact on inflation which is politically damaging not only for states but also the center. If implementation of GST goes according to plan, the full effect of the price adjustment will be felt in the 2018-19 fiscal year – the one exactly preceding the next general elections. It is in the interest of both parties, therefore, to keep rates low and agree on a compensation mechanism that is acceptable to all.

If history serves as a guide, this may not be as simple. Many of the issues surrounding compensation have been discussed before in the context of the implementation of the Value Added Tax (VAT) in 2005. States such as Tamil Nadu under Chief Minister Jayalalithaa, only opted into the system after nearly three years, mainly because of their disagreement with the compensation arrangements. To prepare the groundwork for GST, the Union government decided to reduce the Central Sales Tax (CST) from 4 percent in 2006-07 to 3 percent in 2007-08 and further to 2 percent in 2008-09. Since the tax is distributed among the states, the center promised to compensate them fully for any resulting revenue loss.

In practice, however, India’s states did not get their CST compensation from the central government as promised. This led to what the Finance Minister Jaitley termed a “trust deficit” between the states and the center. To rebuild the consensus in the GST negotiations, the Ministry of Finance released $1.65 billion (Rs.11,000 crore) as CST compensation to states in the 2014-15 fiscal year. However, CST arrears of nearly $1.95 billion (Rs.13,000 crore) until 2010 are still pending, an issue that states would want resolved before yielding on the GST rate negotiations.

The good news is that the states are firmly behind the GST and want to make it work. But they expect the center to keep its side of the bargain this time around. The trust deficit can be bridged with goodwill on both sides, especially when it comes to compensating for the loss in revenue that India’s states have to bear.

Dr. Anit Mukherjee is an adjunct fellow with the Wadhwani Chair in US-India Policy Studies at CSIS and a policy fellow with the Center for Global Development. Follow him on twitter @Anitnath.

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