Explained: Why Central Govt Needs to Compensate States for Collapse in GST Collections

Summary: I went looking for the legal reasons being offered by the central government to not compensate the state governments for the dramatic fall in GST collections. I found a central government paper explaining the logic with a lot of legalese. This piece tries to summarise the legalese in simple English. Along with that, I offer many reasons as to why the central government needs to adequately compensate the states. This is definitely not something you will read in the mainstream media.

As has been reported almost everywhere by now, the central government doesn’t want to compensate the state governments for a shortfall in goods and services tax (GST) collections that is going to happen through this year.

In an earlier piece I had explained why this was a bad decision. In today’s piece we will try and understand the central government’s reasoning behind this decision, at the same time we shall also see why the central government is in a much better position to deal with the situation than states are.

The Story So Far

The GST collections between April and June this year have been around 34.5% lower at Rs 2.73 lakh crore than during the same period in July 2019. As the economy contracts in the aftermath of covid-19, the collections will continue to remain subdued during the remaining part of the year.

The central government needs to share a significant part of the GST with the state governments. Over and above this, there is also a guarantee of 14% growth in GST collections for states for the first five years until 2022. If this is not achieved, the central government needs to compensate the state governments for any shortfall.  The central government has decided not to do so.

The Legalese

This public paper explains the central government’s position on the issue. Let’s see why the government is saying what it is saying.

The Constitution (101st Amendment) Act 2016 contains the following provision:

“Parliament shall, by law, on the recommendation of the Goods and Services Tax Council, provide for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax [emphasis added] for a period of five years.”

Following the above provision, the Parliament enacted the Goods and Services Tax (Compensation to States) Act 2017. The preamble of this Act reads as follows:

“An Act to provide for compensation to the States for the loss of revenue arising on account of implementation of the goods and services tax [emphasis added] in pursuance of the provisions of the Constitution (One Hundred and First Amendment) Act.”

In fact, the emphasised parts (in bold italics) in both the 101st amendment as well as the Goods and Services Tax (Compensation to States) Act 2017, read exactly the same. What does this mean in simple English? It means that state governments will be provided a compensation if there is a loss of revenue on account of problems with the implementation of GST (of course, there have been problems galore, but let’s not go there now).

Hence, the central government could have used this technicality in denying the state governments any compensation for a fall in GST collections.

As the policy paper referred to earlier points out: “The Constitution and the preamble to the Act lay out the spirit and purpose of the GST compensation: namely that it is to compensate states for loss of revenue “arising on account of implementation of GST”. The wording of the Constitution and statutory preamble make it clear that the spirit of the law is not to compensate states for all types of revenue losses, but rather for that loss arising from GST implementation.” Ultimately, the GST collections in 2020-21 will fall majorly because of the negative economic impact of the covid-19 pandemic and not just because of the loss of revenue thanks to the botched up implementation of the GST by the central government.

The interesting thing is that the government hasn’t used the above explanation to deny compensating the states for the GST shortfall. It has gone deeper into the legalese to deny the states a compensation.

But before we get into that, the central government has this to say about the GST shortfall: “Parliament obviously could not have contemplated a historically unprecedented situation of huge losses of revenue [thanks to the spread of covid-19] from the base—arising from an Act of God [emphasis added] quite independently of GST implementation—affecting both Central and State revenues, direct and indirect.”

This is where the act of god phrase came into being, also telling us that the government doesn’t do or say anything without putting it on kagaz [paper] first.

Now let’s get back to why the government has denied compensating the states for the GST shortfall. The Section 7 of the the Goods and Services Tax (Compensation to States) Act 2017, provides the detailed mechanism for the calculation as well as the payment of compensation to the state governments when there is a shortfall.

Nevertheless, Section 7 doesn’t make any distinction between the shortfall in GST collections happening due to implementations reasons and non-implementation reasons. As the government paper points out: “Compensation is payable for the entire shortfall (even if it is not on account of GST implementation). This position has been clarified by the Attorney General and is accepted by the Central Government [emphasis in the original].”

So, if this interpretation has been accepted by the central government, why isn’t it compensating the state governments? If your head is already spinning by now, I don’t blame you for it. The legalese behind which the central government is hiding keeps getting better. Let’s move ahead.

The Section 10 of the Goods and Services Tax (Compensation to States) Act 2017 prescribes the manner of payment of the compensation to state governments in case of a shortfall. Let’s look at this pointwise.

1) The compensation is to be paid out of the non-lapsable GST Compensation Fund.

2) Money flows into the GST Compensation Fund from the GST Compensation Cess levied on sin and luxury goods under Section 8, which includes everything from cigarettes to expensive cars. This is made clear under Section 10(1).

3) Section 10(1) also makes it clear that money can flow into the GST Compensation Fund through “such other amounts as may be recommended by the Council”. Hence, other than the GST Compensation Cess only something cleared by the Council can flow into the GST Compensation Fund.

4) Section 10(2) says that compensation under Section 7 “shall be paid out of the Fund”.

Basically, what the government is saying here is that any compensation to state governments on account of a loss of revenue needs to be paid out of the GST Compensation Fund.

So, the government summarises its position by saying: “The states are entitled to compensation…regardless of the cause of the shortfall. However, compensation is to be paid only from the Compensation Fund and it is not an obligation of the Government of India in the event of a shortfall. It is for the GST Council to decide on the mode of making good the shortfall.”

Of course, with the GST collections falling, the compensation cess will not be enough to make up for the shortfall. Also, what the central government is saying is that the GST Council is a different entity from it. This is the point being made on the basis of some complicated legalese. And this rather complicated legalese has been used to basically shaft, for the lack of a better word, the state governments. The central government paper also talks about the spirit of the law.

As far as the act of god point goes, if a fall in GST collections due to covid-19 is act of god for the central government, it is also an act of god for the state governments as well. What are they expected to do in such a scenario?

And given that, the law needs to be changed, simply because the facts have changed and the situation that has arisen currently wasn’t taken into account when the law was first framed. If every law was perfect as it was written first time around, there wouldn’t be so many amendments going around. As the famous British economist, John Maynard Keynes, once supposedly said: “When the facts changeI change my mind. What do you do, sir?

The Central Government Needs to Compensate

The central government needs to compensate the state governments for this shortfall in GST collections. The state governments are at the forefront of fighting the pandemic and hence, need money. Also, state governments spend more money than the central government during the course of any year and that needs to be kept in mind as well, in a scenario, where the private expenditure has collapsed dramatically post covid.

Also, as the government paper points out: “The notion of borrowing by the GST Council is not practically or legally feasible or desirable. This leaves the options of Central or state borrowing.” Let’s look at what the central government is offering the states as a compensation.

1) The shortfall arising out of the loss of revenue due to the GST implementation has been estimated by the central government to be at Rs 97,000 crore. The state governments can borrow this money under a special window coordinated by the finance ministry. The states can repay both principal and interest by using the money they receive from the compensation cess. Also, this borrowing shall not be treated as debt. Hence, it will not limit any state’s overall borrowing ability.

2) The overall shortfall (thanks to implementation and covid impact) in GST collections has been estimated to be at Rs 2.35 lakh crore. The state governments can borrow this entire amount from the market. An amount of Rs 1.38 lakh crore (Rs 2.35 lakh crore minus Rs 97,000 crore) will be considered to be as debt of the state governments. The state governments will have to repay this debt from their own resources. They can repay the principle from the compensation cess.

The government’s logic in getting states to borrow directly from the market is rather bizarre. Nevertheless, let’s take a look at this.

This is what the government paper says: “The Government of India faces a very large borrowing requirement this year. Additional borrowing by the Centre influences the yields on Central government securities (g-secs) and has other macro-economic repercussions. The yield on G-secs acts as a benchmark for State borrowing as well as private sector borrowing. Hence any rise in Central borrowing costs ipso facto drives up borrowing costs for all borrowers, including not only the States but also the entire private sector. On the other hand, the yields on State Government securities do not directly influence other yields and do not have the same type of macroeconomic repercussions.”

What does this mean in simple English (now how many times will I end up saying this)? The central government will end up borrowing more this year than in other years. In this scenario, it will end up needing a greater amount of financial savings to fund itself. This will push up interest rates at which the central government borrows. When the rate of interest at which the central government borrows goes up, the rate of interest for the entire financial system goes up because lending to the central government is the safest form of lending. When this happens, both the private sector as well as the state governments will end up paying higher interest rates on the money they borrow.

The central government’s contention is that the above logic does not apply to when state governments borrow. Their borrowing doesn’t end up pushing overall interest rates.

This is bizarre to say the least. If the state government borrows more from the same pool of savings, it will end up pushing the overall interest rates in the financial system, upwards.

The question is why doesn’t the central government want to borrow more. The government originally expected to borrow Rs 7.8 lakh crore to finance its fiscal deficit in 2020-21. Fiscal deficit is the difference between what a government earns and what it spends. This has already been increased by more than 50% to Rs 12 lakh crore. Any further borrowing will mean, the central government’s already terrible numbers on the fiscal front, will end up looking even more terrible.

I guess that is the logic running in the minds of the babus at the finance ministry and their minister. The trouble is this logic doesn’t hold. Irrespective who borrows, the state governments or the central government, the public debt or the overall debt of the public sector, will go up. Further, there is an implicit sovereign guarantee on state government debt.

As Shaktikanta Das, the governor of the RBI said in November 2019: “There is an implicit sovereign guarantee in them… On the due date of repayment, RBI automatically debits the state government account and makes the repayment. So, there is an implicit sovereign guarantee.” Hence, ultimately, if there is any trouble on this front, it is the central government’s problem.

Further, the central government is in a much better position to raise money. It can sell its stakes in public sector enterprises. It can also sell their land. It has access to a variety of cesses (tax on tax) from which it can earn money. This is money it doesn’t need to share with state governments. It also has access to the profit made by the Reserve Bank of India, as well as its reserves. The ability of the state governments to tax post GST has come down.

Also, various central government institutions (from banks to insurance companies) end up buying bonds issued by the state governments. In that sense the interest on these bonds gets paid to them. The profits made by these institutions end up with the central government, one way or another (corporate income tax/dividends/special dividends etc.).

Hence, there are many reasons as to why the central government should compensate the state governments for a fall in GST collections. But the biggest reason as the deputy chief minister of Bihar, Sushil Modi told the the Press Trust of India: “It is the commitment of the central government to compensate the states for the shortfall in GST collections. It’s true that it is legally not binding on the Centre, but morally, it is.”

Modi belongs to the BJP.