Daily Answer Writing
31 May 2021

Q) Explain the rationale behind the Goods and Services Tax (Compensation to States) Act of 2017. How has COVID-19 impacted the GST compensation fund and created new federal tensions? (250 Words)

Previous year UPSC CSE(M) 2020, GS 3

Source: <https://indianexpress.com/article/opinion/editorials/covid-second-wave-indian-economy-lockdown-gst-7337211/>

GS 3:  Indian Economy, Budget

Approach Answer:

Introduction: The GST (Compensation to the States) Act 2017 – provides for compensation to the states for loss of revenue arising on account of implementation of the goods and services tax for a period of five years as per section 18 of the Constitution (101st Amendment) Act, 2016. It calls for a compensation by the centre to the states upon a 14% or more shortfall of revenue under GST till June 2022.


Rationale behind GST Compensation Act:

  • Revenue neutral Rate(RNR): GST should generate as much revenue as the previous tax regime to reduce the negative fiscal impact.
  • Average revenue growth of previous years: Given the growth in revenue for the previous years
  • Compensation for manufacturing states: The states like Maharashtra, Gujarat, and Tamil Nadu lost a portion of their revenue as GST is a consumption tax, and thus the tax amount goes to the state of consumption rather than manufacturing state as earlier.
  • Loss of independent Taxation power: the states lost the power to impose revenue independently on all goods except certain sin goods such as alcohol and petroleum products.
  • Creating constitutional liability: The Act created a constitutionally binding agreement between centre and state regarding GST compensation.


COVID-19's impact on GST compensation fund:

Impact on States:

  • Lower tax collection for states: The slide in economic activities due to the imposition of localised lockdowns to deal with the second wave of Covid-19 is likely to further strain the fiscal position of state governments.
  • Gap in Financing vaccines: While economic activity is slow, the vaccination drive gathers momentum. According to an estimate it can gulp up as much as 30% of the state's revenues.
  • Non-Uniform Impact: Considering that the virus spread and lockdown restrictions have varied across states, the loss across states may not be uniform.


• Impact on GST compensation Cess:

  • Uncertainty about future: Any uncertainty over the states’ revenue stream, especially when they have to ramp up spending, will complicate the task of fiscal management.
  • Backlog: There is also the issue of the shortfall from last year that is yet to be adjusted. Although, Centre is hopeful that if collections rise to around Rs 1.15 lakh crore per month,  then it will be able to compensate states by another Rs 30,000 crore for last year.


Problem for Centre:

  • Revenue projection may not materialise: The Centre has assumed a revenue growth of 7% like last year to arrive at the compensation requirement which is difficult to materialize.
  • Its own revenue decline: from both direct and indirect taxes.
  • Risk of Default : The Centre had invoked 'force majeure' to delay GST compensation funds last year.
  • Violation of Constitutional mandate: This is seen as a violation of GST Act as well as the 101st amendment act.


Conclusion: The 15th FC report projects that The gap between GST cess collections and the revenue shortfall faced by the States for implementing the GST could snowball to anywhere between ?5 lakh crore to ?7 lakh crore by June 2022 from the ?2.35 lakh crore estimated for this year.

In this context, the present regime of GST compensation act guaranteeing a revenue growth to the tune of 14% may be unreasonable. Linking it to nominal GDP growth may be a better alternative. For this, the revenue base for the purpose of the calculation, the time horizon for the levy, should be amicably discussed.

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