October 25, 2020

GST Controversy – The Nadir in Centre State Relations

T M Thomas Isaac

The issue was discussed at length in the Empowered Committee of State Finance Ministers, GST Council and even parliament. There was a ticklish question of how would compensation payment be made in case there was a severe shortfall in revenue and there was no money in the Compensation Cess Fund. To quote an instance, this was how the revenue secretary and then union finance minister responded:

“The Secretary stated that Section 8(1) of the draft Compensation Law provided that cess could be collected for a period of five years or such period as may be prescribed on the recommendation of the Council. He stated that this implied that the Central Government could raise resources by other means for compensation and this could be then recouped by continuation of cess beyond five years. He stated that the other decisions including the possibility of market borrowing for payment of compensation was part of the Minutes of the Meeting of the Council (held on 3rd and 4th January, 2017) and need not be incorporated in the Law. The Council agreed to this suggestion.”

Even before the breakout of Covid pandemic, it was clear that the shortfall in GST revenue would not be compensated with the compensation cess collection. Because of demonetisation and other policies of central government, the growth rate of the economy rapidly decelerated to 3.2 per cent in the last quarter of 2019-20. So much so, in the budget speech of 2020-21 that hereafter “the transfers to the fund would be limited only to collection by way of GST compensation cess”. This was a negation of the repeated assurances that were given to the states.
The chairman of the Finance Commission even made a suggestion in the 37th GST Council that the states should revisit the compensation formula which, of course, no state was willing. With the outbreak of Covid, the anxieties of the states grew manifold. The total shortfall in the GST revenue from the legally protected revenue in 2020-21 was expected to be of Rs 3 lakh crore, even after taking into consideration Rs 60-70,000 crores of GST compensation cess collection. The only solution was to borrow to meet the shortfall and repay it by extending the cess collection.
There were two key issues. Who should borrow? How much to borrow? In the 41st GST Council meeting we discussed them for eight hours and fifteen states suggested that the centre should borrow and that the full compensation should be paid. But at the fag-end of the meeting, without any reference to the discussions so far, the central government placed two options before the states to choose.

The option 1 introduced a new concept of dividing the revenue losses ‘‘on account of implementation of GSTand due to the pandemic”. The compensation on account of “due to the pandemic” would be deferred to post 2022. Events like, recessions, pandemics, demonetisation etc were never the considerations when compensation formula was devised.  The Compensation Law clearly defines how compensation is to be calculated and it has no reference whatsoever to any conditions whether it be act of nature, god or man. In the second option, the entire shortfall was to be borrowed by states and the interest burden was to be paid from their consolidated fund. No state wanted even to consider this option.

The centre also argued that AG had opined that the central government is not legally bound to compensate the states from Consolidated Fund of India. Given the history of the discussions, the consensus reached by the states and centre regarding compensation, bringing up these types of arguments to coerce the states to accept one of the two options, is a lowest point in the centre-state fiscal relations.

In the 42nd GST Council, it was announced that 21 states had already opted for option 1. Nine states rejected both the options. There are three cardinal principles which dissenting states have raised. 1) There can be no bifurcation of revenue shortfall for compensation purposes as due to pandemic and due to implementation of GST. Entire shortfall needs to be compensated. 2) Centre should borrow given its better capacity, ability to gain better terms and administrative ease of borrowing. 3) Compensation cannot be linked to normal borrowing or additional borrowing limits allowed to states. Both the options infringed upon the above principles and were unacceptable to us.

It was clear from the AG’s opinion that a decision of the Council was necessary to extend the cess collection and also for deferment of compensation payment beyond five years. The Council decided to extend the cess collection but no such decision was made with respect to deferment of compensation payment. The demand for a formal decision in the Council was not heeded in the name of consensus. If such a decision was made, it would have been binding on states which did not accept option one or two, though we would have continued to agitate on the issue through grievance redressal mechanism or other means. Instead of adopting such a democratic procedure, the meeting was concluded without any decision ostensibly for lack of consensus. Then an announcement was made in the press conference. States who argued for a third option were threatened that choosing of none of the options would mean no compensation.

It would appear that better sense has prevailed and the centre has now expressed its willingness to borrow through special window and provide back-to-back loans to states in lieu of compensation. All the dissenting states have welcomed the move. At least it has met the demand that central government should borrow. Of the Rs 3 lakh crores required as compensation, the centre has agreed to borrow only Rs 1.1 lakh crores. What about the rest of Rs 1.9 lakh crores? Centre seems to be suggesting that this amount will have to wait till 2023 when the collection from the extended compensation cess will flow into the compensation fund. What is the logic in deferring the loss in revenue due to Covid to post Covid times?

Therefore it is clear that the states and the centre have to discuss and reach a consensus on how much to borrow. The dissenting states have made it clear that the entire compensation should be borrowed and paid in the current year itself. Such a borrowing is not going to affect centre’s fiscal deficit and fears of crowding out private investment are totally misplaced. Not only the consumption demand, but the investment demand has also collapsed. In fact, the entire macro-economic reasoning of the centre makes no sense. The union FM has gone to emphasise that since this is a pass-on loan to states that the centre is taking, it won’t be reflected in the centre’s fiscal deficit. But it will be reflected in states’ fiscal deficit.  For any macro-economic analysis or rating what is relevant is the overall fiscal deficit of the centre and states. The union FM on the other hand is not bothered about macro-economic impact of a fall in the state governments’ revenue and consequent cut in their expenditure. In Covid times, the last thing the central government should do is to squeeze the state government expenditure.

It seems that the central government is not agreeable to the dissenting states’ suggestion. It will be an irreparable damage to the functioning of the GST Council if the central government insists on its option 1 and enforces it without a decision of the Council. Perhaps a way out would be to extend to all states 0.5 per cent more unconditional borrowing in the 2 per cent additional borrowing already permitted and continue the negotiations.