CAA’s Articulate – Digging deeper: On GST compensation


  • Four months into FY 2020-21, the Centre has finally managed to pay States the compensation due to them for the previous year under the GST regime. Lower GST revenues have translated into delayed and pending compensation payments to states.

About GST (Goods and Services Tax)

  • It is a value-added tax levied on most goods and services sold for domestic consumption. The GST is paid by consumers, but it is remitted to the government by the businesses selling the goods and services.
  • The Centre will levy and collect the Central GST.
  • States will levy and collect the State GST on the supply of goods and services within a state.
  • The Centre will levy the Integrated GST (IGST) on the interstate supply of goods and services, and apportion the state’s share of tax to the state where the good or service is consumed.
  • States were guaranteed compensation from the Centre for the first five years of the new indirect tax regime introduced in July 2017, for the revenues they lost after the shift from the earlier system where States had the power to levy some indirect taxes on economic activity.
  • This compensation assumed a 14% annual growth rate in a State’s revenue, with 2015-16 as the base year, and was to be paid out from a compensation cess levied on top of the specified GST rate on luxury and sin goods.
    • At present, the cess levied on sin and luxury goods such as tobacco and automobiles flows into the compensation fund.

Background of the GST compensation issue:

  • The pandemic effect: The Goods and Services Tax (GST) collections recorded a 41 per cent decline in the April-June quarter.
    • The increase in revenue in 2019-20 has been a meagre 3.8 per cent compared to the previous year.
  • How the govt. paid last year dues?
    • 50% of the shortfall in last year’s cess fund has been mobilised by tapping cess balances from the first two years of GST implementation.
    • The rest has been mobilised from the Consolidated Fund of India by debiting Integrated GST (IGST) funds that were lying with the Centre.
    • Having thus drawn on these unintended contingent reserves, paying compensation to States this year is going to be even more daunting for the Centre.
    • This raises a fundamental question: How can the gap between fund availability and fund requirement be bridged when the govt. has drawn on contingent reserves?
  • Market borrowing has been discussed as one of the possible solutions for meeting the compensation gap in the GST Council though the legality of the Council to borrow will need to be explored.


  • High 14% rate: The required amount to pay states started rising with a compounded 14 per cent rate which is inordinately high as compensation collections remained around the same level for two consecutive years.
    • It gives states no incentive to make tax efforts of their own. Nor does it make an allowance for an economic downturn, such as the one caused by covid.
    • Adamant states: All states are unanimous on sticking to the 14 per cent assured rate for compensation.
  • Compensation cess inflows could shrink even more with people curbing discretionary spending on luxury goods in order to conserve capital or stay afloat in the pandemic-hit economy.
  • Compensation fund limited to cess only: In the Budget for 2020-21, Finance Minister had said that hereinafter, transfers to the fund would be “limited only to collection by way of GST compensation cess”.
    • This declaration is against the federal consensus between the Centre and states, and the constitutional guarantee enshrined after an elaborate process.
    • Section 10(1) of the Act allows for “other amounts” also to be credited to the Compensation fund with the approval of the GST Council.
  • Restructuring possible after pandemic only: Tinkering of rates of rate structure under GST cannot be done till the effects of pandemic-induced slowdown continue.
  • The bureaucratic tinkering with rates: The most recent example is that of packaged parotta being levied 18% GST, whereas its north Indian cousin, the parantha, is taxed at 5%. Such arbitrariness has resulted in confusion, uncertainty and litigation.  
  • Uninformed decisions: The pre-election sharp reductions in tax rates without serious examination of the revenue implications have also contributed to the fall in revenue. The current rates are not revenue neutral.
  • Alcohol and petroleum: The states remain addicted to special levies on these to fill their coffers. It creates hindrances in achieving single GST slab.

Way forward:

  • Borrowing from the market by the GST Council and crediting it to the compensation fund:
    • The GST Council or the Compensation Fund must be empowered to borrow funds from the market and compensate the states.
    • The advantage: Since the loans are not taken by the Centre, it has no fiscal deficit implications. And the liabilities would be liquidated automatically from the collection of the Cess during the extended period.
  • Options for meeting compensation gap: A paper by Vijay Kelkar (Chairman, 13th Finance Commission)  has listed out following options —
    • lowering the guaranteed rate of compensation,
    • increasing the compensation cess,
    • increasing the state’s share (SGST),
  • GST reforms:
    • A restructuring of the GST model should be considered if the losses for states continue.
    • Review of complex structure of Integrated GST
    • Inclusion of petroleum products under GST
    • Simplification of GST rates and minimising exemptions,
  • Independent GST Council Secretariat:
    • GST Council’s decisions should be based on an estimate of the tax base, the tax elasticity of the commercially important goods, the loss anticipated by such reduction and the anticipated increase in buoyancy through reform measures.
    • This can only occur through the creation of an independent GST Council Secretariat which would provide neutral, unbiased, and pertinent advice on all the matters.


  • With a third of the fiscal year almost over, it would help the Centre and the States to battle the virus more effectively if they had more certainty and clarity on the cash at their disposal.