THE CONTEXT: The Goods and Services Tax (GST) Compensation Cess, initially introduced to offset states’ revenue losses post-GST implementation, has been a pivotal financial tool in India’s fiscal landscape. As its original purpose concludes, discussions are underway to redefine its role and impact on state and national finances.
CONSTITUTIONAL DEFINITION OF CESS
- A cess is defined as a tax levied for a specific purpose and must be used only for that purpose.
- Article 270 of the Constitution allows cess to be excluded from the divisible pool of taxes that the Union government must share with states.
- Any change in the purpose or structure of the cess may require a constitutional amendment.
BACKGROUND OF GST COMPENSATION CESS
Initial Purpose and Timeline:
- The GST Compensation Cess was introduced in 2017 to compensate states for revenue losses arising from GST implementation.
- It was initially levied for a period of five years, from July 1, 2017, to June 30, 2022.
- The cess applies to specific luxury and demerit goods like motor vehicles, tobacco, and aerated drinks.
Extension of Levy till March 2026:
- In June 2022, the government extended the levy of the GST Compensation Cess until March 31, 2026.
- This extended the cess collection period by almost four years beyond the original end date.
Reasons for Extension (Covid-related Loans):
- The extension was primarily to repay loans taken during 2020-21 and 2021-22 to compensate states for GST revenue shortfalls during the COVID-19 pandemic.
- The Centre had borrowed and released Rs 1.1 trillion in FY 2021 and Rs 1.59 trillion in FY 2022 to meet the resource gap of states due to inadequate cess collection.
- The extended cess collections will be used to repay these loans and associated interest by March 2026.
COMPENSATION DISTRIBUTION AND STATE DEPENDENCE
Total Compensation Transferred (2017-2023):
- During July 2017 to March 2023, the government transferred Rs 8.8 trillion to 28 states as GST compensation grants (Rs 6.1 trillion) and loans (Rs 2.7 trillion).
Top 10 States Receiving Compensation:
- Nearly two-thirds of the total compensation was accounted for by 10 large states.
- Maharashtra, Karnataka, Gujarat, Punjab, Tamil Nadu, Uttar Pradesh, Kerala, West Bengal, Rajasthan and Madhya Pradesh.
Variation in State Dependence on Compensation:
- The percentage of GST compensation within each state’s revenue receipts varied substantially, with a higher dependence seen in states such as Punjab.
- Karnataka received a full compensation amount of ₹1,06,258 crore for the five-year transition period since July 1, 2017.
- Some states, particularly manufacturing-heavy states like Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Haryana, were expected to be adversely affected by the GST implementation.
- The compensation provided to states was initially set at 100% for the first three years, 75% for the fourth year, and 50% for the fifth year.
- States’ dependence on compensation varied, with some states requesting an extension of the compensation period due to widening gaps between income growth and expenses.
CURRENT STATUS AND FUTURE PROJECTIONS
The GST Council has made several key decisions regarding the future of the GST compensation cess:
- Decision to repay GST compensation loan by January 2026: The government has announced its plan to repay the entire GST compensation loan, amounting to Rs 2.7 trillion, by January 2026. This is two months ahead of the original March 2026 deadline for the cessation of the compensation period.
- Estimated surplus after loan repayment: After repaying the back-to-back compensation loans (Rs 2.7 trillion) and the associated interest (Rs 0.5 trillion), a surplus of approximately Rs 40,000-48,000 crore is projected. This estimate is slightly higher than the government’s initial projection of Rs 40,000 crore.
- Formation of Group of Ministers to study future of cess: The GST Council has approved the formation of a Group of Ministers (GoM) to assess the future of the compensation cess beyond March 2026. The GoM, headed by Union Minister of State for Finance will:
- Evaluate the purpose and structure of the cess after March 2026.
- Determine the best course of action for the projected surplus.
- Consider renaming the cess, as it can no longer be called “Compensation cess” after March 2026.
- Decide on the sharing mechanism between the Centre and states for any future cess collections.
THE CHALLENGES:
Need for New Purpose if Cess Continues:
- The original purpose of GST compensation cess (to compensate states for revenue loss) is no longer relevant after March 2026.
- The GST Council needs to identify a new purpose if the cess is to continue beyond March 2026.
- Options being considered include renaming the cess and finding new ways to apportion it between the Centre and states.
- One suggestion is to use the cess for green infrastructure projects or energy transition requirements.
Potential Impact of Discontinuing Cess:
- Discontinuing the cess without replacement would significantly reduce effective tax rates on demerit, sin, and luxury goods like cigarettes, SUVs, and tobacco products.
- This reduction in tax rates may be undesirable as the government aims to discourage consumption of these goods.
- Removing the cess could impact the government’s ability to fund specific programs or initiatives that were supported by the cess revenue.
- States may face reduced revenue if the cess is discontinued without an alternative mechanism to compensate for the loss.
Impact on Fiscal Autonomy:
- The transition to GST has already reduced states’ fiscal autonomy by subsuming many state taxes into the GST framework.
- Petroleum, oils, and lubricants (POL) products currently remain outside GST, allowing states to retain some fiscal flexibility in setting tax rates on these items.
- Bringing POL products under GST would further compress states’ autonomy over taxation and revenue generation.
THE WAY FORWARD:
Revamping into a new cess (e.g., green cess):
- The compensation cess could be transformed into a new cess, such as a green cess, to fund environmental initiatives.
- This new cess could be used to finance green infrastructure projects and support India’s energy transition requirements to meet climate goals by 2030.
- The revenue collected through such a cess could be utilized for creating green energy infrastructure, combating environmental pollution, and afforestation.
Sharing mechanism between Centre and states:
- The GST Council will need to consider the proportion in which a new cess would be shared between the Centre and state governments.
- A new sharing formula would need to be developed, as the existing finance commission devolution formula may not be appropriate for sharing such a cess.
- The horizontal devolution amongst states would also need to be considered in developing a new sharing mechanism.
Potential use for bringing POL products under GST:
- The cess proceeds could potentially be used to compensate state governments for losses incurred due to bringing petroleum, oils, and lubricants (POL) products under the GST regime.
- This could serve as a “grand bargain” to convince states to bring POL products under GST, as it would help reduce costs for businesses and make them more competitive.
- However, bringing POL products under GST would further compress states’ fiscal autonomy, which needs to be addressed in the negotiation process.
THE CONCLUSION:
With the impending cessation of the GST Compensation Cess, critical decisions loom regarding its potential transformation and the inclusion of petroleum products under GST. These choices will significantly shape India’s fiscal policies and economic future.
UPSC PAST YEAR QUESTION:
Q. Explain the significance of the 101st Constitutional Amendment Act. To what extent does it reflect the accommodative spirit of federalism? 2023
MAINS PRACTICE QUESTION:
Q. Discuss the rationale behind the extension of the GST Compensation Cess till March 2026. Analyze the potential implications of discontinuing this cess on state revenues and fiscal federalism in India.
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