The Goods and Services Tax (Compensation to States) Act of 2017 was introduced in India to compensate states for any revenue losses incurred due to the implementation of the Goods and Services Tax (GST) system. Under this act, the central government pledged to compensate states for any shortfall in their revenue growth below a certain benchmark.

The rationale behind this act was to provide financial assurance and stability to the states, as the implementation of GST resulted in a degree of uncertainty regarding revenue generation. With the introduction of GST, various indirect taxes levied by the central and state governments were subsumed under a single tax regime. This disrupted the pre-existing tax revenue collection mechanisms of states, leading to concerns about potential revenue shortfalls.

The Compensation to States Act addressed these concerns by ensuring that states would not face any financial hardship during the initial years of GST implementation. The act created a compensation fund by levying a cess on select goods and services that would be used to compensate the states for any revenue shortfalls for a period of five years, from July 2017 to July 2022.

However, the outbreak of COVID-19 in 2020 severely impacted the Indian economy, leading to a significant contraction in economic activities and a decline in GST collections. This resulted in a substantial reduction in the GST compensation fund, making it challenging for the central government to fulfill its commitment to compensate states for revenue shortfalls.

As the GST compensation fund dwindled, tensions arose between the central and state governments. Many states argued that the central government was obligated to provide full and timely compensation as per the terms of the act. On the other hand, the central government faced fiscal constraints due to reduced tax collections and sought alternative solutions to meet the compensation requirements.

These tensions highlighted the challenges of fiscal federalism in India, where the fiscal responsibilities and powers are shared between the central and state governments. The states demanded that the central government borrow from the market to meet the compensation requirements, which led to disagreements over the responsibility for borrowing and repayment.

The issue of GST compensation fund and the subsequent federal tensions were exacerbated by the economic repercussions of COVID-19. The pandemic led to a decline in economic output, reducing GST collections and straining the fiscal capacities of both central and state governments. This necessitated a reevaluation of the GST compensation mechanism and calls for greater coordination and collaboration between the central and state governments to address the fiscal challenges arising from COVID-19.

Rationale behind the Goods and Services Tax (Compensation to States) Act of 2017

The Goods and Services Tax (Compensation to States) Act of 2017 was enacted to address the concerns of states regarding revenue loss during the transition to the Goods and Services Tax (GST) regime. The rationale behind the act can be summarized as follows:

• Revenue protection for states: The GST, being a consumption-based tax, led to a shift in revenue collection from the origin state to the consumption state. This presented a potential risk of revenue loss for states, especially those with a high manufacturing base. The compensation act aimed to safeguard their revenue streams during the initial years of GST implementation.
• Smooth transition to GST: The compensation mechanism provided a safety net for states, encouraging their cooperation and acceptance of the GST. This facilitated a smoother transition and minimized any potential disruptions or resistance.
• Fiscal stability and development: By ensuring stable revenue for states, the act aimed to promote fiscal stability and enable them to continue investing in development initiatives without being hampered by revenue shortfalls.

Impact of COVID-19 on GST compensation fund and federal tensions

The COVID-19 pandemic has significantly impacted the GST compensation fund and created new tensions between the Center and states:

• Revenue shortfall: The pandemic led to a sharp decline in economic activity, resulting in a substantial fall in GST collection. This shortfall directly affected the funds available for compensation to states.
• Extension of compensation period: While the original compensation period was slated to end in 2022, the pandemic necessitated its extension to 2024 to mitigate the economic impact on states.
• Funding issues: The increasing burden of compensation payments amidst declining GST revenue created a significant fiscal strain on the Center. This led to debates on how to fund the compensation mechanism going forward.
• Federal tensions: The Center's reluctance to extend compensation beyond 2022, citing fiscal constraints, triggered protests from states, particularly those heavily reliant on compensation. This deepened the existing federal tensions, with states accusing the Center of reneging on its commitments.

Key takeaways

The COVID-19 pandemic exposed the limitations of the GST compensation mechanism, highlighting the need for a long-term solution to address the fiscal challenges faced by states. The federal tensions arising from the compensation issue underscore the need for a collaborative approach to ensure a sustainable and equitable tax system in the long run.

It is crucial to find a solution that balances the fiscal needs of the Center with the revenue requirements of states while ensuring a smooth and efficient functioning of the GST system.

The Goods and Services Tax (Compensation to States) Act, 2017 is a crucial legislation that supplements the Goods and Services Tax (GST) regime in India. The Act aims to compensate states for any potential revenue loss incurred due to the implementation of GST, which replaced multiple indirect taxes with a single unified tax.

Rationale behind the Act:

1. Revenue Neutrality: GST was designed to be revenue-neutral, meaning that the total tax revenue generated should be the same as the aggregate of the various taxes replaced. However, states were concerned about potential revenue losses, as GST rates were lower than the pre-GST tax rates in some cases.
2. State Revenue Protection: To address these concerns, the GST Council, a constitutional body responsible for governing GST, agreed to compensate states for any revenue loss incurred due to GST implementation. This compensation is intended to ensure that states do not face a revenue shortfall.
3. Formula-based Compensation: The Act uses a formula-based approach to calculate the compensation payable to states. The formula considers the revenue collected in the base year (2015-2016) and the projected revenue growth rate of 14% per annum.

GST Compensation Fund:

The GST Compensation Fund is a designated fund created to compensate states for their revenue losses. The fund is generated from the GST Compensation Cess, a surcharge levied on certain luxury and demerit goods.

Impact of COVID-19 on the GST Compensation Fund:

The COVID-19 pandemic has significantly impacted the GST Compensation Fund, leading to new federal tensions:

1. Reduced GST Collections: The lockdowns and economic slowdown have resulted in a substantial decline in GST collections, leading to a significant reduction in the GST Compensation Fund.
2. Increased Compensation Requirements: As states' revenue collections have decreased, their compensation requirements have increased, putting additional pressure on the already depleted fund.
3. Delayed Payments: The central government has delayed payment of GST compensation to states, citing the fund's inadequacy. This has led to resentment among states, which are facing severe financial constraints.
4. Federal Tensions: The delay in compensation payments has created tensions between the central government and states, with some states accusing the centre of not fulfilling its obligations.

New Federal Tensions:

The pandemic has exacerbated existing tensions between the centre and states, particularly on the issue of GST compensation. The concerns include:

1. Centre-State Disagreements: States are demanding immediate payment of compensation, while the centre is citing the fund's inadequacy. This has led to disagreements between the two, straining their relations.
2. Re-evaluation of GST Regime: Some states are questioning the effectiveness of the GST regime and its ability to generate sufficient revenue. This has sparked a debate on the need to revisit the GST framework.
3. Autonomy and Accountability: The centre's delay in compensation payments has raised concerns about state autonomy and the centre's accountability towards states.

In conclusion, the Goods and Services Tax (Compensation to States) Act, 2017 was designed to address state revenue concerns under the GST regime. However, the COVID-19 pandemic has severely impacted the GST Compensation Fund, leading to delays in payment and straining centre-state relations. The issue has sparked a debate on the need to re-evaluate the GST regime and ensure greater autonomy and accountability in the centre-state fiscal relationship.