GST Reform and State Compensation: Fiscal Responsibility vs Fairness

Context:

The Union government has proposed rationalising the Goods and Services Tax (GST) into a two-tier structure of 5% and 18%. The objective is to simplify taxation and enhance competitiveness in the economy. However, this reform is expected to result in a short-term revenue loss of ₹60,000–1,00,000 crore annually. With the five-year GST compensation scheme (2017–22) concluded, the issue of whether States should receive compensation has resurfaced.

Body:

1. Proposal Overview

• The Centre proposes two main GST slabs: 5% and 18%, while retaining a ~40% rate for sin and luxury goods.

• Average GST rate is expected to fall from 11.5% to ~10%, aligning India with advanced economies and improving competitiveness.

• Short-term revenue loss: Estimated at ₹60,000–1,00,000 crore annually (~0.2–0.3% of GDP); for FY2025–26, projected loss is around ₹45,000 crore.

• State impact:

  • Industrialised States (Maharashtra, Karnataka, Tamil Nadu) may see declines in appliances and electronics revenue.

  • Agrarian States (Bihar, Uttar Pradesh), dominated by essentials, face minimal impact.

• No automatic compensation mechanism exists post the 2017–22 GST compensation scheme.

2. Significance of the Reform

• Unequal fiscal impact: In 2018 GST rate cuts, Maharashtra and Karnataka saw 3–4% dip in monthly collections, while north-eastern States experienced little effect.

• Federal trust: GST was adopted with the Centre’s promise of 14% annual revenue growth compensation; breaking this precedent may weaken GST Council confidence.

• Developmental consequences: Revenue shortfalls may reduce State spending on health, education, and infrastructure. Example: Karnataka’s urban tax dependence increases vulnerability.

• Competitiveness boost: At ~10%, India’s average GST rate is comparable with developed economies, promoting Make in India and attracting global manufacturing investments.

• Political backing: Prime Minister’s Independence Day announcement signals strong support; timing and product classification debates may arise, but reforms are likely to proceed.

3. State Compensation Debate

Case for Compensation:

• Fairness: Industrialised States like Tamil Nadu and Maharashtra should not bear disproportionate costs while smaller States remain insulated.

• Fiscal stability: FY2026 losses (~₹45,000 crore) could undermine State budgets without support.

• Asymmetric exposure: Manufacturing-heavy States depend on higher-tax slabs (e.g., appliances at 28% moving to 18%).

• Global precedent: Advanced economies often combine GST-linked compensation with central support to ease transitions.

• Reform acceptance: Compensation was the “political glue” for GST adoption in 2017; repeating it ensures smoother acceptance of slab rationalisation.

Case against Compensation:

• Fiscal unsustainability: Annual shortfalls (₹60,000–1,00,000 crore) make permanent compensation unviable.

• Moral hazard: Guaranteed revenue may discourage States from plugging GST leakages, despite digital compliance improvements.

• Transition window over: The five-year scheme was intended as a one-time cushion; extension risks permanent bailouts.

• Growth dividend: Lower rates on essentials/durables may increase consumption and shift transactions into the formal economy.

• Alternative models: State-specific stabilisation tools, e.g., Kerala’s flood cess (2019), reduce reliance on Centre-led compensation.

4. Policy Recommendations

• Time-bound support: Provide short-duration relief in FY2026 for the estimated ₹45,000 crore revenue dip.

• Selective assistance: Aid industrialised States facing sharper shocks; avoid uniform distribution.

• Stabilisation fund: Allocate a portion of GST into a flexible contingency pool under the GST Council.

• Performance-linked aid: Link assistance to e-invoicing, compliance, and tax base expansion, reducing moral hazard.

• Strengthening GST Council dialogue: Ensure transparency in revenue projections and product reclassification debates for consensus-based decisions.

Conclusion:

GST rationalisation promises simplicity, competitiveness, and long-term revenue buoyancy, but its short-term revenue shocks could strain State finances. While permanent compensation is fiscally unsustainable, targeted, transitional, and reform-linked support can balance fiscal responsibility with cooperative federalism, ensuring reforms succeed without destabilising State stability.

Source : The Hindu