Breaking down the GST Compensation dispute

Yesterday, Thomas Issac, the Finance Minister of Kerala, stated that a bunch of State Governments were considering whether they should approach the Supreme Court – against the Central Government’s decision to deny them GST Compensation. But, within 24 hours of this development, the Centre agreed to the demand of the State Governments, and stated it would borrow funds from the RBI – to compensate the State Governments for their revenue losses.

In this post, we shall discuss what this controversy is all about. We shall also discuss the constitutional structure of the GST – which shall explain why States such as Kerala had to consider approaching the Supreme Court against the stance that was taken by the Centre.

The constitutional structure of the GST

Since the last week of August, a tussle has been brewing between the Centre and multiple State Governments, regarding the scope and extent of the Centre’s obligation to compensate the State Governments – for the revenue loss suffered by them after the implementation of the GST. Before getting into the specifics of the compensation controversy, it is important to revisit the constitutional structure of the GST, and the change it brought about in India’s indirect taxation framework.

The constitutional framework for the GST was laid down through the 101^st Constitutional Amendment (a.k.a the ‘GST Constitutional Amendment’). This Constitutional Amendment inserted Article 246A – which conferred the Central and State Governments with the power to jointly levy the GST. Prior to the GST Constitutional Amendment, the Centre and the States did not have the power to  levy the same indirect tax. They only had the legislative power to exclusively levy specific indirect taxes. For instance, while the Centre had the exclusive power to levy indirect taxes such as excise duty, the States could levy entry tax, VAT etc.

As the GST is a single tax that replaces all other indirect taxes (like excise duty, entry tax, VAT etc) – it is levied jointly by the Centre and the States, who split the revenue. After the passing of the GST Constitutional Amendment, the Centre and the States have lost the legislative power to independently levy indirect taxes. They now levy the GST jointly, as a common indirect tax.

As the Centre and the States were now going to levy the same tax, a GST Council was set-up under Article 279A of the Constitution – to facilitate collective decision-making between the Centre and the States. The GST Council is headed by the Union Finance Minister, and also consists of the Union Minister of State for Finance, and the Finance Minister of each State Government.

Article 279A of the Constitution confers the GST Council with the power to make decisions on all matters relating to GST implementation. Such decisions are taken through a voting mechanism, where the Centre effectively has a veto over any decision that the GST Council may take. To simplify – even if all State Governments agree to take a specific decision relating to the GST, it shall fail to pass muster if the Centre doesn’t agree, and exercises its veto.

On the other hand, if the Centre wishes to successfully put a proposal before the Council, it shall require the support of 21 State Finance Ministers – who represent their State Government. The decision shall be binding even on those State Governments who vote against the proposal of the Centre. The voting mechanism of the GST Council is hence designed in such a way that tax policies can be imposed even on the dissenting State Governments. Even if the voting mechanism is not resorted to, all the decisions are taken through common consensus.

This leads to a situation where the States have lost the power to independently frame their indirect tax policy, and are bound by the decisions of the GST Council. GST has hence significantly diluted the fiscal autonomy that States previously had – which they could tap in to generate additional sources of revenue. States are now also more dependent on the Centre for their revenue needs - as every decision of the GST Council can go through only with the Centre’s assent.

The obligation to compensate States for revenue shortfall

As the fiscal autonomy of the State Governments has been diluted by the GST, they now have lesser scope for raising additional sources of revenue. The State Governments have always feared that GST shall reduce their overall revenue growth. Hence, while the GST was being discussed and negotiated, the State Governments consistently demanded that the Centre should enact a mechanism to compensate the State Governments for potential revenue losses – that they may suffer after the GST is implemented.

The Centre acceded to this demand while the GST was being negotiated. As Thomas Issac, the Finance Minister of Kerala, pointed out, the State Governments assented to the GST since the Centre had agreed to enact a legal framework to compensate the State Governments for the revenue losses that they may suffer. To this end, Section 18 of the GST Constitutional Amendment states that Parliament shall enact a law to provide for compensation to the State Governments for revenue losses that arise for the first 5 years after the implementation of the GST (i.e. from July 2017 – July 2022).

(It is interesting to note here that although Section 18 is part of a Constitutional Amendment Act, it does not amend or insert any provision into the Constitution.)

In furtherance of this mandate, Parliament enacted the GST (Compensation to States) Act, 2017 (‘Compensation Act’) – which laid down a framework for compensating the States. Under the Compensation Act, if the annual revenue growth of a State is less than 14%, it shall be compensated for the shortfall in revenue. For instance, if the annual revenue growth of Maharashtra is 10%, it shall be compensated for the balance 4% - which is the shortfall. The statute also levies a GST Compensation Cess. The funds collected through this Cess are transferred to a specified fund named the GST Compensation Fund.

The proceeds of the GST Compensation Fund are then utilized for compensating the State Governments, based on their annual revenue shortfall.

The GST compensation controversy

Now, as GST collections significantly fell during the lockdown, the amount present in the GST Compensation Fund is insufficient to meet the total revenue shortfall of the State Governments. In the end of August, the Central Government contended that the Covid-19 pandemic was an ‘Act of God’, and that as the amount present in the GST Compensation Fund was insufficient, it would not be able to fully compensate the State Governments for their revenue loss. The Centre also contended that under the GST compensation framework, it had no obligation to tap funds from other resources to compensate the States – in case there was a shortfall in the GST Compensation Fund.

The Centre stated that it would not borrow any further sum of money to compensate the States – and presented the States with two options through which they could borrow the money themselves. States such as Kerala and Punjab rejected this proposal. They stated that the Centre was in a better position to borrow funds to compensate the State Governments, and the mandate to provide compensation cannot be sidestepped. After negotiations that took place in meetings of the GST Council, 21 States have accepted the terms of the Centre, and had agreed to borrow funds for financing their revenue shortfall.

But, other States such as Kerala, Punjab, West Bengal and Telangana had refused to accede to the Centre’s terms. They continued to hold the view that the Centre is breaching its legal obligation by refusing to fully compensate the States. As the Centre had repeatedly refused to accept the demands made by these States, Thomas Issac (Finance Minister of Kerala) had stated that some of these State Governments may petition the Supreme Court for a resolution of this dispute.

Within 24 hours from this announcement, the Central Government completely changed its stance. The Centre has agreed to borrow the money required to compensate the States from the RBI. The amount borrowed from the RBI will be transferred to the States in the form of back-to-back loans. Hence, the Centre shall now directly fund the States for their revenue shortfall, and the States shall not have to borrow the money from the RBI, or the open market.

The State of Kerala has already stated that it welcomes the Centre’s decision to borrow directly from the RBI. Other States are also likely to follow suit, as the Centre’s decision to borrow the money themselves is in tune with what the States had demanded. This is likely to resolve the stalemate, and State Governments may now refrain from taking this issue to the Supreme Court. A resolution of this stalemate is significant – as the promise of full compensation for revenue losses until July 2022 was one of the founding assurances which convinced State Governments to give assent to the GST Constitutional Amendment.

Multiple pitfalls

At the same time, this compensation controversy has highlighted multiple pitfalls of the GST constitutional framework, some of which are as follows:

• The GST has significantly reduced the ability of State Governments to independently raise financial resources. The States are now even more dependent on the Centre for funds, as GST has not resulted in any significant increase in revenue.

• The decision-making process of the GST Council, where the Centre has a veto power, has led to a situation where the fiscal needs of the State Governments are met only if the Centre gives its blessings. This has significantly reduced the leeway and the autonomy that States previously had in framing their own tax policies. State Governments are left helpless - if the Centre refuses to honor its obligations. For precisely this reason - States such as Kerala were considering whether to move the Supreme Court, as they were left with no tangible remedy when the Centre was refusing to honor its legal commitment.

In this situation where States have lost their fiscal autonomy and are unable to independently raise revenue - the GST scarcely looks like the landmark indirect taxation reform that it was touted to be.