Should States Be Compensated for Revenue Loss from GST Reforms?
Kartavya Desk Staff
- •Syllabus: Economy*
Source: TH
Context: The Union government’s proposal to shift GST into a two-tier structure of 5% and 18% is aimed at simplification and competitiveness, but it may cause a short-term revenue loss of ₹60,000–1,00,000 crore. With the five-year compensation scheme (2017–22) having ended, the debate over whether States should be compensated has resurfaced.
What is it about?
• The Centre has proposed rationalising GST into two slabs (5% and 18%), retaining a higher ~40% rate for sin and luxury goods.
• The reform will bring down the average GST rate to ~10%, from 11.5% currently, aligning India with advanced economies and improving competitiveness.
• The short-term revenue loss is estimated at ₹60,000–1,00,000 crore annually (~0.2–0.3% of GDP), and about ₹45,000 crore in FY2025–26 (first partial year of implementation).
• States will not be equally affected: industrialised States like Maharashtra, Karnataka, and Tamil Nadu may see revenue falls in appliances and electronics, while agrarian States like Bihar or Uttar Pradesh, where essentials dominate consumption, face little impact.
• The five-year GST compensation scheme (2017–22), leaving no automatic cushion for States during this reform phase.
Why it matters
• Unequal fiscal impact: In the 2018 GST rate cuts, Maharashtra and Karnataka saw a 3–4% dip in monthly collections, while north-eastern States barely felt any change — showing asymmetry in outcomes.
• Federal trust deficit: GST was adopted only after Centre’s promise of 14% annual revenue growth compensation for 5 years; breaking these precedent risks weakening confidence in the GST Council.
• Developmental consequences: Revenue stress could limit States’ spending on health, education, and infrastructure — for example, Karnataka’s urban tax dependence makes it vulnerable to shortfalls.
• Competitiveness boost: At ~10%, India’s average GST rate matches developed economies, strengthening “Make in India” and attracting global manufacturing investments.
• Political economy factor: The Prime Minister’s Independence Day announcement signals strong political backing; States may debate timing and product classification, but reforms are unlikely to be stalled.
State Compensation
Case for Compensation
• Fairness in transition: States like Tamil Nadu and Maharashtra, with broader tax bases, should not disproportionately bear reform costs while smaller States remain insulated.
• Fiscal stability protection: In FY2026, expected losses of ~₹45,000 crore could undermine States’ fiscal positions without transitional aid.
• Asymmetric exposure: Manufacturing-heavy States depend on higher-tax slabs (e.g., appliances at 28% moving to 18%), making them more exposed to shortfalls.
• Global precedent: Developed economies implementing GST often used dual mechanisms — GST-linked compensation and central packages — to smoothen the transition.
• Reform acceptance: In 2017, compensation was the “political glue” for GST adoption; repeating it now would ensure smoother acceptance of slab rationalisation.
Case against Compensation
• Unsustainable burden: Annual shortfall estimates (₹60,000–1,00,000 crore) make perpetual compensation fiscally unviable for the Centre.
• Moral hazard: Guaranteed revenue may disincentivise States from plugging GST leakages — despite e-invoicing and digital compliance gains reducing losses elsewhere.
• Transition period over: The five-year compensation window (2017–22) was designed as a one-time cushion; extending it risks setting a precedent of permanent bailouts.
• Growth dividend offset: Lower rates on essentials/durables will expand consumption and compliance — e.g., higher demand for appliances shifts transactions into the formal tax net.
• Alternative models exist: Kerala’s flood cess (2019) is an example of a State-specific stabilisation tool that reduces reliance on Centre-led compensation.
What can be done
• Time-bound support: Provide short-duration relief, especially in FY2026, when the revenue dip is estimated at ~₹45,000 crore.
• Selective assistance: Focus aid on industrialised States facing sharper shocks, not uniform across all States.
• Stabilisation fund: A portion of GST could be channelled into a contingency pool under the GST Council, similar to compensation cess but more flexible.
• Performance-linked aid: Tie assistance to reforms in e-invoicing, compliance monitoring, and tax base expansion to reduce moral hazard.
• Strengthening GST Council dialogue: Maintain transparency in revenue projections and product reclassification debates to preserve consensus-based decision-making.
Conclusion
GST rationalisation promises simplicity, competitiveness, and long-term buoyancy, but its uneven short-term shocks could destabilise State finances. While permanent compensation is fiscally unsustainable, transitional, targeted, and reform-linked support can balance fiscal responsibility with cooperative federalism, ensuring that reforms succeed without undermining State stability.