GST rates rejig: Why states have a strong case for compensation

As the Narendra Modi government pushes for a quick rejig of the Goods and Services Tax (GST) with fewer slabs, lower rates and rate rationalisation, the states are concerned about revenue shortfall – quite justifiably so.

The Centre has maintained silence over the loss of revenue and compensation to the states. The GST proceeds are shared equally between the two sides.

Two scenarios

SBI Research estimates say the total revenue loss could be to the tune of around Rs 45,000 crore in FY26 and around Rs 85,000 crore during the subsequent full fiscals. It draws up two scenarios, according to which, the loss could be between Rs 60,000 crore in scenario 2 and Rs 1.1 lakh crore in scenario 1.

Also read: United front of Opposition-ruled states poses new challenge to proposed GST cuts

Scenario 1 assumes a 30:70 movement of 28 per cent slab shared across 40 per cent and 18 per cent slabs, and scenario 2 a 50:50 movement of 28 per cent slab share across 40 per cent and 18 per cent slabs.

While the actual item-wise shift will be finalised at the GST Council meeting scheduled for September 3-4, the GoM on GST rationalisation has approved (i) most items in the 12 per cent slab to be submerged in five per cent slab (ii) most items under the 28 per cent slab to be submerged in 18 per cent slab and (ii) some ‘sin goods’ in 28 per cent slab to be shifted to 40 per cent (new) slab.

But it was silent on the compensation to be paid to states that this rejig would lead to.

States' revenue share

When GST was adopted in 2017, it was expected that states would at least be able to maintain, if not better, their revenue share relative to their respective GSDP (Gross State Domestic Product) from the SGST (State Goods and Services Tax) collections.

Also read: Opposition states' finance ministers meet in Delhi ahead of GST rate cut

The states had given up their rights to nine indirect taxes, which were subsumed into the GST along with the Centre’s eight indirect taxes. The GST Compensation was designed to meet the shortfall in the states’ revenue for five years (the time GST regime was supposed to stabilise), and it was raised by 14 per cent annually to match the states’ annual revenue growth in the pre-GST era.

But the GST regime has not lived up to its promise – and hence the demand for compensation from eight Opposition-ruled states that met in New Delhi on Friday (August 29).

According to the NIPFP study, the states need to explore options for increasing revenue base by examining new tax sources and finding innovative areas of taxation such as storage and usage of digital information, online video sharing, and robotics.

Their concerns find echo in a study that the National Institute of Public Finance and Policy (NIPFP), a Finance Ministry think tank, published a few days ago. It evaluated the impact of GST on the states’ revenue during FY19-FY24 (“Reflecting on the Past to Plan the Future: Revenue Performance Evaluation of Indian GST”).

Without compensation, it shows, the states would suffer a serious revenue shortfall.

How GST has impacted state finances

The NIPFP study found that during FY19-FY24, some states did not achieve the required revenue share (relative to GSDP); some fell short even with GST compensation; while many are yet to benefit from the GST in terms of higher revenue share (relative to GSDP) — all of which raises questions about “the effectiveness of GST as a money machine”.

Also read: GST, tax reforms under Modi that could barely scratch the surface

It says, “apart from a few years and states”, the SGST collection as a percentage of nominal GSDP fell “short of the revenue subsumed into the GST” in the base year of FY16 (GST was adopted in July 2017).

Of 18 major states it tracked, only six states managed to better the baseline percentage once: Andhra Pradesh (FY19), Haryana (FY24), Rajasthan (FY19), Telangana (FY19), Uttar Pradesh (FY19) and West Bengal (FY19).

Maharashtra did it five out of six fiscals (except FY21). The rest had none.

With GST Compensation, the study found, the performance was much better, yet many states missed the baseline revenue share (during FY19-FY24).

Andhra Pradesh, Goa, Jharkhand, Karnataka, Kerala, Punjab, Rajasthan, Tamil Nadu and West Bengal missed it once. Bihar and Telangana missed it twice, while Chhattisgarh, Gujarat and Madhya Pradesh thrice. Odisha missed it as many as four times. Haryana and Maharashtra, however, had no misses.

Uneven growth

The NIPFP study says the growth in SGST was uneven for states due to two main reasons: (a) rate reductions on “numerous occasions” to mitigate the impact of GST on economic growth and inflation-affected revenue mobilisation (revenue loss) and (b) tax evasion damaged the revenue profile of states.

Also read: Downward GST revisions spark further revenue-cut fears in states

Its suggestion: The states need to explore options for increasing revenue base by examining new tax sources and finding innovative areas of taxation such as, storage and usage of digital information, online video sharing, and robotics.

The NIPFP’s findings would mean the states must be compensated after the proposed rejig in the GST.

Karnataka Revenue Minister Krishna Byre Gowda did have a point when he said, at the Opposition-ruled conclave on GST on Friday, that there were “17 rounds of rate rationalisation” in GST and every round resulted in net revenue loss for the states — thereby the theory of buoyancy was “conclusively proved wrong”.

Individually, the states have said their revenue losses would be Rs 6,000-9,000 crore.

States’ tax revenue kitty

Gowda, however, was wrong in stating that states relied on the GST for 50 per cent of their revenue, though his estimate of a revenue loss of 15-20 per cent may not be.

Going by the data provided by successive Economic Surveys, the states’ “own tax” accounts for most of their tax revenue. The sources of their taxes are: SGST, state excise, taxes on vehicles, stamp duty and registration fees, and land revenue.

Also read: Spotlight on prospective GST rate cuts pushes current sales into the dark

During the pre-GST fiscals of FY12-FY17, their “own tax” averaged 66.6 per cent of GDP.

In the first GST fiscals of FY18, this fell to 64.7 per cent and in the post-GST fiscals of FY19-FY26 (BE), it fell further to 64.6 per cent.

Why did the states' “own tax” fall drastically in FY16 and FY17 – from 9.4 per cent in FY15 to 8.7 per cent in FY16 and 7.8 per cent in FY17?

One reason is the slowdown in the service sector – from 9.8 per cent in FY15 to 9.4 per cent in FY16 and 8.5 per cent in FY17. The other reason is the severe damage caused by the demonetisation of November 2016.

GST a shock to informal sector

GST’s introduction was also a big economic shock to the informal sector due to its input tax credit (ITC) provision. It drove businesses to the formal sector, as thousands of MSMEs shut down across the country.

Growth fell to 3.9 per cent in FY20. The pandemic hit FY21 and partly affected FY22 and the recovery has been even more K-shaped as the informal sector, especially the MSMEs, is yet to recover from multiple shocks.

Also read: Proposed GST reforms aren’t next-gen but design flaws introduced in 2017

For these reasons, growth in “own tax” has been highly uneven, from -5.8 per cent in FY21 to 9.7 per cent in FY22, 7.6 per cent in FY23, 9.2 per cent in FY24 and 6.5 per cent in FY25 has had their impact on the growth of their own tax (shown below).

Apart from its “own tax”, the states get a share of the Centre’s gross tax – as determined by the Finance Commission awards – raising their total tax revenue.

The following graph presents a comparative picture of states’ “own tax” and Centre’s tax transfers as percentage of GDP. The rise in transfers is on account of higher Finance Commission awards — up from 32 per cent by the 13th Finance Commission to 42 per cent by the 14th (FY15-FY20) and 41 per cent by the 15th (Fy21-FY26). The 16th Finance Commission is expected to announce its awards by the end of October.