Federalism and legality

The Centre can still regain trust by increasing the States’ borrowing limits to cover the entire Rs 2.35 lakh crore. States fear they are mortgaging their future

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By denying the payment of GST compensation to States and instead asking them to borrow, the Centre may have been legally correct but it must not be forgotten that the States had made a huge sacrifice in surrendering their taxing powers while agreeing to implement the GST regime. They had bought into the idea of a unified market based on what was promised to be a “Good and Simple Tax.” That promise remains to be fulfilled yet. Multiple rates, technical glitches in the GSTN and difficulties faced by the taxpayers in getting timely refunds, that have bedevilled it since launch, still remain unaddressed. The latest decision of the GST Council may have driven a wedge between the Centre and the States, which have so far wonderfully cooperated in the panel that has, barring a single occasion, voted unanimously on all contentious issues.

This is not to undermine the positive benefits the GST has already brought. It was supposed to be a transformational tax, and in many ways it has been so. It not only eliminated multiplicity of taxes and cesses but also brought down the rate of effective tax and its incidence on most items. The ominous Inspector Raj and long queues of trucks at the state entry barriers are things of the past. Even in a country with a highly fractious political culture, the GST Council has set a shining example of cooperative federalism. However, the future may not be as smooth.

Even before the pandemic had struck, GST revenues were falling. Now the pandemic has wrought havoc and collections are nowhere near last year’s levels. As per the GST Compensation Act, the Centre is supposed to compensate the States at bimonthly intervals for five years till FY-22, in case the revenue losses of the States exceeded 14 per cent growth calculated on the base-year 2015-16 collections. It was supposed to draw from the GST Compensation Fund financed by the Compensation Cess levied on luxury and sin goods like cars, tobacco products and soft drinks. GST payments to States for the current fiscal have been pending since April 2020. For 2019-20, the total compensation paid was Rs 1.65 lakh crore against the compensation fund collections of just Rs 95,444 crore, and the Centre had to tap the balance of cess from the previous years as well as Rs 33,412 crore from the Consolidated Fund of India on account of IGST to meet the States’ dues. Thus the inability to pay States’ GST dues was not just due to the economic morass triggered by the pandemic. The actual collections under the fund now cover only half the monthly requirement of Rs 14,000 crore.

The reduction in GST rates for many items had resulted in an inverted duty structure where the duty on the final product was less than the duty on the inputs, requiring higher refunds.  The options before the GST Council were either to (1) rework the slabs or increase rates to correct the inverted duty structure; (2) increase the rates of compensation cess and expand the item base, or (3) allow the States to borrow more and repay the borrowing using future collections, that is, by extending the compensation cess beyond 2021-22. Given the mayhem caused by the pandemic and the severe contraction of the GDP driving the economy into a comatose state, the Centre was rightly wary of raising or expanding the scope of the cess that might cause further job losses. The Centre thus had only two options: either allow the States to borrow or meet the shortfall from its own resources, which must come from its own borrowings, with corresponding fiscal and monetary implications. Yields of government securities (G-Secs) will harden, putting pressure on interest rates across the economy; credit rating agencies also may view this negatively.  Besides, with the fiscal deficit already having exceeded the full year target of Rs 7.96 lakh crore, it was really a Hobson’s choice for the Centre.

The Act does not deal with this unprecedented shortfall of compensation cess, the reason for which is partly the inefficiency of the GSTN to fix the technical glitches, especially its inability to match the buyers’ and suppliers’ invoices. The Centre had earlier approached the Solicitor-General, who argued that it was not legally obliged to pay full compensation to the States. Armed with this, in the GST Council meeting of August 27, the Centre offered the States two options, the logic of which is questionable. It has cited the unprecedented economic contraction and consequent revenue shortfall due to the pandemic as an “Act of God”, which is not covered by the GST statute that has no force majeure clause, to renege on its promise to pay the States compensation out of its own funds. There is also no denying that the Chinese action on the LAC has necessitated higher security expenditure.

The estimated compensation shortfall of Rs 2.35 lakh crore in the current fiscal was divided into two segments though some accounting jugglery: Rs 97,000 crore on account of GST implementation and the rest due to revenue loss attributable to Covid-19. Accordingly, the Centre offered two options to the states: Option-I for additional borrowing of Rs  97,000 crore under a special borrowing window of the RBI at G-Sec-linked interest rates, to be repaid in full, including interest from the compensation cess fund, without being counted as States’ debt. The rest Rs 1.38 lakh crore will be reckoned as States’ debt. Option-II was allowing them to borrow the entire amount of Rs 2.35 lakh crore from the market, of which only the principal will be paid from the compensation cess while the interest burden will lie on the States’ shoulders. However, it appears that the Centre might allow the interest also to be paid from the cess without creating any burden on the exchequer. The compensation cess will continue to be levied beyond FY22 till the States’ debts get liquidated.

Earlier, under the Centre’s stimulus package, States were given additional borrowing space by raising their borrowing limits from 3 to 5 per cent of GSDP, but save 0.5 per cent, the rest was available only on their implementation of various reform measures, like the One Nation, One Ration Card, Ease of Doing Business, power distribution and augmentation of municipality revenues. Even the 0.5 per cent was conditional upon achievement of the milestones prescribed in respect of the reforms. Now Option-I allowed the States to carry forward any unutilised borrowing space up to 1 per cent of GSDP unconditionally to the next fiscal. The Centre would coordinate the borrowing and also bear the extra interest cost above the G-Sec yield through a subsidy. However, no such extra borrowing space would be available for Option-II; the entire borrowing exceeding Rs  97,000 crore will count as the States’ liability. The interest would be decided by the market and not linked to G-Sec yields.

States are understandably furious at what they see as “betrayal” of the Centre, especially the non-BJP ruled ones like Punjab, Delhi, Puducherry, Kerala, Madhya Pradesh, Rajasthan and Chhattisgarh. They feel the distinction in the shortfall on account of GST implementation and the pandemic is “unconstitutional.” In any case, they want the entire borrowing to be accommodated by increasing the borrowing limit. They are apprehensive that the borrowing would translate into “mortgaging of the future.” States have a legitimate grouse not only because the delay in compensation payment has pushed their already precarious finances to the brink, but also because they get no share from the various cesses and surcharges levied by the Centre on items like petrol, diesel, education, health or social welfare.

Understandably it was not an easy decision for the Centre, and it militates against the spirit of cooperative federalism so far demonstrated convincingly by the GST Council. As regards borrowing by the States, there may not be much difficulty. The market is awash with liquidity with little demand for credit as evidenced by the FCI being able to raise loans of Rs 75,000 crore at only 4.6 percent. Banks are flush with funds from the stimulus package, which are being parked at the RBI at the reverse repo rate. But the Centre still can regain the States’ trust by increasing their borrowing limits further to accommodate the entire Rs 2.35 lakh crore. In federal relations, trust is as important as legality.

(The author is a former Director General, Office of the Comptroller & Auditor General of India and an academic.)