GST revenues: The fate of the compensation cess amid Centre-state row

In our piece yesterday, we reviewed the performance of the Goods and Services Tax (GST) over the past seven years, emphasising that the states did well but at the cost of a revenue sacrifice by the Centre. In this piece, we look ahead to consider the fate of the compensation cess.

This cess is due to be reviewed over the coming year because it has now lost its major rationale, which was to fund the temporary revenue guarantee that the Centre had provided to the states – a guarantee that has now expired. Accordingly, the GST Council’s review will need to answer two important questions. First, what should be done with the cess? Second, should the revenue guarantee be revived?

With respect to the first question, some have proposed that the cess be eliminated on the grounds that such an action could boost consumption growth. But it’s a long-standing principle that tax rates should not be dictated by short-term cyclical considerations. It is true that consumption growth has been quite weak in recent quarters. But perhaps next year it could prove quite strong. Would anyone then recommend raising GST rates? We think not.

Instead, GST rates should be set according to longer-term considerations. Foremost among these is the consideration that some goods are “demerit goods”, which should be taxed more heavily to discourage their consumption. In India, these demerit goods include tobacco, aerated drinks, and motor vehicles. So, for example, a cess of 2-22 per cent has been levied on top of the 28 per cent GST rate for motor vehicles.

Another important consideration when designing the GST is the need for the government to fund its activities. At present, the cess raises considerable revenue, nearly half a percentage point of GDP. Accordingly, if it were simply eliminated, the government would need to find other sources of income, which would involve (by definition) taxing goods and services whose consumption it really doesn’t want to discourage. And if the states were not confident about the revenue prospects from such taxes, they might ask for revenue guarantees.  

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That said, there’s no reason for the cess to be retained in its current form. That’s because the cess rates themselves are monstrously complicated, varying not only in magnitude but also according to end-use. So, there is a strong argument for simplifying the system.

Our view is that the cess should be drastically rationalised, reducing it to just one rate as suggested in the Revenue Neutral Rate (RNR) report of 2015. This rate should be set so that no additional fiscal burden arises, which probably implies a rate of 12-15 per cent. And proceeds from this revamped cess should be shared between the Centre and the states, just like revenues from any other GST rate.

Once that is decided, the GST Council will need to tackle the thorny second question of whether the revenue guarantee should be revived. Our answer is no.

We say this for several reasons. For a start, the guarantee was always understood to be temporary, a compensation for any initial teething problems with the new GST system. It was never envisaged to be a permanent feature of the system.

Nor do we think that guarantees will be needed. In our new paper, we calculate the revenue consequences of our proposal for the states. If revenues remain as buoyant as they have been in the past two years, the rising tide will lift all boats. Even if revenue-Gross State Domestic Product (GSDP) collections remain at current levels, our calculations suggest that states as a whole and nearly all states individually will see an increase in revenues from current levels. So too will the Centre.

What’s the intuition behind our finding? Right now, states are not receiving any revenues from the cess (nor too is the Centre) because it is being used to repay loans taken by the compensation fund during Covid. As a result, once the loans are repaid, cess revenues of roughly half a percentage point of GDP will be available for distribution, both to the Centre and the states. If we assume that the state-wise distribution of cess revenues is similar to that for other GST revenues, all states should gain.  

Admittedly, the gains will not be uniform, but even this would not be a problem, since broadly (with exceptions) the large gainers would be the poorer states, such as Chhattisgarh, Jharkhand, Bihar, Uttar Pradesh and Rajasthan. And it is precisely the poorer states that are most in need of additional revenues.

But what if we are wrong? Why not revive the guarantee, just in case there are teething problems with the reformed cess? We would not favour such a move on the grounds of moral hazard. We say this not just for theoretical reasons, but also based on experience. In the first two years of the GST, the Centre and the states pressed to reduce GST rates in the Council, the latter knowing that they would not have to bear the revenue consequences because their own revenues were guaranteed. The Council acquiesced, cutting rates on a wide range of goods ranging from detergents to honey. As a result, overall GST collections fell far below the level collected by the equivalent taxes in the pre-GST era (as we showed in yesterday’s article). With debt and deficit levels still high, the country cannot afford to repeat that mistake.

Accordingly, we would propose a different solution. If it turns out that some states have lost out from our proposal, the Sixteenth Finance Commission could fill in the gaps through grants, as is customary for special cases.

Finally, the Centre and the states should complement the cess reform by simplifying the GST system. Some lower rates should be increased, bringing the number of rates to two (plus the one cess rate). If the Council can accomplish all this, the system would become economically more efficient and significantly easier to administer, thereby becoming more buoyant.

In addition, the government should maintain data transparency, which received a setback yesterday with the apparent discontinuation of the monthly PIB report on the GST. The GST would then finally come into its own, fulfilling its early promise.

Varun Agarwal and Theerdha Sara Reji are with CEGIS. Josh Felman is Principal JH Consulting. Arvind Subramanian is Senior Fellow, Peterson Institute for International Economics. Devashish Deshpande contributed to the analysis.