Why did the central government refuse to pay up GST compensation to states across India?

The nation wants to know!!!

The Story

Back when GST was originally introduced (in 2017), the tax legislation had one big problem. It was a consumption-based tax. Meaning states with higher consumption figures were ideally expected to benefit more than producer states. For instance, Karnataka would collect taxes on biscuits consumed in its state, even if the biscuits were manufactured in Tamil Nadu. And this bit was deeply problematic because states like Tamil Nadu made massive investments on roads, highways and ports in a bid to incentivize manufacturing. Until the introduction of GST, they were entitled to extract a return on their investment by claiming taxes at the point of origin i.e. where the goods were manufactured. But with GST, they were in a bind because this tax revenue was now being apportioned to the consumer states.

And although the central government kept insisting that the likes of Tamil Nadu would still have many avenues to shore up tax revenues, manufacturing states wanted guarantees. So a bargain was struck. The centre promised to compensate them until they could work out alternatives. The idea was to create a projection for five years and tally it with actual GST revenues. For instance, each year a state’s tax revenue was expected to grow at 14% (from the base 2015–16) and then, if actual collection fell short of these projections, the centre promised to make up the shortfall. To this end, the centre created a GST compensation fund and began extracting a cess (a tax over and above GST) from the sale of certain products including tobacco. They hoped to pay states using money from this fund.

But this begets a very interesting question — why did the centre expect state tax revenues to grow at 14% when their GDP was still languishing in the single digits. Why would they agree to shoulder such a monumental burden when they had no reason to do it? Why was the compensation fixed at such a high level, when they could have driven a hard bargain. Well…

As an article in the Scroll notes —

While it was called “compensation”, it actually served a dual purpose: it was so generous that it acted like an incentive for states to accept the GST.

While GST has been forcefully opposed by the states in the previous Manmohan Singh-led Union government — including by Gujarat chief minister Narendra Modi — this opposition melted away when cash-strapped states saw this juicy carrot dangled before their eyes. In effect, states were ready to barter their powers of taxation for the short-term promise of increased revenues… Even Tamil Nadu — the most recalcitrant state when it came to GST — was happy with this windfall.

And although the central government got states on board, they fully knew compensating states was always going to be a challenge. But on Thursday, when the finance ministry made its sobering admission, this challenge metamorphosized into a catastrophe. The finance minister confessed that the centre would not be able to make up the shortfall due to COVID. It’s as an Act of God, she said and then went on to argue that the pandemic had absolved the centre of all responsibility to pay its dues.

After all, who are we to question divine intervention?

Right?

Well…

That question is a tad bit challenging.

Taylor vs Caldwell

The year is 1861. Two owners of a music hall in Surrey, London enter into a contract. They agree to rent out the facility to a concert crew for a monetary consideration. Unfortunately, just a week before the first performance, the music hall burns down to the ground. The concert crew immediately sue the owners for breach of contract alleging that they had failed to rent out the facility. The owners refuse to pay. They argue that although there was no explicit clause in the contract that release them from their obligation, there was a phrase at the end of the contract that read — “God’s will permitting.”

The judge sees merit in this argument. He notes that the owners could be excused from discharging their obligation since the hall had perished without any fault of theirs. And since the hall no longer existed, neither party could be held accountable. The contract has been “frustrated”, he declares by an “Act of God.”

So when people use the phrase, they aren’t attributing blame to divine intervention. Instead, they are are simply arguing that they no longer have to hold their end of the bargain because of an unforeseen event that has affected their ability to perform their duties. In fact, the finance ministry quantified the impact of COVID to make its case more compelling.

The centre was expected to pay close to 3 lakh crores to shore up the shortfall. They collected 65,000 crores using the GST compensation cess. That leaves us 2.35 lakh crores short. And then they argued they were short 1.38 lakh crore simply because of COVID. That, according to the government is not its fault.

But hold your horses. Invoking the “Act of God” doesn’t mean the finance ministry ought to be absolved of all responsibility.

As Rahul Menon, assistant professor, School of Livelihoods and Development, Tata Institute of Social Sciences notes—

The current justification used to not pay GST dues shows that the central government is using the language of the private contract in place of the social contract. A private contract is limited to the interactions between both parties that sign the contract and allows one party to walk away in case of events beyond anyone’s control.

Moreover, a private contract assumes that the costs of contract failure can be borne by the two parties involved alone. But the logic of a private contract is not applicable in the current situation, because the failure of the “contract” between the Centre and states imposes a huge burden on those not party to the initial contract. The citizenry will have to bear the burden when states cut back on developmental spending. The Centre is not abiding by its social responsibility to bear the risks and burdens that individuals simply cannot.

But what makes anybody think the Centre can bear this burden? After all, COVID has massive implications for tax revenues at all levels. It’s callous to presume only states are impacted by the crisis, no?

Well, you could argue that. But bear in mind, the central government made that lofty compensation promise. And they can’t deliver right now because they haven’t been entirely honest about their precarious financial condition.

For instance, the government claimed last year that it’s fiscal deficit (read as total money spent by the government in excess of the total income earned) stood at 3.4% of the country’s GDP. Usually, governments make up this shortfall by borrowing money. And for the most part, the government can manage this debt burden.

Except there is one little catch.

As we noted in one of our articles last year

Consider NHAI.

NHAI is the National Highways Authority of India. Their job is to build and maintain roads. But building and maintaining roads is an expensive affair. Granted, the government offers budgetary support and finances NHAI’s many operations but sometimes you can run out of cash. It happens to the best of us and NHAI is no exception.

So on occasion, they go out and borrow money from other investors. And here’s where things take a rather interesting turn.

NHAI has no income to speak of. It is simply an executioner. The money it makes is promptly ploughed back to the government. And so, one would be inclined to think that the money it borrows is also government borrowing. Think about it. If you loan out money to NHAI and they fail to meet their interest obligations, you can’t go out there and start seizing roads and highways. Your only recourse is the government. So effectively NHAI’s borrowings = Government’s borrowings. However, it isn’t classified as such. And that makes all the difference.

Because when the government says that the fiscal deficit is under control, they’re not including all this extra debt on the side. But then if you include borrowings of this kind from all other government-owned entities like NHAI, the Food Corporation of India (FCI) and many others, fiscal deficit shoots up to a whopping 5.8%.

We are not saying this… The government’s auditor (CAG) is.

Bottom line — The government doesn’t have the legroom to borrow money right now because it’s heavily indebted and expense management hasn’t been its strong suit. States don’t have the room to borrow money because they have been profligate spenders as well. The only thing separating the two parties is that no state ever accounted for the possibility of a central government failing to honour its obligations and that means the centre has to own up.

Fortunately, they did offer the state governments some leeway by extending a couple of financing options.

Option 1: “Borrow 97,000 crores (shortfall that isn’t attributable to COVID) using a special window in consultation with the RBI. We will make sure you can borrow at very low rates. And don’t worry, you can pay the interest using the GST compensation cess each year until 2022. Because that’s when we promised we would stop this whole compensation business remember? However, we are willing to make an exception here. The principal and the interest that remains will be paid using the GST compensation cess. We will extend the program. The smokers will pay the cess. They have the money. And oh, the shortfall attributable to Covid — the extra 1.38 lakh crore. That’s on you guys. Sorry”

Option 2: “Borrow 2.35 lakh crore (the entire shortfall amount) from the market. Listen, when you are borrowing from the market, you have to pay market-determined rates. It will be higher. And you’ll also have to pay the interest yourself. However, you can pay the principal using compensation cess and we will extend the program beyond 2022 until you can pay your dues in full. So yeah, you decide.”

Okay… To be perfectly honest with you, this isn’t how the government actually put it. We grossly oversimplified this bit and left out many key details. So if you want to see the full draft, check out this article here.

But besides that, I think we’ve covered most things here. So if you’ve been discussing this matter with a friend, family member or colleague, it’s time to share this article (on WhatsApp, Twitter, or LinkedIn) and revive the discussion once again. I promise you’ll have a new perspective this time.

Also, do let us know, what you’d do if you were one of these states, yeah? Tweet at us and share your opinion. It matters to us.

Until then…