Context

The five-year transition period after the adoption of the Goods and Services Tax (GST) on July 1, 2017, came to an end on June 30, 2022. With this, the era of GST compensation that the state governments were entitled to has ended.

High estimated loan issuance

• Many state governments have asked for the compensation period to be extended by a few years.
• To tangibly assess the near-term outlook for state finances, we have to rely on the states’ own estimates for their market borrowing requirements for the second quarter of 2022-23.
• The indicative calendar of market borrowings by 23 state governments and two Union territories for the second quarter has pegged their total state development loan issuance — the primary source of financing state government deficits — at Rs 2.1 trillion.
•  This projected issuance is 29 per cent higher than the same period last year, and at an eight-quarter high.
• This high level of issuance projected by states reflects concerns that some of them might rightfully have regarding the uncertainty of their cash flows in the post-GST compensation era.
• High dependence on GST compensation: Of these 23 states, Tamil Nadu, Andhra Pradesh, Haryana, Punjab and Gujarat have indicated large increases in borrowings.
• Most of these states have an above-average dependence on GST compensation.

Implications of discontinuation of GST compensation

• Alter the revenue compensation: The discontinuation of the GST compensation flows would alter the revenue composition of some states adversely, particularly those with a relatively larger share of such receipts in their overall revenue streams.
• Increase in debt level: To offset a portion of the associated revenue loss, such states are likely to enhance their borrowings and/or to undertake some expenditure adjustments in the quarters ahead.

Adjustment of borrowing limit of the States by the Centre

• At the time of communicating to states their annual borrowing limits for the ongoing year, we understand that the Centre had informed state governments that their off-budget borrowings for the past two years (2020-21 and 2021-22) would be adjusted from their borrowing ceiling this year.
• Data on off-budget borrowing: It appears that the calculation of the adjusted borrowing limit required the submission of detailed data by the state governments related to their off-budget borrowings for the last two fiscal years, followed by a thorough assessment of the same by the Centre.

Need for early step up in tax-devolution

• On the whole, though, states appear to have entered the year with a comfortable cash flow position.
• This follows from the back-ended release of the tax devolution to states for 2021-22 — nearly half of the full-year amount was released in the fourth quarter.
• Additionally, the total amount was also well above the revised estimate, providing an unexpected gain to states.
• This may have allowed them to temporarily withstand the changes related to their borrowing permission.
• Subsequently, the release of the GST compensation grant of Rs 869 billion for several months in May is likely to have further eased their cash flows.
• If the government does decide to step-up tax devolution to the states in the near term, instead of back-ending it as was done in the last year, it may reduce the size of state borrowings in the second quarter.
• But more significantly, such revenue certainty, despite the end of the GST compensation era, may embolden states to ringfence their capital spending, providing a positive impulse to the economy.

Conclusion

The discontinuation of the GST compensation flows would alter the revenue composition of some states adversely, tax devolution to the states in the near term could cushion the blow of the discontinuation.

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Back2Basics: Compensation under GST regime

• The adoption of the GST was made possible by the States ceding almost all their powers to impose local-level indirect taxes and agreeing to let the prevailing multiplicity of imposts be subsumed under the GST.
• While the States would receive the SGST (State GST) component of the GST, and a share of the IGST (Integrated GST), it was agreed that revenue shortfalls arising from the transition to the new indirect taxes regime would be made good from a pooled GST Compensation Fund for a period of five years that is set to end in 2022.
• This corpus in turn is funded through a compensation cess that is levied on so-called ‘demerit’ goods.
• This GST Compensation Cess or GST Cess is levied on five products considered to be ‘sin’ or luxury as mentioned in the GST (Compensation to States) Act, 2017 and includes items such as- Pan Masala, Tobacco, and Automobiles etc.

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