GST Compensation Reduces Incentives For States To Improve Growth, Compliance; It’s Time To Revisit The Arrangement

One of the key concepts frequently discussed by several in the policy establishment across the world is of 'moral hazard'.

Moral Hazard basically represents a situation where there is no incentive to guard against any risk of a particular action when one is protected from its consequence.

The concept is an important one for finance, and in economics, as many have tried to develop structures that reduce the problems associated with the same.

The present pandemic has brought in the problem of moral hazard at the forefront of the relationship between Centre and States.

However, the pandemic has only exposed the extent of the problem as the proposed structure itself gave rise to this problem.

Goods and Service Tax was a historic reform and required political navigation through different political interests.

Consequently, several concessions were made during the introduction of the Goods and Service Tax.

The most significant of these concessions was regarding the revenue mobilisation of state governments, where the government effectively guaranteed the states a 14 per cent annual increase in revenue for a period of five years.

In the event that tax collections did not grow at 14 per cent, the Central government would compensate the states with the difference.

Here is why it was problematic. For starters, growth of tax revenue is often a function of two things — growth rate of economic activity and improvements in compliance.

By virtually guaranteeing states a 14 per cent growth in revenues, they lack any incentive to improve their growth rates.

Therefore, there is little incentive for them to undertake productivity enhancing reforms at the state level.

The same is true for improving compliances as state governments are insulated and hence have no incentive to improve compliance of GST.

Moreover, there is no real incentive for them to simplify the GST structure or take into consideration the frequent changes that have been made as an outcome of repeated iterations.

Several tweaks have happened over successive GST councils due to states pushing for lower (or higher) rates for several items based on special interest groups and domestic political realities.

All of this has a cost in terms of revenue realisation — but since states are insulated from it, the entire burden falls on the Central government.

The lack of incentive has become a major problem during the pandemic — as state governments continue to undertake localised lockdowns and issue notifications that are dampening the process of normalisation of economic activity, which is delaying the process of our growth recovery.

However, at the same time, they have been persistent with asking the Central government to clear all dues, pointing to the promise made on compensation in case of shortfall.

With West Bengal extending the lockdown further, there is a need to step back, revisit the arrangement, and evaluate whether such blanket compensation should be provided to states.

While the government may have to compensate the states, it is important to state that any revenue shortfall arising due to lockdown by state governments without consultation with the Central government will not be compensated under any circumstance.

This is important for many reasons as state governments continue to shirk their responsibility towards ensuring a vibrant economy — which is in contrast with how states were operating in the period before the GST.

Moreover, a fundamental difference between pre-GST and post-GST situations is with respect to the average inflation which has been lower.

Tax is always levied on the actual cost of an item and, therefore, lower inflation means low increase in tax revenues (and nominal growth rates). Therefore, in a period of lower inflation, compensating a 14 per cent annual growth becomes all the more challenging and becomes a permanent drag on Central finances.

Hopefully, some of these issues would be addressed by the 15th Finance Commission while the GST Council would succeed in finding a solution to the deadlock on the issue of compensation.

But this entire experience reinforces the need to have systems that have incentives for different stakeholders to pursue economic growth rather than take actions which could potentially dampen them.

One hopes that the lesson learnt during the pandemic will be one that is remembered for years to come.