GST Compensation: Centre Does Not Have To Pay States Out Of Consolidated Fund Of India; What Are The Other Options?

GST Compensation: Centre Does Not Have To Pay States Out Of Consolidated Fund Of India; What Are The Other Options?Finance Minister Nirmala Sitharaman should now focus on revival of growth.
  • Principles of fiscal austerity and central bank independence are only instruments in the service of larger economic goals.

    They cannot be allowed to stand in the way of rescuing the economy.

The goods and services tax (GST) compensation to states is a real issue. States want to hold the Union government responsible for the shortfall and for compensating them. The agreement was that states would get 14 per cent annual growth in their GST share for five years up to March 2022. Mind you, states were not seeing their sales tax collections grow 14 per cent every year before.

In fact, some states (eg: Tamil Nadu) have seen their GST collections rise faster post-GST than during the pre-GST years. Tamil Nadu was one of the states that was reluctant to let go of its autonomy to levy sales tax. True, states lost their fiscal autonomy.

However, it is also true that states do not use all their revenue generation mechanisms. Property tax, user charges for water and electricity, road transport fares, etc, are not revised at all for years.

The promise was that a cess (levy) would be applied on luxury and sin goods and that would be credited to a GST compensation fund to pay states in case the actual GST collections (due to states) fell short of the 14 per cent annual growth rate. It was never the intention that the Union government would pay out of the Consolidated Fund of India (ie, out of pocket).

Fungibility Was Not A Good Thing

But, the atmosphere of trust and goodwill was vitiated when the Union government dipped into this cess in 2017-18 and in 2018-19 and took the amount into the Consolidated Fund of India. That has been rectified and states — that fell short of the 14 per cent growth in GST collection — have been compensated fully up to 31 March 2020. That was one drawback.

Former chief economic adviser Arvind Subramanian points this out:

First, in 2017-18, the Centre played fast and loose with the IGST settlement, delaying and reducing the amounts paid to the states. Second, in 2018, it did something similar, transferring the compensation cess to its own coffers, the Consolidated Fund of India, rather than to the compensation kitty. [Link]

Subramanian acknowledges that the Centre has put the money back into the cess. Guess the damage to credibility and trust was done.

But, Growth Slowdown Is Not The Union Government’s Sin

The second implicit criticism of the states, sometimes made explicitly, is that the economic slowdown itself has been caused by the Union government’s acts of commission and omission. That is a stretch.

That is what I argue in my column in Mint. I checked the real GDP growth rates of about nine key emerging economies. All of them have witnessed sharp deceleration in growth rates since 2010.

Data are from the International Monetary Fund World Economic Outlook Database with forecasts for 2020 updated based on the Fund’s June 2020 projections.

GST Compensation: Centre Does Not Have To Pay States Out Of Consolidated Fund Of India; What Are The Other Options?

In addition, there are other players like the Reserve Bank of India, the Supreme Court of India, the National Statistics Organisation, etc. All of them have played a role in the economic slowdown. I discussed them briefly in my column in Mint.

A Promise Without Ownership

A long article in makes a factual error. It states:

To this, the Union government agreed, assuring that the agreed-on compensation would be paid even if the cess fell short. The council itself decided that the law should be amended. [Link]

According to the government of India and as per the minutes of the meeting, the late Arun Jaitley, the then finance minister, said this in the GST Council meeting held in December 2016:

“…the demand for payment of compensation from the Consolidated Fund of India essentially meant funding compensation from Income Tax or non-tax revenues of the Central Government, which would be a challenge as the Central Government also had its own committed expenditure. He said that based on these considerations, certain principles had been agreed upon, namely that the compensation would be funded out of the cess mechanism, which would have a pool of revenue and if there was any shortfall in this pool, it could be supplemented by some mechanism that the Council might decide” [Link]

Again in January 2017, it was reiterated:

“…in case the amount in the GST Compensation Fund fell short of the compensation payable in any bimonthly period, the GST Council shall decide the mode of raising additional resources including borrowing from the market which could be repaid by collection of cess in the sixth year or further subsequent years” [Link]

In fact, a member of Parliament moved a resolution to have the shortfall compensated from the Consolidated Fund of India and the motion was voted upon and defeated.

So, clearly the intent was not to pay the compensation for GST shortfall out of the Consolidated Fund of India.

Also, as I point out in my column for Mint, it was a collective decision of the country to go for GST. It was not an idea foisted by the Union government on states. The idea was that there would be a single market; more efficiency; faster economic growth and more revenues hence.

Therefore, everyone would benefit. If the benefit was solely meant for the Union government, then it has a moral obligation to make up the shortfall by itself. That is not the case and hence, I do not agree that the Union government has a moral obligation to make up the shortfall.

We can discuss — as I do below — the efficiency of Union verus states’ borrowing. But, it is not a moral thing.

We have disposed of three questions:

(1) The Union government did indeed act in bad faith in 2017-18 and in 2018-19

(2) The Union government cannot be held solely responsible for the growth slowdown in the last few years.

(3) There was no intent to make up the shortfall from the Consolidated Fund of India and for the Union government to pick up the bill.

Who Borrows To Make Up The Shortfall?

Ira Dugal raises three questions in her column for BloombergQuint and she concludes that it would be complicated for the state governments to borrow, each one with different cost of capital, etc:

If the RBI lends to states, will the central bank hold state government debt on its balance sheet? It has not done so in the past. Equally, how will it price these loans? If, as the government suggested, it is priced at a spread above central government g-secs, how will that spread be determined and will it be homogeneous across states? As a peripheral issue, if the RBI does take that route and lends at the same rate to all states, it goes back on its long-held dream of creating a differentiated market for state debt based on fiscal parameters. [Link]

Option 1 Combined With States Doing The Borrowing

In the two options that the Union government presented to the states, the government of India seems to favour option 1 whereby it limits its support to the states to the extent of shortfall arising out of GST implementation. That amount is Rs 97,000 crore.

The Union government offers to provide an interest subsidy of 0.5 per cent for this borrowing; interest and principal payment would be paid out of future cess collections and, three, this option also unlocks the 0.5 per cent of conditional borrowing limit granted states in May.

That is around Rs 1 lakh crore. Further, there is a likely Rs 65,000 crore of compensation cess that is expected to be available this year from GST collections. That is an estimate only.

On that basis, the states would get Rs 2.62 lakh crore out of their expected shortfall of Rs 3 crore from GST collections. Further, if the states agree to have 0.0 per cent increment (and not 14 per cent) for 2020-21 as Arvind Subramanian suggests, then the amount of borrowing will be correspondingly lower.

Former CEA Wants The Union Government To Borrow And Make Up Shortfall

Subramanian’s proposal:

The agreement would have three parts. First, for fiscal 2020-21, the states would receive a compensation of X per cent, where X is somewhere in between – Y per cent (the expected shortfall in GST revenues) and 14 per cent, the original compensation guarantee. Second, for 2021-22, the Centre should commit to going back to the 14 per cent commitment, recognising that this is the last year of the compensation window. And finally, to the extent that the agreed compensation exceeds collections, the Centre, not the states, should secure the needed amounts through borrowing in financial markets.
Many possible formulas for X could be envisaged. For example, the Centre and states could agree that X should be: the same level of compensation as last year; equal to the average of – Y per cent and 14 per cent; or sufficient to ensure that state GST receipts are the same as last year. [Link]

Notice that he also proposes that the Union government borrows and gives it to states.

Ira Dugal Concurs:

Beyond the technicalities, if one takes a wider view, it is the sovereign which is the ultimate risk-bearer. In an unprecedented situation such as the one we are facing, the sovereign will need to step in to provide support. It has shown its willingness to do so for private corporations via schemes such as guarantees offered to small businesses.
As such, the sovereign ought to be willing to step in to support states as well. Should it decide that it is willing to do so, the RBI steps in, in some ways, as the agent of the sovereign. It can then design a special window of support in a way that distortion of market signals is kept to a minimum.
Such special support from the central bank, while technically possible for entities beyond the sovereign, should ideally be restricted to the Government of India to avoid setting a poor precedent.

Isn’t It Against Federalism For The Union Government To Borrow On States’ Behalf?

But, Ira Dugal might be contradicting herself somewhat. If the Union government borrows, then the idea of differentiated market for state debt with their own fiscal parameters will be lost. So, it cannot be an open-ended precedent.

In fact, stretching the logic to its conclusion, one can then have a situation of states not borrowing at all since the Union government is at least as efficient as if not better than states as a borrower.

In that case, once the states’ budgets are approved, the Union government borrows and gives the money to states. Can it, will it or should it do without imposing any conditions on how states earn their revenues and spend and on how much it would borrow for them? That would be anti-federalism in full force.

So, this has to be strictly one-off.

Who Makes Up The Shortfall Is Not Independent Of The Quantum Of Shortfall Estimation

The sticking point is that this philosophical principle — as Ira Dugal puts it — of who borrows is also tied to the amount of shortfall that the states are willing to accept as arising out of GST implementation and the amount that is owing to the Covid-19 pandemic and the overall economic slowdown.

If the Union government’s view of the shortfall being Rs 97,000 crore ‘only’ arising out of GST implementation is accepted, plus/minus an agreement to limit the increment to something less than 14 per cent and plus/minus the amount of cess collected above or below Rs 65,000 crore that is currently anticipated, then the question of who borrows becomes somewhat irrelevant. The amount is much smaller.

Revenue shortfall of the states is a worldwide problem due to the economic slowdown. States have to borrow and pay the market rate (or whatever rate the lender demands, if it is RBI), instead of expecting the Union government to borrow and give it to the states.

Letting each state borrow will also let them know their true credit standing and the risk profile of the debt. It will have short-term negative implications for their finances if their interest cost is much higher than the rate the Union government would pay.

So, it is a familiar short-term vs. long-term trade-off. There are no easy answers.

Are The Union Government’s Concerns Exaggerated?

The Union government appears reluctant to borrow in its name. The government G-Sec yield is the benchmark even for private sector borrowers.

Therefore, if the explicit borrowing by the Union government increases, it could raise the cost of capital all around. This is the government’s argument.

The counter-argument is that the market takes the consolidated government debt and deficit into account and not the Union government’s debt and deficit ratios alone.

Therefore, by letting the states borrow at higher interest rate is inefficient and it does not help as the market would, in any case, assume that the Union government stands behind state debt, eventually.

It would only mean a higher consolidated deficit on account of states borrowing at a higher interest rate.

Therefore, eventually the G-Sec yield too would rise, negating the purpose of letting states borrow directly. This is the counter-argument. Perhaps, this is more likely.

Admittedly, it is all a guessing game anyway.

The Final Proposal

(i) It would make sense for the Union government to borrow Rs 97,000 crore (based on its Option 1), put it in the cess account and compensate the states.

(ii) For 2021-22, the GST Council can negotiate the incremental growth rate for states’ GST amount, instead of assuming it would be 14 per cent. It should be brought down to a number, say, between 5 per cent and 7 per cent.

(iii) States will borrow the shortfall. Centre can facilitate with some interest subsidy up to a ceiling, as it is proposing to do now.

(iv) No support or subsidy from the Union government after 2021-22

‘Tough Love’ Is The Right Policy At The Wrong Time

Overall, the sense one gets is that the Union government is being ultra-cautious and it has not benefited from its own caution and conservatism.

It imposed a stringent lockdown — perhaps rather early in the process — and at short notice to the public.

The economic slowdown in the first quarter of 2020-21 (23.9 per cent in constant prices and 22.1 per cent in current prices compared to first quarter of 2019-20) can be partly or largely attributed to the stringent nation-wide lockdown that was in place for the first quarter.

That statistic might be historical but the depth of contraction affects future economic activity. It induces stasis. Soumya Kanti-Ghosh thinks so:

The pandemic is unlikely to have hit a peak and it is most likely that Q2 GDP will also witness a double-digit contraction, and we might not get a positive GDP growth in any of the forthcoming quarters in FY21. [Link]

The government might have been worried about hurting the economy through higher borrowing cost if its credit rating went down consequent to a fiscal stimulus. But, it has to reflect on whether its caution is appropriate to the context. A risk management approach to fiscal deficit suggests that it is prudent to be less cautious now.

‘Expansionary austerity’ does work if fiscal credibility is low. India meets that condition. But, there is another factor to consider.

Going into 2020-21, the Indian economy was fragile and the banking system was still reeling from accumulated bad debts.

The private sector — formal and informal — had to adjust to the effects of demonetisation, the introduction of the goods and services tax, the introduction of the Insolvency and Bankruptcy Code, the collapse of IL&FS and hence the drying up of credit from non-banking channels as well.

On its part, the central bank preached tough-love. State governments were reneging on contracts for purchase of power and state electricity boards were in default too.

On top of that, global growth is weak. There is no support to growth from external demand. When Canada embarked on expansionary austerity in the mid-1990s, America was growing briskly and so was Europe.

I am also wondering if the case of Canada is the only positive data point in favour of ‘expansionary austerity’. It failed in Asia in the aftermath of the Asian crisis and again in Europe after 2010, when imposed on Greece.

So, that leaves the government as the only player in town, along with the central bank. If they do not act in time, the fruits of fiscal austerity and central bank independence and prudence would be lost.

The resulting economic misery would force both of them to pursue more audacious policies but too late. The country risk premium would rise rather than fall and these approaches will have achieved nothing.

Therefore, the government has to rethink its caution and whether it is following the right advice but at the wrong time. Yes, it is true that putting money in people’s hands — normally considered the most efficient way of providing stimulus — is not the best way when they are afraid to go out and spend.

So, the question is one of figuring out the best possible way of providing immediate stimulus rather than one of sticking to caution. Even if the public saves 40 per cent of the stimulus payment, the economy gets the benefit of them spending the other 60 per cent.

The other player that needs to rethink its caution, associated with the mantra of independence is Reserve Bank of India. There does not appear to be any discussion of central bank financing of government debt between them and the Union government. That is unfortunate.

The discussion the country needs right now is between the central bank and the central government on how best to spend, how quickly to spend, how much would the central bank finance it and for how long.

Principles of fiscal austerity and central bank independence are only instruments in the service of larger economic goals. They cannot be allowed to stand in the way of rescuing the economy.

After the first quarter GDP contraction and the downward revision of forecast for the rest of the year, the time to cast off the shackles is now.

This article first appeared on The Gold Standard, and has been republished here with permission.


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