Compensating the state – submitted proposal from Gujarat

Dated 18th September, 2014

The state of Gujarat has submitted a proposal to the Union government and to the states highlighting certain measures for compensating the states for their revenue loss under the proposed Goods and Service Tax (GST) regime.

This is essential considering the observation of the Standing Committee of Parliament that the destination-based interstate GST (IGST) model favours predominantly consumer states more than producer states and therefore, the revenue concerns of these states also must be addressed. The proposed GST model should not thus act as a dampener or as a disincentive for states with a strong manufacturing base.

As per the model we have proposed, the Union government would share a portion of its increased revenue—from inter-state trade—with the states, which would protect the interests of not only manufacturing states, but also of mineral- and resource-bearing states like Goa, Rajasthan and Odisha, of oil-refining states like Assam and foodgrains producing states like Punjab and Haryana.

The basic principle is that while the Union government shares a part of its increased revenue (2% of the Central GST component of the output IGST) with the exporting state, dealers in the importing state get full credit for the taxes previously paid on value addition for meeting their output tax liability. This is beneficial for both the exporting and the importing states. We have explained this to officials of all the states and we are glad that they have accepted this win-win solution. Two components of Central and State levies of probably equal rate will make up the total integrated GST rate. IGST rate may be equal to the GST rate applicable on intra-state trade. It is the states, not the union government, that would suffer revenue losses in a scenario where the central sales tax (CST) is phased out as planned—all indirect taxes except the basic customs duty are subsumed in GST and taxation of services fail to yield the expected revenue to states. Therefore, we need a solution involving sharing of a part of the Union government’s additional income from inter-state trade with the states so that there are no losers. GST is conceived such that the states would get taxation powers on services also, while the Union government will extend taxation powers beyond production to distributive trade.

Manufacturing states have made heavy investments on roads, highways and ports and have extended many incentives to projects. Refining states, on the other hand, make investments for the protection of their environment and pollution control. Such progressive steps made towards facilitating economic activity should not be adversely impacted by a new tax system.

An efficient, upfront and independent compensation mechanism is essential for the successful implementation of GST considering that the destination-based taxation principle and the removal of tax cascades under the new indirect tax regime would result in revenue loss to states. (As told to Gireesh Chandra Prasad)

By Saurabh Patel- is the minister for planning and energy, government of Gujarat

A recent meeting of the sub-committee of the empowered committee of state finance ministers (EC) considered the proposal of the Gujarat government that suggested that the exporting states be permitted to retain 2% of the integrated GST (IGST) to be levied by the Centre to compensate the producing states.

This does not seem to be a rational solution for the problem of compensating states for loss of revenue. The proposed IGST is not similar to the existing CST. While the current CST is origin-based, the IGST will be destination-based and will be collected by an independent agency. It will not adversely affect the consuming states. IGST would require timely transfer of funds to the importing states. Any delay will seriously affect the flow of revenue in the importing states. In fact, the revenue of IGST would be used to offset the SGST, CGST and IGST payments of the importing state dealer. If 2% of the IGST revenue is paid to the producing states, there would be a breakdown of the overall GST mechanism. The proposal to allow the exporting states to retain 2% of the IGST is, therefore, contrary to the basic premise of IGST.

However, the states’ demand for compensating loss of revenue from the introduction of GST is a genuine demand. And here it is important to recognise that the loss may be to a producing state as well as to a consuming state. This would primarily depend upon the proposed tax rates for GST. Hence, the issue here is compensation to the producing states as well as to the consuming states, if these too lose revenue due to the introduction of GST.

Another important issue is that the experience of the states so far in receiving compensation for CST loss has not been very satisfactory. The UPA II finance minister P Chidambaram had announced at the conclusion of the Bhubaneswar meeting of the EC that the Centre would fully compensate the states for phasing out CST. The total compensation was estimated at nearly R34,000 crore. The former finance minister had provided for R9,300 crore as the first installment in the FY13 budget but for some reason, only R1,940 crore was finally released. The states feel that as the Centre continues to have difficulty in managing its fiscal deficit, they might face problems in getting timely compensation for the CST loss of revenue. It is important that the Centre instill confidence in the states.

For the Centre to instill confidence in the states that the compensation for GST losses will not be left to the whims of any agency, it is suggested that in the Constitutional Amendment Bill, a provision be made for a state-specific GST pool (SSGP). This pool will compensate the states for any loss of revenue due to the introduction of GST.

The SSGP should have a flow of resources (as some percentage share) from the revenue of Central GST (CGST) on a regular basis. The outflow from the SSGP for compensating states should be decided by a “Working Group” or a team of representatives from the EC and the Centre. This will ensure the exact compensation to be made to the states with no interference from the Centre. This would ensure certainty and automation in the system. The proposed mechanism of SSGP would, therefore, be an automatic institutional mechanism not having any dependence on the funds of the Centre.

By Mahesh C Purohit - is former member-secretary, Empowered Committee of State Finance Ministers, and currently, director, Foundation for Public Economics and Policy Research, New Delhi