By Tushar Chakrabarty
The indirect tax paradigm in India changed with the implementation of the Goods and Services Tax (GST) in July 2017. The underlying compass of taxation changed, too, as GST is collected at the place of supply of goods/services as compared to the earlier regime where tax was collected at the source. GST subsumed a number of taxes that were being levied by the Union and state governments.
At the central level, the taxes subsumed included central excise duty, service tax, and central sales tax while at the level of the states, value added tax, entertainment tax, and purchase tax, among others, were subsumed. As the tax reform completes five years, we discuss some of the key trends under the regime.
Revenue growth under GST
The ratio of GST-revenue-to-GDP has been lower than the ratio of indirect-taxes-to-GDP in the pre-GST period (when calculated considering the taxes that were subsumed under GST). This was 6.3% in FY22, which is a shade lower than the 6.5% in FY16. In the pandemic year, FY21, the ratio of GST-revenue-to-GDP had declined to 5.7%.
If the revenue from compensation cess (which is used to compensate states for any loss in revenue from implementing GST) is excluded from total GST revenue, this ratio falls to around 5.3% in FY21 and 5.8% in FY22.
In 2015, the report on the revenue neutral rate and structure of rate under GST had recommended a revenue neutral rate of 15% to 15.5% under the tax regime. In 2019, the Reserve Bank of India (RBI) had estimated that the weighted average GST rate had declined from 14.4% in May 2017 to 11.6% in September 2019 through rationalisation of rates. The 15th Finance Commission had recommended achieving a GST-to-GDP ratio (excluding compensation cess) of 7% over the medium term. The Commission had observed that in case of several goods, the GST rate structure is inverted.
This implies that the tax rate on inputs is higher than the tax rate on the finished products. This leads to large refunds through input tax credit and less than expected net tax collections for the general government. The 15th Finance Commission estimated that in 2018-19, about 78.5% of the tax liability on taxable supplies was paid through input tax credits. According to the Commission, the inverted duty structure can be corrected without a decrease in the weighted effective tax rate under GST.
One of the reasons for the relatively lower revenue collections under GST could also be due to slowdown in economic growth. Between FY18 and FY20, the growth rate of real GDP declined from 6.8% to 3.7%. In FY21, real GDP contracted by 6.6% due to the impact of the Covid-19 pandemic and national lockdowns.
Revenue growth of states before GST
The GST (Compensation to States) Act, 2017, provided for the compensation of states for the loss of revenue arising due to the implementation of GST. According to the Act, the growth rate of revenue from the taxes subsumed under GST for a state was projected to be 14% per annum over the base year of 2015-16.
Any shortfall in GST revenue collections from this growth rate was to be compensated from compensation cess collections for a period of five years.
An analysis of data from 21 states and two UTs shows that the annual growth rate of revenue of most of these states from taxes subsumed under GST was less than 14% between FY14 and FY17.
In the pre-GST period, only a handful of states such as Bihar, Meghalaya, Mizoram, and Nagaland, had their revenue growing at an annual rate of more than 14%.
Between FY19 and FY22, the GST revenue growth of most states was less than the 14% annual rate of growth. The growth rate of revenue under GST for some states was significantly lower as compared to the pre-GST regime. For instance, Karnataka which registered a 11% annual growth in the revenue from taxes subsumed under GST from FY14 to FY17, saw its revenue growth under GST decline to 3%.
As a result, several states received compensation to meet the shortfall between actual and projected revenue.
Reliance on compensation
The compensation requirements of the states were exacerbated due to the economic slowdown in FY20 and contraction of the economy in FY21 from Covid-19 related lockdowns. In FY21, Goa, Punjab, and Uttarakhand had a shortfall in excess of 50% in their SGST revenue as compared to the projected revenue.
For larger states such as Karnataka, Maharashtra, and Uttar Pradesh, this shortfall amounted to 40%, 34%, and 31%, respectively. Due to the increased need for compensation by states in FY20 and FY21, the collection under the compensation cess pool fell short of the amount that was due to the states.
In order to meet the shortfall in the compensation payment, the Union government borrowed Rs 1.1 trillion in FY21 and Rs 1.59 trillion in FY22 and passed it onto the states and UTs with legislature as back-to-back loans.
The borrowed amount will be repaid out of the collection of future compensation cess receipts. For this purpose, the levy of the compensation cess has been extended beyond June 2022 till March 31, 2026.
For FY22, the compensation needs of several states have reduced from the levels seen in FY21. This was driven by recovery in economic activity as the GDP is estimated to grow by 8.7% in FY22.
However, it is important to note that they continued to be dependent on compensation for meeting the projected annual revenue growth of 14% under GST. After June 2022, when the five-year period, during which states were guaranteed an annual revenue growth rate of 14% under GST, ends, states’ revenue is likely to be adversely impacted.
(The author is with the research team at PRS Legislative Research.)