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The curious case of GST Compensation to States

The curious case of GST Compensation to States

The finance ministry recently stated that the Centre had released 30000 crore rupees to the states as GST compensation on 27th March 2021. The total amount of compensation released so far amounts to 70000 crore rupees for the year 2020-21. Before this, the Finance Minister had stated that the Compensation fund was expected to face a shortfall of about 2.35 lakh crore rupees at the end of the current financial year.

What is GST Compensation?

The Constitution (101st) Amendment Act of 2016[1] was the law which provided for the mechanism for levying a nationwide GST. In this law, it was provided that states would be compensated for the loss of revenue arising out of the GST implementation. The GST adoption was made possible by states ceding almost all their powers to impose local level indirect taxes and agreed to let the prevailing multiplicity of imposts be subsumed under GST.

While the states would get the SGST component of the GST and also a share of the IGST, it was agreed that revenue shortfalls arising from the transition to the new indirect taxes would be made good from a pooled GST compensation fund for 5 years period, which is set to end in 2022. This corpus is funded via a compensation cess which is levied on the so-called demerit goods. The computation of the shortfall is done annually by projecting a revenue assumption based on 14% compounded growth from the base years’ revenue and calculation of the difference between the figure and the actual GST collections in that year.

Before the introduction of GST, there were various forms of indirect taxes such as Excise Duty, Service Tax, VAT, CST, etc., that were levied by the Central government and the states at different rates in their exclusive domain. Then came GST, where all these indirect taxes were subsumed into a single tax, which has only a limited rate structure, a much talked about Revenue Neutral Rate notwithstanding, no one can predict if the tax revenues would be same under the GST regime also.

Subsuming numerous taxable events to one, unifying the valuation provisions, fixing GST rate concerning the cumulate rate of taxes levied on each item of goods and services under the legacy regime, foray into new tax domain are the challenges that can resist any projections in this respect.

Background story of the GST compensation

A few months back, the major issue of compensation was threatening the very fabric of Indian federalism. As it can be recalled, the Centre had offered two options to make the shortfall good in the amount of cess needed for compensating states.

In both options, the borrowing had to be done by the states without being facilitated by the centre. In the first option, the centre proposed to fund the principal and interest through the compensation cess, which would be extended beyond the transition period, whereas in the second the offer was restricted to the repayment of the principal from the proceeds of cess. Many states were not pleased with the proposal, and after protracted and intense reciprocation, all the states came on board option one.  

Thereafter the centre borrowed a total of 1,10,208 crore rupees through a special borrowing window at a weighted average interest rate. Apart from providing funds through the special borrowing window, the government of India also granted additional borrowing permission equal to 0.50% of the gross states domestic product. It was extended to meet the GST compensation shortfall and help states in mobilization of the additional financial resources.

Now, in this context, it can be stated that in the present fiscal year, the states and union territories have together raised a total of 7.3 lakh crore rupees from the market. This is 30% more than the borrowings in the corresponding period of 2019-20. As stated in the study by the CARE ratings, this is a reflection of the poor financial condition of states. The disruption caused by the Covid-19 pandemic with sharp increase in the expenditure by almost all states to meet the slowdown challenge has seen a rise in market borrowings.  

The year on year borrowing of states such as Madhya Pradesh (112%), Maharashtra (54%) Karnataka (43%), Tamil Nadu (37%), Kerala (28%) and Assam (27%) have been especially on the higher side. Most of these states are in election mode where largesse ranging from cash to white goods, shall be given from such money borrowed at market rates.


According to the GST Compensation to States Act, states should be compensated for loss of revenue arising due to the GST implementation with effect from 1st July 2017 for five years. This expires in 2022. With the economy gaining momentum, the compensation quantum for the last year and the substantial burden on the centre is likely to reduce.  In any case, the Centre should be able to fulfill its end of the deal.

Read our article: A Complete Detail on GST on Liquidated Damages

Ashish M. Shaji

Ashish M. Shaji has done his graduation in law (BA. LLB) from CCS University. He has keen interests in doing extensive research and writing on legal subjects especially on corporate law. He is a creative thinker and has a great interest in exploring legal subjects.

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