GST
( Compensation to States) Act

GST (Compensation to States) Act, 2017

The GST (Compensation to States) Act, 2017 was enacted to provide compensation to the states for the loss of revenue due to the implementation of the Goods and Services Tax (GST) in India. The act ensures that the states are compensated for any shortfall in revenue during the transition to GST for a period of five years (from 2017 to 2022). Below are the key details of the act:

Background and Purpose

Before GST, states had the authority to levy taxes like Value Added Tax (VAT), entertainment tax, and other local taxes, which provided a substantial part of their revenue. With the introduction of GST, these taxes were subsumed under one uniform tax, leading to concerns among states regarding potential revenue loss. Hence, the GST (Compensation to States) Act was introduced to ensure that states were not at a financial disadvantage for five years after GST came into effect on July 1, 2017.

Compensation Formula

The Act guarantees states an annual growth rate of 14% in revenue from their 2015-16 levels. Any shortfall in revenue growth compared to this benchmark was to be compensated by the Central Government.

• Base Year Revenue: The compensation is calculated based on the revenue states were earning from taxes subsumed under GST during the base year (2015-16).

• Projected Growth Rate: The revenue for each state is assumed to grow by 14% per annum from the base year’s revenue.

• Shortfall: If the actual GST collection of a state is lower than the projected revenue (calculated based on the 14% growth), the shortfall is compensated by the Central Government.

Compensation Fund

The compensation to states is paid from the GST Compensation Fund, which is created by levying a cess on certain luxury goods and sin goods (e.g., tobacco, aerated drinks, coal, luxury cars). This cess is collected over and above the GST, and the proceeds go into the fund to pay states their due compensation.

Cess on Luxury and Sin Goods

The GST compensation cess is levied on products like:

• Tobacco and tobacco products
• Aerated drinks
• Coal
• Motor vehicles
• Luxury and high-end products

This cess will continue to be levied until the compensation is fully paid off to the states.

Duration of the Compensation Mechanism

Initially, the compensation mechanism was to remain in place for five years, ending in June 2022. However, due to the economic slowdown and COVID-19 pandemic, many states demanded an extension of the compensation period. There has been ongoing discussion about whether to extend the compensation scheme beyond 2022.

Challenges and Borrowing

In 2020-21, due to the COVID-19 pandemic, there was a significant reduction in GST collections, leading to a major shortfall in the compensation payable to states. The Central Government allowed states to borrow to meet the shortfall, and a special window for borrowing was created to meet the GST compensation requirements.

Dispute Resolution

In case of any dispute regarding the compensation, the matter can be taken to the GST Council, which is responsible for making recommendations on GST-related matters, including the compensation mechanism.

Amendments and Extensions

There have been discussions and amendments around extending the compensation period, especially considering the financial challenges faced by states due to lower-than-expected GST collections post-COVID.