Should States be compensated for revenue loss from GST reforms?

With the average tax rate set to come down, how do you think the government will maintain revenue?

Manoj Mishra: Whenever we talk about GST rate cuts, there is always an immediate concern of how much revenue we are really giving up. If you look at the proposals on the table, whether it is rationalising multiple slabs into just two, or cutting the 28% or 12% slab to 18% or 5%, the short-term impact is real. As per current estimates, that cut may impact ₹60,000 crore- ₹1,00,000 crore per year, which is roughly 0.2-0.3% of India’s GDP. In the first year of implementation (FY2025-26), when the new structure may only apply for part of the year, the likely hit would be closer to ₹45,000 crore. But this is not a permanent loss. A higher rate of around 40% on sin goods and luxury goods will help recoup some of the revenue. Second, when tax rates go down on essential goods and durables, consumption generally goes up. If you put more people into the formal billing system, you reduce leakages. We have seen this before. So, in my opinion, initially there will be a dip, but growing compliance and an increase in demand will make up for it to a large extent.

About 70% of GST revenues come from the 18% slab. That slab is not going to change materially, so the impact from these overall rate cuts is not likely to be very big. Do you agree?

Pratik Jain: You are right. That is the reason why the 18% slab is not being changed. One of the proposals was to merge the 12% and 18% slabs. But that is not happening because the government did not want to touch the 18% slab, given the revenue implications.

There are revenue implications with items moving from the 12% slab to the 5% one, and with many products moving from the 28% slab to the 18% one. But these implications would not be as severe as if the 18% slab was reduced to, say, 13% or 14-15%.

What would the average rate of GST be after the cuts?

Pratik Jain: Before GST came in, the average tax incidence was apparently around 15%. This got reduced to around 11.5% after GST came in and after the rate cuts. Currently, it is around 11.5%. The estimate is that it will be close to 10% after the rate cuts proposed by the Centre are implemented. That puts India with the best of the developed economies. To my mind, 10% is a very moderate rate. That should really put us in good stead, as we want to attract more manufacturing over a period of time.

GST revenues are divided between the Centre and the States. But are they divided equally among the States? In other words, will the revenue hit from the tax cuts be divided equally?

Manoj Mishra: The revenue distribution is not equal. When we talk about GST rate cuts, the impact is never going to be uniform. For example, States such as Maharashtra, Karnataka, and Tamil Nadu are manufacturing and service-heavy States with strong urban centres. If GST is reduced on appliances or electronics, the immediate revenue collection from GST for these States would take a visible hit. On the other hand, States that are more dependent on agriculture, such as Bihar or Uttar Pradesh, may not see the same proportion of dent in revenue. This is simply because their consumption basket is tilted towards essentials, which are already exempted or are at a lower slab. When the GST Council cut rates in July 2018, there was an almost 3-4% dip in the monthly collections of States such as Maharashtra and Karnataka. But the smaller States, such as those in the north-east, barely felt any impact because their tax base is narrower.

Should the States’ revenues be protected?

Pratik Jain: When GST was launched in July 2017, the Centre provided to the States a compensation guarantee for five years. At that point, they believed that five years is a long period for a transition and so, the States would start standing on their feet after that period got over. Five years have gone by and therefore, technically, there is no compensation (to be given). I think it is very difficult for the Centre to keep compensating the States for a regular tax. There are, of course, ways of looking at allocating more funds for, say, infrastructure development. But as far as taxation is concerned, the States will have to start looking at their own systems and processes. They need to think of how they can plug leakages, how they can increase the tax base, and how they can attract more investment, so that they are self-sufficient in tax. For a country such as ours, a regular compensation provided to the States for any loss on taxation is perhaps not an option.

Manoj Mishra: Whatever Pratik is saying is absolutely correct, but we have to understand that there is no equal distribution of GST revenue. So, the bigger States with larger manufacturing facilities receive a larger share of GST, while the smaller, less industrialised States receive a negligible share of total GST collections. There has to be some mechanism by which these States are compensated. Not necessarily by means of a compensation cess or something like that. There could be another mechanism. There could be a mechanism within the Consolidated Fund of India. I think in many of the developed countries which implemented a GST, initially this kind of process was followed. On the one hand, these countries provided a compensation that came from GST itself, such as the compensation India’s Centre gave the States, and on the other, these countries also provided support through their consolidated funds in the form of special packages.

Pratik Jain: I think that a separate fund could be created. A few years ago, Kerala had imposed a flood cess to raise funds for recovery. So, maybe a part of GST could go to a contingency fund where, depending on the specific situation in a State, the GST Council may decide to allocate funds. I think the States will have to see this (the rate cuts and rationalisation) as a larger reform: as a step towards ease of doing business in India and attracting more manufacturing and more investment into India. Yes, economic theories and past experience will tell you that when you reduce the tax rate, your tax base increases. But, obviously, the States will really want to see how this evolves. So, at this point in time, of course there will be some nervousness, but they must come together and appreciate and understand the long-term benefits of any tax reform.

So far, the GST Council has taken all decisions by consensus save maybe twice in its history. How optimistic are you that the GST Council will actually go ahead with the changes that the Centre is proposing and that it will not get derailed by the States which are not agreeing to this?

Manoj Mishra: I believe that they have already done their homework. Otherwise, the Prime Minister would not have announced this in his Independence Day speech. So, it is highly unlikely that GST Council will oppose these rate cuts. There could be some discussions around the compensation to make up for the losses, but the possibility that they will not go ahead with the rate cuts seems highly remote to me.

Pratik Jain: The Prime Minister made this statement and then it was reiterated by several government officials, so there already seems to be some consensus. I think that there could be discussions about some products, about whether they should fall in the 5% or 18% slab, for instance. Or there could be discussions about when this should be made effective. But I think they will go ahead with the decision — if not with a consensus, maybe with a vote. I see a very strong possibility of it happening in the next upcoming GST Council meeting.