Coronavirus and the Constitution – XXXV: Examining the GST Compensation Crisis [Guest Post]

[This is a guest post by Varun Kannan.]

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Over the course of the last two weeks, multiple State Finance Ministers have criticized the Central Government’s decision to avoid compensating the State Governments for the revenue shortfall that has occurred due to the implementation of the Goods and Services Tax (GST). Thomas Issac, (Finance Minister of Kerala), and Manpreet Badal (Finance Minister of Punjab) have argued that the Central Government has a legal, and a moral obligation to compensate the State Governments for the revenue shortfall (see here and here).

On the other hand, the Central Government has inter alia contended that the revenue shortfall is on account of the Covid-19 pandemic, which is an ‘Act of God’. Instead of directly compensating the State Governments, the Centre has presented them with two alternative options, under which the State Governments shall have to themselves borrow the money.

In this piece, I shall examine the Central Government’s contention that it has no legal obligation to compensate the State Governments for the shortfall in revenue that arose after the implementation of the GST. After examining the constitutional framework of the GST and the relevant provisions of the GST (Compensation to States) Act, 2017, I aim to address an inherent contradiction in the Central Government’s contentions. I shall also discuss as to how this crisis highlights a basic design flaw in the functioning of the GST Council, where the Centre’s veto allows it to renege on its assurances to the States.

The Constitutional framework of the GST

Before we discuss the nuances of the Centre’s arguments, it is instructive to refer to two significant features of the constitutional framework upon which the GST is founded. The constitutional framework for the GST was given effect through the GST (101^st Amendment Act), 2016 (‘the GST Amendment’). As the GST is a single tax that replaces multiple other indirect taxes, both the Centre and the States had to give up their exclusive powers to levy different indirect taxes. Through the GST Amendment, the Centre lost out on its power to levy taxes such as excise duty, while the States could no longer levy entry tax, VAT etc.

As the GST is a tax that is to be levied concurrently by the Centre and the States, a GST Council was established under Article 279A of the Constitution. The GST Council is headed by the Union Finance Minister. The other members of this body include the Union Minister of State for Finance, and the Finance Ministers of all the State Governments.  The GST Council was envisaged to facilitate collective decision-making between the Centre and the States, for all matters concerning the GST, including the rate of GST applicable on different goods and services.

As the GST is implemented through a process of collective decision-making, both the Centre and the States have lost out on their autonomy to unilaterally determine their indirect tax policies. This is reflected in clause (9) of Article 279A, which lays down the voting pattern that shall be adhered to before any recommendation of the GST Council is ratified.

Under the voting pattern, the Centre’s vote shall have a weightage of one-third of the total votes cast, which effectively gives it a veto over all decisions that may be put to vote before the Council. While the State Governments can also collectively exercise a veto, no individual State Government can exercise a veto over any decision of the Council. But the significant point here is that the Centre’s veto power allows it to block any proposal moved before the GST Council, even if all the State Governments unanimously approve of the same. This veto power also has implications for the present crisis, which I shall address in the concluding sections of this piece.

Another significant aspect to note here is that the State Governments ceded their autonomy to independently frame their tax policies because they were assured of full compensation from the Centre, for revenue losses that may arise under the GST. This is reflected in Section 18 of the GST Amendment, which states that – “Parliament shall, by law, on the recommendation of the Goods and Services Tax Council, provide for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax for a period of five years” (emphasis supplied).

Interestingly, although Section 18 was part of the Constitutional Amendment Bill, it did not amend any provision of the Constitution. But it mandated Parliament to pass a law that would lay down a framework under which States would receive compensation for 5 years from the date of GST implementation (1^st July 2017).

As Thomas Issac (Finance Minister of Kerala) points out, the assurance of compensation was one of the main foundations on which the States agreed to the GST in the first place, and ceded their autonomy to frame their tax policies independently. If this assurance of compensation was not mandated by law, States may not have agreed to the GST in the first place. In furtherance of the mandate given under Section 18 of the GST Amendment, Parliament enacted the GST (Compensation to States) Act, 2017 (‘the Compensation Act’). This legislation forms the root of the present controversy, as the Centre’s arguments to deny payment of compensation is based on its provisions, which we shall discuss next.

The Compensation Act

The Preamble of the Compensation Act clearly states that the statute aims to provide “compensation to the States for the loss of revenue arising on account of implementation of the goods and services tax in pursuance of the provisions of the Constitution (One Hundred and First Amendment) Act, 2016”. The statute lays down the manner in which the compensation is to be paid for the first 5 years of the implementation of the GST (i.e. the transition period). Under Section 3 and Section 7 of the Compensation Act, the percentage of annual revenue growth of a State has been projected to be 14%. Under Section 7, if the annual revenue growth of a State is less than 14%, the State is entitled to receive compensation under the statute.

The compensation that is to be paid is the shortfall in the revenue growth. For instance, if the annual revenue growth of Maharashtra after GST implementation is 4%, it shall be compensated for the balance 10% – which is the shortfall. On the other hand, if the revenue growth of Tamil Nadu is 12%, it shall be compensated for the balance 2%. Under Section 9, the Centre has been granted the power to levy a GST Compensation Cess, which shall generate the funds required to compensate the States. The proceeds of this Cess have to be transferred to the GST Compensation Fund, from which the States shall be compensated for their revenue shortfall. Now, Section 10(2) of the Compensation Act states that “All amounts payable to the States under section 7 shall be paid out of the [GST Compensation] Fund”.

The Centre’s arguments and its discontents

As of today, the amount present in the GST Compensation Fund is insufficient to cover the revenue shortfall of the States. This is a result of a fall in GST collections due to the lockdown, and the Centre has been unable to collect the amount of Cess that is required to meet the revenue shortfall of the States. In this scenario, the Centre has taken benefit of Section 10(2) of the Compensation Act to argue that it has no further obligation to pay compensation to the States.

Through a Policy Paper issued by the Ministry of Finance (available here), the Centre has referred to Section 10(2) to contend that in case the amount present in the GST Compensation Fund is insufficient to fulfil the revenue shortfall of the States, it has no further obligation to compensate the States by tapping into other sources of funds. The Centre has argued that by virtue of Section 10(2), it has no obligation to compensate the States through the Consolidated Fund of India, or through any other source of finance.

But, at the same time, the Policy Paper also acknowledges that the Centre has an obligation to compensate the States for the entire shortfall of projected revenue, that arises by virtue of implementation of GST. Moreover, the Policy Paper accepts that this mandate cannot be evaded on account of an ‘Act of God’, such as the Covid-19 pandemic. The Policy Paper also refers to a legal opinion given to the Ministry of Finance by Attorney General K.K. Venugopal. In his legal opinion, K.K. Venugopal mentions that the Centre has an obligation to pay the full amount of compensation, even if there is a shortage in the amount available in the GST Compensation Fund.

This highlights an inherent contradiction in the arguments of the Centre. On the one hand, the Centre states that it has no obligation to compensate the States by tapping funds from other sources if there is a shortfall in the amount present in the GST Compensation Fund. But, simultaneously, the Centre is also acknowledging that it has an obligation to pay the full amount of compensation to the States, even if there is a shortage in the GST Compensation Fund. The Policy Paper itself accepts that there is no provision in the GST Amendment or in the Compensation Act, which exempts the Centre from paying compensation, on account of an ‘Act of God’. This is a mutually contradictory argument – as if the obligation to pay compensation is absolute, the Centre cannot then renege on its legal mandate.

Moreover, Section 10(2) of the Compensation Act does not bar the Centre from tapping into other sources of funds to compensate the States. Section 10(2) only states that all amounts payable to the States under Section 7 of the statute shall be out of the GST Compensation Fund, and does not in any way state that if there is a shortfall, the Centre can evade its primary obligation to the States. In this scenario, Section 10(2) should also be read in conjunction with Section 18 of the GST Amendment, and the Preamble of the Compensation Act. Both Section 18 and the Preamble unambiguously mention that States are entitled to compensation for the loss of revenue, which arises on account of GST implementation.

Also, as discussed above, the constitutional bargain which cements the GST is based on the Centre’s obligation to compensate the States for the shortfall in revenue. If the Centre would not have assured compensation to the States, the States would never have consented to the GST Amendment, by limiting their taxation powers. Hence, if the true spirit behind Section 18 of the GST Amendment is taken into account, it can be argued that the Centre has an absolute obligation to compensate the States without exception – even if the amount present in the GST Compensation Fund is insufficient.

Another argument made by the Ministry of Finance in the Policy Paper is with reference to Section 10(1) of the Compensation Act. Under Section 10(1), the inflows to the GST Compensation Fund are to be made from the GST Compensation Cess, and any other sources as may be recommended by the GST Council. The GST Council can hence decide to tap the shortage and compensate the States through any other source of finance, such as the Consolidated Fund of India. But this is exactly where the design flaw in the GST Council’s functioning begins to hurt the States.

The Centre’s veto – a design flaw in the GST Council’s functioning

As mentioned above, the Centre effectively has a veto over any proposal made in the GST Council. Even if all the States were to unanimously agree to a proposal, the proposal cannot be passed unless the Centre agrees. As Alok Prasanna Kumar and Suhrith Parthasarathy point out (see here and here), this veto power results in a situation where the Centre always wins, and no proposal can go through if the Centre does not want it to. In this scenario, even if all the State Governments were to agree that the Centre should tap into other sources of finance to compensate the States, the Centre can effectively veto this proposal. Although there has been no formal vote in the GST Council on this issue of pending compensation payments, the Centre’s veto power ensures that any such voting process initiated in future will be a foregone conclusion.

This also gives the Centre the leeway to entirely transfer the burden of revenue loss to the States. This is exactly what the Centre has done in the present case, by providing the States with two options under which the States will have to themselves borrow the amount of revenue shortfall. This design flaw in the GST Council’s voting mechanism has effectively put the States at the mercy of the Centre, and unless the Centre relents, the States have no scope to successfully push an alternative proposal.

The road ahead

Based on our discussion above, it is clear that this crisis can be resolved if the Centre takes note of the true spirit on which the GST’s constitutional bargain was based, and provides full compensation to the States for the projected shortfall in revenue. At the same time, this crisis highlights the need for the States to develop a consensus against the voting mechanism of the GST Council, and propose a constitutional amendment that would reduce the Centre’s veto power. This is significant, as similar stalemates where the States are left at the Centre’s mercy may arise in future as well.

There is also a larger question which the Centre must address here. When Late Finance Minister Arun Jaitley pioneered the GST Amendment in Parliament, he mentioned that the GST would usher in a new era of cooperative federalism. This is possible only if the Centre honors the foundations on which the States sacrificed their taxation powers. Unless this is done, the States would be left as mere appendages of the Centre, and this experiment of cooperative federalism is bound for failure.