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March 21, 2023

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GST Compensation Cess: States Seek Payment Extension

With the implementation of the Goods and Services Tax (GST) in India in July 2017, states were assured of protection from any potential loss in their tax revenue. The GST Compensation Cess was created to facilitate the process. This cess was levied on certain luxury and demerit goods to provide financial assistance to the states facing any shortfall.

The initial period for compensation was 5 years till June 2022. However, the levy of the compensation cess was extended up to March 2026 for repaying the borrowed amount by the states during the pandemic period to pay their compensation liability.

Now, the question regarding the future of this system has become a significant one for states. Various states claim that the cessation of compensation may cause them more stress in the financial aspect. For instance, the state of Punjab is demanding the extension of the compensation cess and its revenue sharing.

What Is GST Compensation Cess?

The GST Compensation Cess is the cess that is levied on top of the GST leviable on certain items. The tax was introduced through the Goods and Services Tax (Compensation to States) Act, 2017.

The purpose of the levy of the tax was to compensate the states for losses in revenues because of the introduction of the new tax regime.

Under the initial scheme, the states were guaranteed annual growth in revenue of 14% based on the protected revenue base. The deficit between the protected revenue and the actual GST revenue could be made good.

This was particularly critical because the adoption of the GST system transformed India's indirect tax system into one that is destination-based.

Also Read: GST Cess in India: Rate, Applicability, and Calculation Explained

Why Was the GST Compensation Cess Extended?

The COVID-19 pandemic has brought about an unforeseen issue.

GST revenues have seen a significant decline amid the pandemic, even as state governments demanded compensation. The cess collection revenue that could be raised was not sufficient to meet the compensation requirement.

In order to bridge this gap, the Union government had to resort to borrowings and make them available to the state governments by way of back-to-back borrowings.

As per the data released by RBI, the Centre had to borrow ₹1.10 lakh crore in 2020-21 and ₹1.59 lakh crore in 2021-22, on account of which the repayments were dependent on the continuance of GST compensation cess collections.

Therefore, the compensation cess collection period has been extended till March 31, 2026.

Also Read: How GST Has Affected the Indian Retail Sector

GST Compensation Timeline

Period	Key Development
July 2017	GST was introduced, and the compensation mechanism started
June 2022	Original 5-year compensation period ended
2020-21 & 2021-22	Centre borrowed funds to meet compensation requirements
March 2026	Extended cess collection period scheduled to end
Beyond 2026	States continued to raise concerns about revenue support

Why Are States Asking for an Extension?

The major problem here is revenue stability.

GST has altered the system in which the states levied indirect taxes. Several taxes that used to be collected by states have been subsumed into GST. Hence, states have much less flexibility on many indirect tax rates.

The states claim that their revenue growth does not always correspond to their expectations within the GST system.

Punjab has been one of such states advocating for the extension. According to some reports, Punjab's Finance Minister Harpal Singh Cheema claimed that further continuation of the compensation mechanism might solve the problems caused by revenue losses from the subsumed taxes. Punjab also cites its own estimates on the annual revenue loss amounting to ₹5,000 crore to ₹7,000 crore from the subsumption of purchase tax.

The problem here is not only about this particular tax. The issue is about the financial relations between the Union government and the states.

Also Read: Impact of GST on the FMCG Sector

What Happens When Compensation Support Ends?

With the cessation of the compensation mechanism, states are left with no choice but to rely more on their usual GST income, internal taxes, and other transfers.

It may lead to varied impacts for different states.

1. Increased Revenue Pressure

Those states where GST revenue collection is relatively weak may experience more revenue pressure.

2. Reduced Revenue Shielding

Under the previous compensation framework, those states that were eligible had a shield to protect them against revenue loss up to a particular level.

3. Increased GST Dependence

With time, states would become more dependent on the total GST revenue and GST revenue shares.

4. Increased Centre-State Negotiations

The matter may bring in increased negotiations regarding revenue sharing, GST rates, and state financial autonomy.

What Is the Current Status of GST Compensation Cess?

This distinction needs to be made clear.

The initial period of statutory compensation concluded at the end of June 2022. The cess continued after this period mainly to repay the borrowings raised by the government due to the pandemic. Official documents issued by the GST Council stated that the total amount of GST compensation provisionally eligible till June 30, 2022, had already been released to all states.

The GST Council has also deliberated on how to proceed after March 2026 regarding the cess. It was observed that maintaining a cess after this period will require a completely new policy environment rather than merely continuing the compensation regime.

Hence, while a state seeks an extension, the issue is not merely about an extension of a tax. This includes consideration of how states are to be safeguarded from revenue pressures in the post-compensation GST regime.

GST Compensation Cess and GST 2.0

The issue has also been altered due to the changes in the rates of GST.

In the new system of GST, there are numerous items which were previously subjected to the compensation cess and have shifted into new GST classifications. As a result, the compensation cess is becoming a less significant tool for the taxation of various items.

This means that the following problem arises: if there is no more compensation cess to provide revenue to states, should there be any other source of revenue for them?

This question will most probably stay relevant when considering the issue of India's GST regime.

Why Does the Issue Matter for Businesses?

GST compensation, at the outset, would seem like an issue between governments. Nevertheless, businesses can also be impacted by any structural change in the GST.

Any significant shift in cess/GST rates can impact:

Product pricing
Tax computation
Invoice amount
Compliance rules
Margins of business
Demand from consumers
Pricing strategies

Businesses dealing in products which have traditionally been subject to compensation cess must keep track of any developments regarding GST notifications and rate structures.

For small businesses, maintaining their tax calculations is all the more necessary due to their sensitivity to even a slight change in the rate structure.

GST Compensation Cess: Key Points at a Glance

Point	Details
Introduced	2017
Main purpose	Compensate states for GST-related revenue shortfalls
Original compensation period	5 years
Original end date	June 30, 2022
Cess collection extended until	March 31, 2026
Major reason for extension	Repayment of COVID-era borrowings
Main concern now	Revenue stability for states
Key policy issue	Future revenue-sharing and state support

What Could Be the Way Forward?

In order to achieve a sustainable solution, a trade-off will have to be made between the fiscal position of the State and that of the Centre.

One way to achieve this can be through a modification of the revenue-sharing formula. Alternatively, this can be done through GST rate changes or provision of targeted assistance to states with large revenue needs.

Nevertheless, any such mechanism that is designed will have to take into account the broader fiscal situation of GST, state-wise differences, and the simplicity of the Indian indirect tax system.

The GST Council will continue to be a critical institution since both the Union and State governments share decisions regarding GST.

Conclusion

The arguments in favor of the GST Compensation Cess and its extension are linked to the issue of fiscal federalism in India as a whole.

GST was implemented to introduce a single taxation regime in the country, but the transition process led to questions regarding the security of revenues for the states. It was addressed with the help of the compensation mechanism, whereas later on, the extension of the collection of cesses allowed repaying debts accumulated due to the pandemic.

With the expiration of the extended compensation cess mechanism, states are trying to secure their future revenues. Thus, the main task for decision-makers is to design such an approach that would ensure adequate revenue stability for states while at the same time not complicating GST itself.

Businesses should bear in mind that GST policies are still being developed, and thus monitoring the changes in rates, cess policies, and GST Council decisions is very important.

If you operate under GST registration, checking your billing settings is always useful to make sure that everything works properly.

FAQs

1. What is GST Compensation Cess?

GST Compensation Cess is an extra tax chargeable on some specific products or services to compensate the State Government for any financial loss that occurred because of GST.

2. Till what date did the GST Compensation Scheme remain in place?

At first, the GST Compensation Scheme existed for 5 years, until June 30, 2022.

3. Why was the GST Compensation Cess period extended?

The main reason for extending the cess collection was to repay the loans borrowed by the central government during the pandemic to meet GST compensation.

4. Why are the states demanding an extension?

Some states claim to be under the burden of revenue post-GST transition and demand further assistance or a new revenue sharing arrangement. Punjab was one such state seeking to extend the compensation regime.

5. Does GST Compensation Cess impact businesses?

Certainly. Businesses involved in goods and/or services that come under the cess should take into consideration the cess while making their calculations regarding taxes, invoices, and GST. Any modification in the GST system might also make an impact on pricing as well.

6. Is GST Compensation Cess going to be in effect beyond March 2026?

In fact, the extended period of the GST cess ends on March 31, 2026. Any extension beyond that period depends on a new policy decision. The discussion regarding this matter took place in the GST Council.

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