On May 23, the chief minister of Rajasthan, Ashok Gehlot, wrote to another chief minister pointing out that his state had been demanding an increase in the Goods and Services Tax compensation period for another five years after its original deadline in 2022. Earlier this year in January, Gehlot had made the same demand by writing to the prime minister.

Rajasthan isn’t the only state to make such a demand. “The projected income for states should be extended for another five years,” Chhattisgarh minister TS Singh Deo told the Business Standard. Bloomberg Quint has reported that seven opposition states – West Bengal, Jharkhand, Punjab, Kerala, Rajasthan, Tamil Nadu and Chhattisgarh – met in May to discuss the issue of the extension.

Praveen Chakravarty, a political economist with the Congress, was even more blunt, arguing that without compensation, GST would end: “GST is being held together by a loose thread called revenue guarantee and that thread is about to snap in July 2022. So the choice is clear, if you want GST, you tighten that thread again.”

And maybe most remarkable is that even BJP-ruled Uttarakhand has backed the demand marking a rare instance where a chief minister has batted for his state in violation of party unity.

The new Goods and Services Tax – a pan-India tax which subsumed a range of Central and state taxes – came into being in 2017 with much fanfare. So what does this discussion about extending compensation say about the success of the new tax?

What is compensation?

To understand why this demand for extended compensation is so problematic, we need to go back and see why it exists in the first place.

In theory, the GST would generate as much revenue as the previous tax regime. However, the new regime meant that consumption, not manufacturing, would be the point of tax – which meant manufacturing states would lose out. Tamil Nadu, for example, was vociferously against the very idea of GST.

It was to assuage these states that the idea of compensation was mooted. To make this promise watertight, the idea of compensation was both written into the Constitution and its finer details passed by way of central legislation. It was assumed that state revenues would grow at a rate of 14% year-on-year on a base of the state’s tax revenue in 2015-’16. Any gap between this projection and actual GST revenue would be the compensation. This would be financed by way of a special compensation cess, levied over and above the GST on sin (for example, tobacco) or luxury goods (for example, SUVs).

That this number – 14% – was so high is a hint that “compensation” was not simply limited to being a temporary crutch to tide over GST’s teething troubles. Assuming state revenues would grow by 14% was absurd even at that time. The GDP growth rate for 2015-’16 and 2016-’17, for example, was far short of that figure at 10.5% and 11.8%, respectively. Since then, things have become much worse with a growth of 4% in 2019-’20 and the world’s worst GDP contraction during the Covid-19 pandemic.

Failed bargain

Clearly then “compensation” was a sort of bribe dangled before states. It was this promise of a five-year revenue windfall – rather than any intrinsic belief in the benefits of the news tax – that persuaded states to sign up. This also explains why states till then, including ironically Modi-ruled Gujarat, had not signed up for the new tax. By itself, GST was not an attractive enough proposition for the states. The “compensation” was a necessary addition.

In effect, states were ready to barter their powers of taxation for the short-term promise of increased revenues. This has been, in fact, a unique feature of post 1990s Indian federalism where state leaders often give up responsibility to New Delhi in order to garner short term gains that they can leverage during elections.

However, in offering such a significant compensation, the Union government was also forced to completely distort GST and introduce a version with multiple slabs. Thus, while there now existed a tax called GST, its main feature – simplicity – was gone.

And not only did GST not live up to its promise of simplicity, it failed on the inflated promises of revenue too. Right from the start, GST underperformed – a failing which became critical as the Indian economy itself started to falter (one factor, ironically, widely held to be GST itself). In fact, in the previous financial year, the Union government even reneged on its promise of compensation, citing the poor economy, even though the state of the economy was not a factor in the actual compensation law where the rate was hardwired in.

Right from the start, GST underperformed – not only with respect to its promises but also compared to the old tax regime.

Lack of belief

Now not only was GST compensation critical to bringing states on board, a whole five years later, it is critical to keeping them on board. The GST has fallen so far short of what was promised, that by itself, without a compensation bribe, it has little appeal for the states.

This is, of course, a significant problem for India. The indirect taxation system of a federation of 1.3 billion cannot be run on a rolling five-year bribe. Either the states accept that they signed onto GST and accept the revenues it throws up. Or, more drastically, there should be serious discussions on states taking the responsibility for their own taxation – as the situation existed pre-2017.

For the states to both legally accept the GST system but then simultaneously not believe in its revenue generating powers and to thus ask perpetually for a teething compensation is a chaotic solution to the critical issue of taxation. Clearly this state of affairs cannot be allowed to go on for too long.