GST – Let’s Get Realistic – Bandhan Mutual Fund

The year gone by was one of realisation. Tax collections faltered, forecasts were marked down and states faced delay in guaranteed compensation payments from the centre. While the economic slowdown continues to have its impact, GST buoyancy has stayed damp due to tax-rate cuts, several structural/design issues and evasion. The experience so far should ideally guide the government to set more realistic GST revenue budget estimates for FY21, also given a quick V-shaped recovery in growth is unlikely. Simultaneously, the government needs to address structural issues and ground-level bottlenecks to enhance tax buoyancy and compliance. It also needs to find a credible permanent solution to the issue of compensation payment to states, at a time when their expenditure should not be constrained. Tax rate hikes may be eventually required, but have to wait or at least needs to be done in steps.

First, the numbers

For FY19, centre’s gross GST collection (CGST + net IGST + Cess) was marked down by Rs. 1 lakh crore and further by Rs. 62,000cr as we moved from Budget Estimate (BE) to Revised Estimate (RE) and then to Actual. FY20 final budget still estimated 14%y/y growth over FY19 actuals, despite a Rs. 1 lakh crore mark-down again from the interim budget.
FY20 collections till Dec19 is only 69% of the budgeted amount and has pushed up the required monthly run rate to improbable levels. Our estimates suggest overall GST collection is likely to be short of the budgeted amount by Rs. 84,000cr, with centre’s gross collection and SGST each lower by Rs. 42,000cr. This is even after assuming a mild pickup in the next three months. In terms of net inflows, this means Rs. 16,000cr shortfall for the centre and Rs. 68,000cr shortfall for states.
Important to note here is we do not take SGST budgeted as the sum of state estimates as this would not reflect the 14% annual growth-guarantee states have on their GST collection and it inflates the required monthly run rate. Instead, we take SGST budgeted to be the balancing number which makes total state collections grow 14% y/y from FY19, after plugging in the compensation cess and states’ share of CGST. Our estimates are also based on CGA data, typically lower as it is net of refunds, unlike PIB data released initially.

Buoyancy – prioritise improvement of design over tax rate hikes

In FY20, GST collection grew 2.1%y/y in H1 (vs. nominal GDP growth of 7%) and 3.7% till end of Q3. This clearly suggests low buoyancy even vs. slower growth.
Multiple tax rate cuts might have pushed GST into the revenue-deficit mode, but the timing doesn’t seem apt for an immediate corrective return to higher rates. Hikes may have to wait for a healthier economic and consumer demand backdrop and/or be done in small steps not to worsen the slowdown. The more critical issues now can be divided into three aspects:

1. Structural design. A review of the underlying framework is essential. This includes thresholds for charging GST and the composition scheme, reverse charge mechanism (GST-registered buyers paying tax instead of unregistered suppliers), inverted duty structure (inputs attracting more tax than the final product which leads to high claims for input tax credit), zero-rated supplies (items on which GST is not charged), exclusions (real estate, liquor, etc.) and compensation payment to states (funded through cess charged on select goods like tobacco, cars, etc.).

2. Process. This involves ensuring simpler but comprehensive forms for tax return filing, accuracy of IT algorithms (e.g. to calculate IGST settlement towards CGST and SGST), timely settlement of exact refund and provisional input tax credit amounts and, most importantly, complete application of invoice matching in a non-disruptive manner.

3. Culture of compliance. Rampant evasion has been reported through transactions involving un-branded goods, fake entities to claim input tax credit, fake bills, no or fraudulent invoicing, reverse charge mechanism (showing personal expense as company expense and vice versa which distorts informal sector representation in the value chain) and B2C entities (currently only invoices above Rs. 2.5 lakhs in inter-state supplies are to be uploaded as buyer does not claim input tax credit). Ensuring compliance through a strict mechanism of checks, raids, penalties and punishments may work only on paper. Instead, a system which creates incentives for entities to be part of it without being forced, like how the personal income tax framework has progressed, is essential in the medium-to-long run.

Compensation to states – fix the mechanism or bite the bullet

States are guaranteed 14% y/y growth on collection of taxes subsumed under GST till 2022, funded by cess charged on certain goods. The recent debate on the delay in releasing payments highlights not just the shortfall in cess collection but the issue with the guarantee mechanism and rate.

Recent reports[1] suggest states’ relevant taxes grew only 8% annually in FY14-17 vs. the guarantee of 14%. While it was important to get all states on board during implementation, 14% growth in revenue seems unrealistic based on historical trend, expected growth and tax buoyancy. This creates fiscal pressure and could lead to disruption of the smooth functioning of the GST Council, one of the best examples of co-operative federalism in India so far.
The likelihood of a fiscal shock to states at the end of the guaranteed five-year-period, if compensation is stopped, is becoming more obvious. It could be worse if future economic growth disappoints. To avoid this, compensation payment will have to be extended or an alternative mechanism put in place. For the former, states may have to agree to a guaranteed rate which is lower and in line with historical growth rates or an annually-dynamic new rate based on growth, buoyancy and GST Council deliberations. They have already expressed disagreement but a compromise may have to be struck in their own interest. Any alternative which garners higher revenue for states would be pro-cyclical in a slowing economy (bigger pie) and/or eats into the central government’s revenue share when it is already constrained (bigger share for states in the same pie). This brings us back to the earlier point of the 3 aspects to focus on to improve buoyancy, in addition to measures to revive the economy.

1 https://www.financialexpress.com/economy/states-facing-gst-trouble-buffer-data-tell-different-story/1811363/

The more immediate problem is tiding over FY20. Our estimates suggest cess collection is likely to fall short by Rs. 15,000cr while compensation requirement could be higher by Rs. 55,000cr than budgeted. Adjusting for latest stock in the cess pool (likely Rs. 18,000cr at end-December) and that compensation for last 2 months of FY20 could be paid only in FY21, states could be left with a net additional requirement of Rs. 50,000cr as compensation.
However, centre’s devolution of taxes to states in FY19 was done as per the revised estimates, and not actuals, which was possibly higher by Rs. 50,000-60,000cr mainly due to shortfall in personal income tax and CGST collection. This could be set off against the excess compensation due in FY20, implying almost-nil net additional transfer to states. Despite this, states have been raising the issue of delay in compensation as the timing of flows impacts their expenditure and borrowing. However, if the central government does not agree on paying the additional compensation, it could be a double whammy for states.
During Apr-Nov, tax receipts for 20 states grew 1.5%y/y in FY20 vs. 13% in FY19. Expenditure growth is 8.6% vs. 14.5% last year, with capital expenditure growing only 2% vs. 19%. Central government expenditure at 12.8%, better than 9.1% last year but short of 20.5% estimated for the full year, seems set to get slower in the March quarter owing to the tight fiscal situation. This creates a tough situation for the centre, states and the economy.
The surprising fact here is the absence of any mention in the GST Compensation to States Act about the mechanism to fund compensation payments in the event of a shortfall in cess collection. The 7^th, 8^thand 10^th GST Council meeting minutes (Dec16-Feb17) notes ‘some mechanism the Council might decide’, ‘mode of raising additional resources including borrowing from the market which could be repaid by collection of cess in the sixth or further subsequent years’ and ‘possibility of market borrowing for payment of compensation which was part of the Minutes of the 8th Meeting of the Council and need not be incorporated in the Law’ respectively. While some states interpreted this as central government borrowing, additional borrowing owing specifically to this is unlikely given the possibility of set-off in March when typically, payment to states are bunched up. This uncertainty should immediately be ended by finalising a permanent mechanism.

A related issue is the year-end IGST settlement – balance taken to the centre’s Consolidated Fund of India, which is then devolved as per the Finance Commission’s formula and not ‘settled’. This was also highlighted by the CAG for FY18, but is yet to be resolved. While the initial round of IGST settlement towards CGST and SGST have increased, centre has been receiving a larger portion. Additional provisional settlements have also been made. However, any larger non-settled IGST amount at the year-end (although zero balance may not be possible) could intensify the debate between centre and states, impact GST council decision making on other important aspects and is bad news for Union Territories as they don’t have a share in devolution unlike in settlement.

Slowdown beckons realistic reckoning for FY21

We estimate maximum FY20 growth in total GST collection could be 4%y/y, implying a monthly run rate of 94,500cr in FY20 vs. 91,100cr in FY19 (as per CGA data), lower than the likely FY20 nominal GDP growth.
The recently released report on National Infrastructure Pipeline (NIP), estimates FY21 nominal GDP growth at 10.5%. This roughly implies real GDP growth of 6.5% assuming CPI inflation at 4%, the RBI’s target and close to its H1 FY21 estimate of 4.0%-3.8%. This could be on the higher side of expectations as the growth slowdown we are amidst is unlikely to witness a quick V-shaped recovery, given impediments to both supply and demand. The argument, one needs to look at the GDP deflator and not CPI inflation to derive growth, would actually imply an even lower FY21 real GDP estimate as the deflator is typically lower than CPI (as WPI and prices of other services get factored in). 24 of the 30 quarterly GDP deflator readings in the last 8 years as per the new GDP series were below the quarterly CPI average (with an overall average gap of 1.5%). A 10.5% growth with a buoyancy of 1.0 could imply an additional monthly collection of Rs. 10,000cr from Apr20. With current buoyancy also below 1, this may be difficult to generate.
For e.g., a lower nominal growth assumption of 9.0% and a buoyancy of 0.85, owing to structural and process improvements, translates into higher monthly collections of Rs. 7,000cr. This could be relatively more realistic.
Also given prior mark downs, a very high FY21BE which seems less plausible could raise questions about the budgeted domestic market borrowing if collections don’t pick up soon thereafter, unless any plan to tap foreign capital is unveiled. This could hinder monetary transmission at a time when it becomes even more critical.

The long and short of it

The GST experience so far has been one of shortfalls and estimate mark downs, and this year is likely no different.
GST collection so far has been below nominal GDP growth, implying low buoyancy, notwithstanding the impact of the recent economic slowdown.
While tax-rate-cut reversals might have to wait or be done in small steps, immediate focus should be on the three aspects – Structural design, Process and the Culture of Compliance. This includes addressing issues with reverse charge mechanism, inverted duty structure, exclusions, process of refund and input tax credit settlement, creating incentives to be part of the system and introducing invoice matchingcomprehensively but not disruptively.
The guaranteed 14% annual growth of compensation to states is high based on past experience and likely growth and buoyancy. To avoid a fiscal shock, states might have to agree to tweak the rate (lower or dynamic) if the 5 year period is to be extended, unless an alternative mechanism is introduced which is not pro-cyclical or eats into the centre’s share.
The immediate problem is states’ compensation shortfall for FY20. This could be set-off against excess FY19 devolution if the centre first agrees on the additional payments this year. States’ expenditure, already low, could be impacted at a time when central government expenditure could be constrained. Importantly, the GST Council should permanently end the uncertainty over the mechanism to fund compensation when cess collection falls short.
A repeat of the FY18 IGST year-end settlement issue should be avoided, particularly given higher IGST transfers to CGST this year, to ensure smooth functioning of the GST Council.
The GST experience and the economic context demands realistic GST budgeting by the Central Government in its upcoming budget. This essentially means realistic assumptions on nominal GDP growth and buoyancy, which would make the GST estimates and borrowing numbers more plausible.

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