Role of cess in the GST Revenue

It is true that consumption growth has been quite weak in recent quarters. But perhaps next year it could prove quite strong.

The compensation cess is due to be reviewed over the coming year because it has now lost its major rationale, which was to fund the temporary revenue guarantee that the Centre had provided to the states- a guarantee that has now expired.

It’s a long-standing principle that tax rates should not be dictated by short-term cyclical considerations. GST rates should be set according to longer-term considerations. Foremost among these is the consideration that some goods are “demerit goods”, which should be taxed more heavily to discourage their consumption. In India, these demerit goods include tobacco, aerated drinks, and motor vehicles.

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Another important consideration when designing the GST is the need for the government to fund its activities. At present, the cess raises considerable revenue, nearly half a percentage point of GDP. Accordingly, if it were simply eliminated, the government would need to find other sources of income, which would involve taxing goods and services whose consumption it really doesn’t want to discourage.

Right now, states are not receiving any revenues from the cess (nor too is the Centre) because it is being used to repay loans taken by the compensation fund during Covid. As a result, once the loans are repaid, cess revenues of roughly half a percentage point of GDP will be available for distribution, both to the Centre and the states. If we assume that the state-wise distribution of cess revenues is similar to that for other GST revenues, all states should gain.

In the first two years of the GST, the Centre and the states pressed to reduce GST rates in the Council, the latter knowing that they would not have to bear the revenue consequences because their own revenues were guaranteed. As a result overall GST collections fell far below the level collected by the equivalent taxes in the pre-GST era. With debt and deficit levels still high, the country cannot afford to repeat that mistake.

Finally, the Centre and the states should complement the cess reform by simplifying the GST system.

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