GST compensation uncertainties pose a key risk to fiscal health of states.

State governments, which are at the forefront of tackling the COVID-19 pandemic, are facing a serious revenue shock, which could be aggravated by delays in collecting sufficient refunds for goods and services tax (GST). Indirect taxes, such as State Goods and Services Tax (SGST), dominate the states’ own tax revenues (SOTR) and form the backbone of most states’ revenue receipts.

During the lockdowns, we expect consumption of disposable goods and services to have been squeezed and slowly recovered afterward, eroding state and government revenues in FY2021.

Nevertheless, under the GST (Compensation to States) Act, 2017, the difference between the real SGST collections of the state governments and the so-called covered revenues is expected to be released to the states bi-monthly by the GoI in the form of GST compensation until June 2022. Safe revenues are estimated based on an annual base year (FY2016) sales growth of 14 percent subsumed in the GST.

With all states’ covered revenues projected at Rs 7.7 trillion for FY2021, and considering the anticipated shortfall in SGST collections, we are estimating their GST reimbursement demand for the current fiscal year at a massive Rs 4.1 trillion.

The basis of GST insurance funding is a cessation imposed on particular things use, including vehicles, gas, etc. In FY2021 these collections are expected to be half as large as Rs 494 billion.

This pales compared to the amount of about Rs 4.6 trillion required against the total GST reimbursement requirement for FY2020, which was pending at the end of March 2020, and the expected fresh demand for FY2021, along with a paltry estimated balance of unused cessation of the previous years of Rs 255 billion at the end of March 2020.

And how do you pay the GST compensation? The options include the allocation of such funds from the GoI’s own sources, GoI-guaranteed borrowings to be collected by the GST council (whose legal dispensation is unclear), or any other qualifying body, etc.

Until clarity emerges, the magnitude and timing of the GoI ‘s release of GST compensation will pose a significant revenue risk for the state governments.

Other SOTR sources would also suffer, notably tax on motor vehicles, and collections of stamps and registration. The hikes in sales tax / VAT on fuels introduced by several states would only partly offset the losses due to those products’ low usage in Q1 FY2021.

A quarter of the revenue from the states consists of central tax devolution, based on the recommendations of the current finance commission. Provisional data pegged the gross tax receipts of the GoI at Rs 1.5 trillion less than their updated FY2020 projections.

Accordingly, we estimate that the real central tax devolution in FY2020 was higher than required Rs 484 billion which would be changed in FY2021.

In addition, given the projected decline in non-discretionary consumption and the effect of the pandemic on corporate productivity, employment losses, and income rates, we estimate gross tax receipts from the GoI to be 30 percent lower than the FY2021 Budget Estimates. Devolution to states overall will shrink from Rs 6.5 trillion in FY2020 to Rs 5.5 trillion in FY2021.

At the same time, spending on health and social security for the state governments will increase during the crisis. With several lockdown extensions, the GoI has raised the state government ‘s net borrowing cap for FY2021 from 3 percent to 5 percent of the gross national product (GSDP). The unconditional rise, however, is limited to just 0.5 percent of GSDP, which we estimate to be a modest Rs 1 trillion.

State governments’ borrowing caps present a soft limit to the scale of their fiscal deficits. Ultimately, capital spending will have to be cut or postponed to maintain many of the states under their FY2021 fiscal deficit/borrowing threshold.

Some states whose fiscal profile has generated a revenue surplus over the past few years could be comparatively better off in terms of the amount of capital spending they may incur without violating the fiscal norm.

Nonetheless, the states that have to enforce regional lockdowns even in Q2 FY2021 that experience a prolonged compression of revenues and have to cut the CAPEX further to stay within the fiscal threshold. Specifically, the ICRA expects SGST revenues from the states to contract by a substantial 30 percent to Rs 3.5 trillion in FY2021 from Rs 5 trillion in FY2020.