GST rationalisation: Karnataka CM Siddaramaiah backs move with a caveat, demands revenue protection for 5 years

Karnataka Chief Minister Siddaramaiah has cautioned the Centre against pushing for rationalisation of Goods and Services Tax (GST) rates without adequate safeguards to protect the state revenues.

“Karnataka supports rationalisation of tax slabs, only if it is accompanied by a robust revenue protection framework. We are for rationalisation of the rates, ease of compliance and reducing the burden on the people. But, simplification of GST rates must not come at the cost of states’ fiscal stability,” said Siddaramaiah, in his note placed before the GST Council.

After Prime Minister Narendra Modi's announcement of a "next generation tax reforms" in his Independence Day speech, the group of ministers on GST rate rationalisation met and discussed the Centre's plan to reduce the tax slabs. However, seven states - Karnataka, Tamil Nadu, West Bengal, Telangana, Himachal, Punjab and Jharkhand have rejected the GST rate rationalisation in the current form - reducing the number of rate slabs from four to two (5 per cent and 18 per cent) and moving several items to the lower slabs. The states cited that the reduction in slabs would lead to a total revenue loss of ₹85,000 crore - ₹2 lakh crore to the states.

“GST is a shared fiscal arrangement between the Centre and the states, built on the constitutional principles of consensus and cooperation. Any attempt to push rationalisation without adequate safeguards will cause severe harm to states’ revenues and widen fiscal imbalances,” said Siddaramaiah.

Revenue shortfalls

Siddaramaiah noted that the states relied heavily on GST as their primary source of revenue (50 per cent), while GST makes up only 28 pc of the Centre’s revenue, as it has multiple other sources like direct taxes, dividends from public enterprises, customs and excise duties, cesses, and surcharges. It also has a greater borrowing capacity, to act as a counter-cyclical measure in times of revenue uncertainty. A reduction in rates affects state revenues and undermines their fiscal stability too,” said the chief minister, calling for a comprehensive assessment of revenue losses and transparent communication to help the States gauge the extent of shortfall and mitigate adverse impacts on public expenditure and developmental obligations.

Withdrawal of compensation cess

The withdrawal of the GST compensation cess in 2022 has already exposed states to fiscal vulnerability, stated Siddaramaiah. “The 2017 compensation cess had provided much-needed revenue stability to the states during the transition to GST. Although states lost significant fiscal autonomy, this mechanism created trust and cooperation needed for the GST rollout. But after the compensation period ended in 2022, the states’ GST-to-GSDP ratio fell sharply from 3.7 pc in FY 2022 to 2.8 pc in FY 2024, an average of 0.6 pc drop in GSDP revenues. Today, once again, the states are facing the possibility of another substantial revenue loss in the absence of an assured revenue protection plan,” explained Siddaramaiah.

Lack of clarity on luxury goods taxation

The cess on demerit and luxury goods accounts for 7-8 pc of overall GST collections. However, the current proposal lacks clarity on how the effective tax rate on luxury goods will be maintained, say states.

“For instance, pan masala currently attracts an effective tax rate of around 88 pc. Reducing this to 40 pc would result in a revenue loss of 48 pc. While the Centre’s proposal states that the effective rate will remain at 88 pc, there is no clear picture on how the additional 48 pc will be apportioned, nor whether states will get a share of this collection. Similar risks exist for all demerit and luxury goods currently subject to compensation cess. Clarity on these issues is critical to address state revenue concerns,” said Siddaramaiah, seeking an additional levy on demerit and luxury goods to maintain current effective tax levels.

Karnataka Revenue Minister Krishna Byregowda, who is the state’s representative at the GST Council, said, “We demand revenue protection until the tax inflow stabilises. We will oppose the rate cut proposal if it does not safeguard state’s interests. The rationalisation exercise should benefit the common man and not only a few companies.”

GST revenue short of target

In every round of rationalisation, the buoyancy expected to offset revenue losses had not materialised, flagged the states. “It is estimated that, due to rationalisation of rates, the net effective GST rate has fallen from 14.4 pc in 2018 to 11.6 pc in 2024. Notably, GST revenue (net of refunds) as a percentage of GDP has not yet exceeded the levels recorded in the pre-GST era. With the current proposal, the net effective GST rate is expected to fall below 10 pc,” said Siddaramaiah

What Karnataka proposes

1. Impose an additional levy on demerit and luxury goods over and above the proposed 40 pc, to maintain current effective tax levels, with all proceeds transferred to the states. This is necessary to protect state revenues, curb the consumption of harmful goods, and promote public health.

2. Set FY 2024–25 as the base year for revenue protection, with compensation assured at 14 pc annual growth (average growth rate of the last three financial years), following earlier GST Council precedents. The revenue of states for 2024–25 should include their GST revenue as well as compensation cess dues based on the place of supply principle, as this best reflects the revenue capacity of states. Revenue protection is required both for losses due to rationalisation and for losses from the possible non-availability of compensation cess.

3. Revenue protection should be assured for a minimum period of five years. This timeframe is necessary to provide states with stability for medium-term fiscal planning. After this period, the mechanism can be reviewed based on GST growth and buoyancy.

4. If a revenue gap persists even after such an additional levy, the Centre should borrow against the future revenue stream of this levy, as done during the Covid-19 crisis.