A cesspool of cesses
Aheated debate is raging over the terms of reference for the Fifteenth Finance Commission (FFC), which will determine the formula for distributing central taxes among the states for five years from April 2020. Some states have questioned the use of the population data of 2011 while making the recommendations for tax devolution. There are other questions as well that have arisen from suggestions to the FFC to use populist measures as one of the criteria for proposing performance-based incentives for the states or to consider the imperatives of the New India programme of the Narendra Modi government while making recommendations for devolution of tax revenues.
These questions are important and need to be settled before the FFC can finalise its recommendations. However, an equally important issue that has received little attention so far pertains to the levy of cesses and surcharges by the Union government. The terms of reference for the
FFC do mention the need for it to examine the impact of the goods and services tax (GST) and the abolition of several cesses on the finances of the Centre and the states. But the current debate on the FFC's terms of reference has so far largely stayed away from evaluating the deleterious impact of the Union government's predilection for levying cesses and surcharges.
This is surprising. Total collections from cesses and surcharges levied by the Centre have been rising at a steady pace. In 2016-17, for instance, these grew by about 50 per cent over the previous year, compared to just about 18 per cent growth in gross tax collections for the Centre. Last year, the growth rate for cesses and surcharge collections dipped to about 9 per cent, but the current year will see record growth of over 106 per cent, compared to the gross tax collections growth of 17 per cent.
Cesses and surcharges are not part of the divisible pool of the revenue that is shared with the states under the tax devolution formula. To the extent that the Centre levies cesses and surcharges, the states lose out on revenues they would have otherwise got if they were collected through taxes. So, why shouldn't the FFC be exercised and concerned over this from the point of view of an equitable and fair distribution of tax proceeds among the states?
The bigger concern for the FFC is that the share of cesses and surcharges in the Centre's gross tax collections is expected to rise even after the roll out of the GST, under which all the various cesses were to be subsumed. In other words, states are likely to lose a legitimate share in the central revenues even after the launch of the GST, which was expected to have abolished all the cesses.
Consider how the Union government has undermined the spirit of the GST that was to introduce a single tax after subsuming under it a host of other taxes and cesses. The share of cesses and surcharges in total tax collections by the Centre was a little less than 6 per cent in 2015-16. In the following two years, that share crossed the 7 per cent mark. And in 2018-19, it is expected to be over 12 per cent (without including the GST compensation cess). In the last two years, cesses and surcharges were as much as a fifth of the total taxes that would be shared with the states. In the current year, this share is set to be over a third of the total devolution to the states.
The Union government's fondness for mobilising more revenue from cesses and surcharges has created three types of distortion. One, apart from reducing the states' share in the divisible pool of central tax revenue, the practice of using cesses and surcharges imposes an additional cost burden on businesses. The GST regime allows for credits on input taxes paid at various stages of production of goods and services and thus eliminates the incidence of cascading of taxes. If cesses and surcharges continue to be levied by the Centre, businesses do not get refunds of whatever they pay by way of such nonshareable imposts. The advantages of cost efficiency that the GST regime usually imparts to any economic activity are also neutralised.
Two, there is now a tendency to introduce new cesses under the GST regime to address specific problems afflicting certain sectors of industry. A proposal to levy a cess on sugar sales and help reduce the arrears of sugarcane farmers is now under the consideration of the GST Council. But the idea of imposing a cess on sugar can set an unhealthy precedent and is likely to be the proverbial thin end of the wedge. Not only will this open fresh demands from different sectors going through similar financial woes for a GST cess as a bailout measure, it will also further damage the integrity of the new tax regime.
Finally, the system devised for treating the unclaimed portion of the GST compensation cess is extremely flawed. The GST law on compensation cess mandates that its proceeds will be credited to the GST Compensation Fund, which is non-lapsable. States that establish their revenue losses would be compensated from this Fund after a period of two months. The cess will be abolished after five years, at the end of which 50 per cent of the money remaining unclaimed in this Fund will be transferred to the Centre and the balance amount will be distributed among the states in the same ratio that is used for their tax devolution.
Going by the buoyant GST collections seen so far, a very small number of states may be able to establish a revenue loss and qualify for a share in the compensation cess. According to one estimate, as much as three-fourths of the cess collections may remain unclaimed. The collections from compensation cess in 2018-19 are estimated at ~900 billion. Assuming this amount remains unchanged for the next four years, the GST Compensation Fund will be saddled with unclaimed cess funds of over ~3.38 trillion, half of which will have to be transferred to the Centre and the other half will have to be distributed among states in 2022.
The disturbing question is whether sequestering such a huge amount of cess collected from trade and industry and keeping them in the Fund for about five years will have adverse macroeconomic consequences for the economy. Worse would be the consequences in 2022 when the entire unclaimed cess amount would be recycled back into the system. This will create a sudden fiscal bonanza for the Centre and the states, which could also result in unhealthy splurging of the additional one-time resources at their disposal. The gains would have been more if the Centre and the states were given the freedom to settle the cess claims and distribute the unclaimed resources in the Fund at the end of every year.