In a stunning development during the Monsoon Session of Parliament, the Union Finance Ministry officially confirmed that it does not have enough funds in the GST compensation pool to distribute among the states. This disclosure has rattled state governments, economists, and policymakers alike, exposing a severe crack in India’s much-hyped Goods and Services Tax (GST) framework.
The Goods and Services Tax, once celebrated as India’s biggest tax reform in decades, was designed to unify the country under a "One Nation, One Tax" system. However, eight years after its launch, the federal compact between the Centre and the states is now under stress, thanks to the central government’s inability to fulfill its compensation commitments.
What Did the Finance Ministry Reveal?
In a written reply to a question in the Rajya Sabha on July 31, 2025, the Finance Ministry confirmed that “no amount is currently available in the GST compensation fund” to disburse to states. The response acknowledged that multiple states are still awaiting their dues from past quarters, and future payments remain uncertain due to insufficient cess collection.
The GST compensation cess is primarily levied on luxury goods, tobacco, aerated drinks, and automobiles, and is supposed to be channelled into a separate fund, meant only for compensating states for revenue shortfalls. Unfortunately, this fund now appears to be empty, raising both economic and constitutional concerns.
The Origin of GST Compensation: Why Was It Necessary?
When GST was implemented in July 2017, state governments had to forgo several independent taxation rights, including levies like VAT, octroi, and entertainment tax. Since these taxes formed a large portion of state revenues, the Centre offered a guarantee of compensation for a period of five years, assuring an annual revenue growth of 14% over the base year (2015–16).
The mechanism was formalized through the GST (Compensation to States) Act, 2017, and a cess was imposed on certain "sin goods" to create a dedicated pool of money for payouts. The understanding was simple: if a state’s GST revenue fell below the protected level, the Centre would make up the difference.
What Went Wrong with the Compensation System?
1. Cess Collection Sluggishness
The GST compensation cess was expected to cover all payouts, but collections remained sluggish, especially during and after the COVID-19 pandemic. Economic activity dropped, luxury consumption dipped, and cess inflows shrank.
2. Rising Compensation Demands
Despite low collections, demands from states kept rising. As their expenditures grew (especially on health and welfare), the gap between actual revenues and the 14% guaranteed growth widened significantly.
3. Centre’s Alleged Misuse of Funds
There have been allegations that the Centre diverted cess collections for other uses, including general budgetary needs and GST shortfall borrowings. The CAG reports in 2020 and again in 2024 highlighted inconsistencies in cess accounting.
4. Policy Delays
There was no timely plan to extend or replace the compensation mechanism after it officially expired in June 2022. States continued to expect support, but the Centre did not frame a concrete alternative.
Which States Are Bearing the Brunt?
The current crisis doesn’t affect all states equally. The worst-hit are those with lower tax buoyancy and a higher dependence on central support.
- Punjab and Kerala: Struggling with low industrial output and high social sector expenditure.
- Chhattisgarh and Jharkhand: Facing rural distress and declining mining revenues.
- West Bengal: Managing rising subsidy bills in the backdrop of political tensions with the Centre.
- Rajasthan and Bihar: Dealing with high debt and lower GST penetration.
Even states like Maharashtra and Tamil Nadu, which have robust economies, are concerned about the Centre’s silence on future compensation, as it disrupts their medium-term fiscal planning.
How Much Does the Centre Owe the States?
According to recent estimates provided by the Standing Committee on Finance, the Centre owes ₹61,000 crore in pending GST compensation dues as of July 2025. This includes:
- ₹20,000 crore from FY 2023–24
- ₹31,000 crore from FY 2024–25
- ₹10,000 crore in dues carried forward since 2022
The Finance Ministry, however, says future disbursements depend entirely on cess inflows, which are not even sufficient to cover one quarter of demand at present.
Centre’s Justification: Is It Valid?
The Centre argues that:
- The GST Compensation Act lapsed in June 2022, so it is under no legal obligation to continue payouts.
- Any extension requires a GST Council consensus.
- The Centre had already borrowed ₹1.1 lakh crore in FY 2020–21 and ₹1.59 lakh crore in FY 2021–22 to cover shortfalls.
- Current cess inflows are too low to fund state needs.
However, states argue that the pandemic and economic shocks extended beyond 2022, and compensation should have been extended at least until 2026. Many claim they were misled into giving up taxation powers, and now the Centre is reneging on its moral responsibility.
Legal Remedies: States Gear Up for a Constitutional Battle
Several states are actively exploring legal action under Article 131 of the Constitution, which allows states to sue the Centre in the Supreme Court for disputes over constitutional obligations.
Past examples, like Kerala vs. Union of India in 2020 (over borrowing limits), set a precedent for federal disputes. Legal experts believe the states have a strong case, especially if they can prove that the cess collected was diverted or mismanaged.
What Does This Mean for India's Federalism?
The GST Council was formed to preserve cooperative federalism, but the current crisis has deepened the trust deficit. Many state finance ministers have publicly expressed disappointment over:
- Delayed meetings of the GST Council
- Lack of transparency in cess accounting
- Centre’s unilateral decision-making
The very fabric of fiscal federalism appears to be under strain, prompting experts to demand a complete overhaul of the GST system, including its architecture and decision-making protocols.
Is There a Way Out? Possible Solutions
- Extend Compensation Period: Legislate an extension till FY 2026.
- Centre-Led Borrowing: Raise a fresh ₹70,000 crore bond program backed by future cess collections.
- Rationalize GST Rates: Simplify the 5/12/18/28% slab system into fewer rates to improve compliance.
- Broaden the Tax Base: Reduce exemptions and bring sectors like petroleum and real estate under GST.
- Transparency Reforms: Publish quarterly GST compensation data for accountability.
Broader Economic Impact
- Reduced capital expenditure by states, affecting infrastructure and job creation.
- Delayed social schemes, including subsidies for health, education, and food security.
- Strain on public debt, as states are forced to borrow more.
- Political volatility ahead of the 2026 General Elections.
If the deadlock persists, credit rating agencies may revise India’s sub-sovereign risk ratings, making borrowing costlier for states.
Frequently Asked Questions (FAQs)
1. What is the GST compensation fund?
The GST compensation fund is a special pool created using cess collections to pay states for revenue shortfalls caused by the implementation of GST.
2. Why is the fund empty now?
The fund is empty due to weak cess collections, high demand from states, and possible diversion of funds by the Centre.
3. Which states rely most on GST compensation?
States like Punjab, Kerala, West Bengal, and Chhattisgarh rely heavily due to limited own tax revenues.
4. Is the Centre legally obligated to pay states?
Legally, the obligation ended in June 2022, but many argue that a moral and federal responsibility remains.
5. Can the Centre borrow money for this purpose?
Yes, it has done so in the past and can do it again, but it affects the overall fiscal deficit.
6. What is the GST Council’s role in this crisis?
The GST Council, composed of Centre and state ministers, is responsible for resolving such disputes but has been largely inactive.
7. Has the Centre misused GST cess funds?
There are allegations, and audit reports have pointed out irregularities, but no formal admission from the Centre.
8. What reforms are being proposed for GST?
Suggestions include rate simplification, better compliance tools, cess reform, and better fund tracking mechanisms.
9. Can states challenge the Centre in court?
Yes, states can and are planning to move the Supreme Court under Article 131 of the Constitution.
10. What happens if the issue isn’t resolved soon?
States may cut essential expenditures, increase debt, and the federal relationship could deteriorate, hurting the economy.
Conclusion: Time for a Fiscal Reset
The Centre’s admission of a GST compensation shortfall isn’t just about money—it’s a wake-up call about how India manages federal responsibilities and economic fairness. As states wait for their dues and prepare for legal battles, the Centre must act decisively. Transparent reforms, urgent fund disbursement, and renewed cooperative spirit in the GST Council are no longer optional—they’re critical.
If GST is to survive and deliver on its promise, it must evolve into a more balanced and transparent system, one where both the Centre and the states feel empowered and respected.
Report by Toofan Express