Compensation Cess - The Bhishma Pratigya of the GST World

When we launched the Goods and Services Tax (GST) in 2017, it wasn’t just about simplifying tax codes or eliminating border checkposts. It was a full-scale economic re-engineering. But such transitions come with bruises! The states, rightly suspicious, worried that giving up their local taxes would mean falling revenues. To convince them otherwise, the Centre offered a guarantee: a 14% annual increase in tax revenue for five years. And to pay for this promise, it introduced the GST Compensation Cess.

This cess too was no ordinary tax. It was a financial sponge designed to soak up extra money from luxury and sin goods—tobacco, aerated drinks, coal, and luxury cars. The idea was noble: let the big spenders and vice-indulgers foot the bill so that state governments could be at peace.

By guaranteeing states a 14% annual growth in revenue for five years, funded through a levy on goods deemed luxurious or socially undesirable, the Centre undertook a commitment that extended beyond numbers. It was a promise of trust, anchored in the principle of cooperative federalism.

Yet, as history so often reminds us, the best-laid policies are not impervious to unforeseen disruptions. The COVID-19 pandemic, with its severe contraction of economic activity, upended revenue flows and widened the gap between expectation and reality. The Centre, compelled to uphold its constitutional responsibility, borrowed ₹2.69 lakh crore to meet its compensation obligations. In doing so, it preserved institutional trust but also extended the life of a cess that was, by design, temporary.

What began as a transitional arrangement has now acquired a more complex identity.

Who Really Pays? The Consumer, of course, you silly!

While the Centre borrowed to pay states, but guess who’s paying it back? You. Me. Anyone who buys a car, or a fizzy drink. You’d think you were buying a bottle of cola, but surprise! You’re also underwriting Kerala’s budget shortfall. The compensation cess continues, and it’s quietly collecting crores to service a loan that was taken to uphold a promise made between governments.

Though the cess is mainly levied on so-called “luxury” or “sin” goods, in practice, the impact goes far beyond that label. Luxury cars, for instance, attract both GST (28%) and cess (22%), leading to a total tax burden of 50%. A mid-range SUV priced at ₹8 lakh before tax can end up costing ₹14 lakh after GST, cess, and road tax. This has led to strong protests from the automobile industry, which says the high taxes are killing demand.

Beyond luxury items, even coal—which powers most of India’s electricity—faces a ₹400 per tonne cess. This increases costs for electricity and manufacturing, which eventually trickle down to everyday consumers. An Inter Ministerial Committee, set up by the Coal Ministry, said that a ₹100 per tonne increase in coal price makes power costlier by around ₹0.06 per unit. So, the GST compensation cess alone is increasing the price by around ₹0.24 per unit.

By July 2024, consumers had collectively paid a whopping ₹7.6 trillion through this cess since GST’s start, and this figure is projected to reach around ₹8.6 trillion by March 2025. That’s a substantial sum drawn from taxpayers, which is not going into new schools or hospitals directly, but rather to clear a past obligation that financed state budgets during the shortfall.

Is this fair? Does anyone care?

There are arguments on both sides. On one hand, continuing the cess is in line with the original principle that those consuming luxury or harmful products pay a bit extra – a socially conscious form of taxation – and that extra goes toward the public good (in this case, stabilising state finances). It prevented an abrupt shock to state revenues; without it, some states would have faced severe budget cuts when the compensation period ended, especially states that had become dependent on these payouts.

From a common citizen’s perspective, one could argue there’s fairness in ensuring your state government doesn’t suddenly go broke due to GST – the roads, schools, and hospitals in your state benefit from the stability that the compensation provided. In states like Punjab or Chhattisgarh that heavily relied on GST compensation to fund over 10% of their spending, this was a lifesaver

On the other hand, critics point out that ordinary consumers are footing the bill for what was essentially an inter-governmental promise. A citizen in a state that didn’t have a large shortfall – say a state that managed 14% revenue growth or more – still has to pay the same higher tax on her purchase of an SUV or a cigarette as someone in a state that needed a big compensation.

The ethical trade-off is between collective responsibility and individual burden. The GST Council – where states and Centre together made this decision – opted for a collective resolution: everyone pays a bit to fix the shortfall, rather than leaving any state to fend for itself or default on payments.

As we move forward, the continuation of the cess until 2026 signals that the chapter hasn’t fully closed. It serves as a reminder that policies often have extended tails – the decisions made to protect state revenues in 2017 are still affecting our wallets today!