Balancing Growth and Revenues

The GST Council in its 56th meeting on September 3, 2025, approved a rationalised GST tax structure by collapsing the 12 per cent and 28 per cent of the four-rate structure into two rates, 5 per cent “merit rate” for essential goods and 18 per cent “standard rate” plus a special 40 per cent “demerit rate” on select sin and luxury items. The new rates will become effective from September 22, 2025. The present rate restructuring was preceded by two much smaller exercises in rate reduction in 2017 and 2018. However, the present exercise is much more far-reaching and comprehensive, covering more than 450 goods and services. With this restructuring of rates, the effective tax rate of GST is estimated to be lowered to around 9.5 per cent from the existing 11.6 per cent. It may be pointed out that at the time of the introduction of GST in July 2017, the effective average GST rate was 14.4 per cent, which fell to 11.6 per cent as a result of the earlier rejigging of rates.

The decision of the Council is a welcome move towards a ‘Good & Simple Tax’. India is among the very few countries in the world to have such a complex rate structure that largely contributed to high compliance costs, encouraged tax evasion and militated against ease of doing business. The much-awaited reforms address the crying need to simplify the complex rate structure to obviate ills of classification disputes, inverted duty structure, complexity in GST architecture and ease compliance.

All the state governments, cutting across party lines, have supported the rationalisation and welcomed it as being people and taxpayer-friendly. However, eight opposition-ruled states have expressed concern over its negative impact on state revenues and have appealed to Centre to work out a mechanism for compensating the states for the revenue loss. They have proposed that either the present dispensation of cess be continued beyond the completion of repayment of the loan taken for GST Compensation or the rate of tax be increased only on sin (tobacco products, among others) and luxury goods.

While experts differ on the quantum of revenue loss, it is estimated to be somewhere between Rs 1.5 lakh crore and Rs 2.1 lakh crore annually. The Central government, however, has pegged the total losses to about Rs 48,000 crores annually by factoring in revenue gains that would result from higher spending by households. While it cannot be disputed that the sweeping rate reduction on all major goods and services will kickstart increased consumption of goods and services and, to some extent, offset the revenue loss, the figure of Rs 48,000 crore appears to be a gross underestimation of the actual loss which the Centre and states may suffer. Experience shows that a reduction in rates does not immediately result in higher consumption commensurate with the loss in revenue due to the rate reduction. There is always a time lag of 2-3 years for the increase in consumption to fully offset the loss due to the rate reduction. The steeper the rate reduction, the longer the time lag. As there has been a steep reduction in GST rates (lowering of effective tax rate by 2.1 per cent), the neutralisation of its impact on revenue by higher consumption will definitely be spread over 2-3 years.

The dependence of the states on SGST is much greater than the Centre, as it constitutes almost 40-50 per cent of the States’ Own Tax Revenue (SOTR). With the states having to bear 60 per cent of the total expenditure responsibility as compared to 40 per cent by the Centre, any shortfall in SGST collection is bound to adversely affect the fiscal position of the states. Unlike the states, the Centre can cushion the revenue loss as it has other sources of revenue like cesses and surcharges, flexible internal and external borrowing, direct taxes like income tax and corporate taxes and buoyant non-tax revenues.

The most defining feature of the decision of the GST Council has been the complete consensus among the states. The states, irrespective of their political affiliations and concerns, have unanimously approved the move to simplify the GST architecture. However, the “unanimity” in the Council, a democratic body, masks the disquiet of the states. It is a misnomer to consider states as a homogenous ‘bloc’ in the GST Council. While the states fight for their individual and collective interests in the Council, there is a clear division among them along party lines. When the push comes to shove in taking any decision in the Council on any issue (in this case, the rate rationalisation), the stand of the states apart from their individual state’s interests is often guided by the party diktat or wish. Given the inherently democratic character of the GST Council, this is neither surprising nor abnormal. Therefore, the concern of a handful of opposition-ruled states on the revenue loss and their demand for compensation may not necessarily be the “minority view” but the view of an “unexpressed or silent majority”. Further, the constraints of political economy prevent states from opposing any proposal for rate reduction, especially when it benefits the industry and the common people. It is, therefore, not surprising that since the inception of the GST Council, the tweaking of rates has largely been in the downward direction.

The rationalisation of the rate structure is only the first step towards a “flawless GST”. While the efforts of the GST Council and the states’ collective should be lauded, a bigger challenge in the years to come would be the broadening of the GST tax base. This is even more imperative given that the current tax buoyancy and share of GST revenues in the GDP, as compared to the pre-GST period, have improved only marginally or even declined.

The cooperation of the states will be essential to further take forward the future reforms in GST. In such a situation, it is incumbent on the GST Council that nothing should be done to develop a “trust-deficit” with the states. On the contrary, the Council should capitalise on every opportunity that presents itself, in this case, the whole-hearted support of the states on rate rationalisation, to strengthen mutual trust between the Centre and the states. As the states fear and rightly so that their fiscal position will be badly hit, the GST Council would truly strengthen the cause of “cooperative federalism” if it works out a credible compensation mechanism (notwithstanding moral hazard) to the states for at least FY 2025-26, FY 2026-27 and FY 2027-28. While this move will go a long way in assuaging the fear and anxiety of the states on the loss of revenue, the current GST reform could only then be hailed as a genuine exercise in “cooperative federalism”.

Views expressed are personal. The writer is a retired civil servant