Source: The post Two-tier GST reform will likely impact revenue and States. has been created, based on the article “Should States be compensated for revenue loss from GST reforms?” published in “The Hindu” on 29 August 2025. Two-tier GST reform will likely impact revenue and States.
August 2025
UPSC Syllabus Topic: GS Paper 2- Indian Economy- Taxation.
Context: The Centre proposes shifting GST to two main slabs—5% and 18%—with a lower average rate. Announced as a “Deepavali gift,” it raises core questions on near-term revenue, uneven State-level effects and support, and whether the GST Council will clear the overhaul soon.
For detailed information on GST Reforms – Need & Challenges read this article here
What exactly changes—and why now?
- Proposed structure and objective: The Finance Ministry has signalled a move from four slabs to a predominantly 5% and 18% structure, with a lower average incidence. The aim is simpler slabs and rationalised rates.
- Why the 18% slab stays: About 70% of GST revenue comes from 18%. Merging 12% with 18% was dropped to avoid a large revenue risk. Shifting items 12→5 and 28→18 has a smaller effect than cutting 18%.
- Average incidence and competitiveness: Pre-GST average incidence was ~15%. After GST and earlier cuts, it is ~11.5%. Post-reform, it may be ~10%, a moderate rate that can support manufacturing over time.
What is the near-term revenue impact?
- Quantified short-term dip: Rate rationalisation could reduce revenue by ₹60,000–1,00,000 crore a year (≈0.2–0.3% of GDP). In FY2025-26, with partial-year application, the likely impact is ~₹45,000 crore.
- Offsets and compliance gains: A higher ~40% rate on sin and luxury goods can recoup part of the loss. Lower rates on essentials and durables can lift consumption, expand formal billing, and reduce leakages. Compliance growth can narrow the gap over time.
- Why the hit is contained: Because the 18% anchor remains, the aggregate impact is smaller. Relief is targeted at the edges (12% and 28%) while protecting the core base.
How will States be affected?
- Uneven distribution by structure: GST revenue shares differ. Manufacturing- and service-heavy States with large urban centres face more visible collection hits when durables become cheaper.
- Consumption baskets matter: Agriculture-dependent States, where essentials dominate spending and are exempt or low-rated, see a smaller proportional dent.
- Evidence from 2018 cuts: After the July 2018 reductions, Maharashtra and Karnataka saw a 3–4% monthly collection dip. Smaller north-eastern States barely felt it, reflecting narrower tax bases.
How should State-level risks be handled?
- Compensation window ended: The 2017 compensation guarantee lasted five years. Extending routine compensation for a regular tax is difficult. States must plug leakages, widen the base, and attract investment.
- Alternative support channels: Given uneven distribution, support can also come via the Consolidated Fund of India, including special packages, as seen in early GST phases in some countries.
- Contingency fund idea and long view: A need-based pool could be created. Kerala’s flood cess is a precedent for targeted funding. States are urged to treat rationalisation as long-term ease of doing business that can expand the tax base.
Will the GST Council approve the overhaul?
- Signals of consensus: The Prime Minister’s announcement and subsequent official reiterations suggest groundwork; outright opposition is unlikely, though support modalities may be debated.
- What remains to debate: Placement of specific products between 5% and 18%, and the effective date of rollout.
- Timing and likelihood: Approval in the next Council meeting is seen as likely. If consensus falters, a vote is possible, but derailment appears remote.
Question for practice:
Examine how the proposed two-tier GST (5% and 18%) would impact revenues and what support, if any, States may need.
