GST Reforms and State Compensation Debate

GST slab rationalisation promises simplicity and competitiveness, but uneven revenue losses raise debate on compensating states for fiscal stability.

Should States Be Compensated for Revenue Loss from GST Reforms?

Syllabus: Economy (UPSC GS III)
Source: TH

Context:

The Union government has proposed simplifying GST into two slabs — 5% and 18% (with ~40% rate on luxury/sin goods retained). While this may improve competitiveness, it could cause a short-term revenue loss of ₹60,000–1,00,000 crore annually. With the earlier five-year compensation scheme (2017–22) having ended, the issue of state compensation has resurfaced.

What is Proposed?

Move from multiple GST slabs to a two-tier system (5% and 18%).
Average GST rate to fall from 11.5% to ~10%, closer to global norms.
Estimated revenue loss: ₹45,000 crore in FY2025–26 (partial year) and ₹60,000–1,00,000 crore annually thereafter.
Impact will differ across states:
- Industrial states (Maharashtra, Karnataka, Tamil Nadu) may face higher losses.
- Agrarian states (Bihar, Uttar Pradesh) less affected as essentials dominate their tax base.

Why It Matters

Unequal impact: Previous GST rate cuts (2018) showed industrial states losing more revenue than smaller states.
Trust in federalism: GST was agreed upon only with the Centre’s 5-year compensation promise; not supporting states now may weaken GST Council trust.
Developmental risks: States under stress may cut spending on health, education, and infrastructure.
Competitiveness boost: Lower rates (10%) align India with advanced economies, strengthening Make in India and global manufacturing appeal.
Political context: PM’s Independence Day speech indicates strong political push for GST reform.

Case For Compensation

Fairness: Industrialised states with broader tax bases bear higher costs than smaller states.
Fiscal stability: Transitional aid can prevent FY2026 losses (~₹45,000 crore) from destabilising finances.
Asymmetric exposure: Manufacturing states are more affected by slab shifts (e.g., 28% → 18%).
Global practice: Many economies provided temporary compensation during GST transitions.
Political glue: Compensation was key to GST adoption in 2017; repeating it may ensure smooth reforms.

Case Against Compensation

Unsustainable: Centre cannot bear an annual shortfall of ₹60,000–1,00,000 crore.
Moral hazard: Assured revenue may reduce state efforts to curb tax leakages.
Transition over: The 5-year window (2017–22) was meant as a one-time cushion.
Growth effect: Lower rates can expand demand and formalise transactions, boosting future revenues.
Alternatives exist: Kerala’s flood cess (2019) shows states can create stabilisation tools independently.

Way Forward

Time-bound relief: Short-term aid, especially in FY2026.
Targeted support: Focus on industrialised states facing sharper shocks.
Stabilisation fund: Create a GST-linked contingency pool under the Council.
Reform-linked aid: Tie compensation to compliance improvements (e-invoicing, base expansion).
Strengthen dialogue: Maintain transparency in projections and rate classifications.

Conclusion

GST rationalisation will bring simplicity, competitiveness, and long-term buoyancy, but uneven short-term shocks could destabilise state finances. While permanent compensation is not feasible, transitional and reform-linked support can strike a balance between fiscal responsibility and cooperative federalism.