Opinion: GST 2.0 — Should States be compensated?
Effective implementation of the tax reform will ensure equity and address the States’ revenue loss
By Seela Subba Rao
The 56th meeting of the GST Council, held on 3 September 2025, will be remembered as a landmark in India’s tax history. By shifting to a two-rate structure, the Council has taken a bold step towards a simpler, fairer, and growth-oriented system.
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The new structure — 5 per cent and an 18 per cent rate, along with a 40 per cent de-merit rate for select goods — is transformational. Effective from 22 September 2025, it covers 546 goods, of which over 80 per cent have seen rate reductions.
This rate rationalisation will reduce compliance burdens, enhance predictability for business, and make the tax regime more citizen-friendly, aligning it with global best practices. Similar simplified GST frameworks are followed in countries such as Australia and Canada. The announcement that the GST Appellate Tribunal (GSTAT) will be operational by year-end also marks a remarkable institutional advance.
For taxpayers, this means faster dispute resolution, more consistent rulings, and greater trust in the system. Other reforms, such as provisional refunds for inverted duty structures, risk-based compliance checks, and harmonisation of valuation rules, further strengthen the framework.
Easing Burden
Healthcare has received a powerful boost through exemptions and reductions on essential drugs and devices for rare diseases and chronic conditions. These will ease the financial burden on the household. Similarly, farmers stand to benefit as fertilizers and farm inputs like sulphuric acid and ammonia have been moved from 18 per cent to a 5 per cent slab. Correcting inverted duty structures (when raw material is taxed higher than finished goods) will see a reduction in cultivation costs and improve productivity in agriculture.
Labour-intensive sectors stand to gain as well. Reduced rates on handicrafts, marble, granite, and leather goods will stimulate demand and secure employment avenues. A reduction on man-made fibre and yarn to 5 per cent eliminates a distortion that had long plagued the textile value chain. The GST on cement, a cornerstone for housing and infrastructure, has been reduced to 18 per cent, from the earlier 28 per cent. This will have multiplier effects in construction and infrastructure.
The reform is equally significant for micro, small, and medium enterprises (MSMEs), which employ around 110 million people and contribute substantially to the GDP of the country. For years, compliance complexities and uneven tax structure discouraged many small firms from formalising. GST 2.0 simplifies processes, reducing friction and encouraging wider participation in the formal economy.
Supporting States
When GST was launched in 2017, the States were guaranteed compensation for five years to offset potential losses from subsuming multiple taxes into a single GST. It was envisaged that States would become self-sufficient after the transition period ended, ie, by 2022. Five years have elapsed, yet no compensation system is in place.
Moreover, revenue distribution remains skewed — there is no equal distribution of GST revenue. The bigger States with larger manufacturing facilities receive a larger share of GST, while the smaller or less industrialised States receive a negligible share.
It was envisaged that States would become self-sufficient after the 5-year transition period that ended in 2022. Yet, no compensation system is in place
Opposition-ruled States have argued that GST 2.0 could lead to a potential revenue loss of 15-20 per cent. They have demanded a five-year compensation package to offset this anticipated loss, and suggested higher levies on sin and luxury goods beyond the 40 per cent GST rate, besides seeking safeguards against profiteering after tax cuts.
The Finance Minister, however, remains optimistic and believes that a spurt in consumption will help bridge the estimated shortfall of Rs 48,000 crore in GST revenues. Yet, the risk of a larger revenue loss is not being ruled out.
Analysts suggest two options to tackle the expected revenue shortfall in 2025-26 — either reduce expenditure or increase fiscal deficit. For this, the States may have to resort to higher borrowing or cut expenditures in view of the revenue losses that they may suffer. And both these options will have an adverse impact on real growth. Monetary interventions such as repo rate cuts or liquidity expansions, could trigger inflation, while monetising fiscal deficit has its own risks.
Fair Framework
Many developed countries, which have implemented GST, have addressed such imbalances by offering compensation packages from GST revenues itself, along with special packages from consolidated funds. India may need a similar mechanism to ensure equity. Besides, weaker States can be offered limited targeted compensation.
However, even as funds are allocated to areas such as infrastructure, the States must also explore systems and processes to increase their tax base and attract more investment, so that they are self-sufficient in tax. Investment in strengthening digital infrastructure and plugging revenue leakages will help.
A fair framework that offers an equitable solution to address the States’ revenue concern will preserve trust in the GST Council while sustaining reform momentum.
Bigger Picture
By taking up GST reforms, the government has created a framework that balances revenue requirements with economic growth objectives. Implementation challenges remain, no doubt, but the comprehensive nature of these reforms positions India for sustained economic expansion. Revenue loss may be immediate, but over time, as consumption rises, businesses formalise and compliance improves, revenue gains would emerge.
The success of GST 2.0 will depend on effective implementation and the extent to which businesses pass on the tax reduction to consumers. As India navigates global uncertainties, this domestic consumption-focused strategy provides a solid base for resilience and growth. The reforms have transformed GST from merely a revenue collection mechanism into a proactive tool for economic stimulus and inclusive development in the country. They also create a stronger foundation for realising the vision of Viksit Bharat by 2047.
(The author is former Assistant General Manager of Nabard)
