40 in favour of states

The regime’s four major tax slabs will be collapsed into two from 22 September and a new slab rate will be introduced as a penal rate for super-luxury goods and ‘sin’ items like tobacco. The earlier multiplicity of tax rates had militated against the spirit of a “good and simple” tax right from its rollout stage.

So, the shift to just two rates is a very welcome reform. The 12% and 28% rates have been eliminated and the 5% and 18% rates have been retained. As such, the 18% rate was already garnering two-thirds of all GST revenue, and only 7% of the mop-up was coming from the 5% slab, with the other two slabs of 12% and 28% accounting for 5% and 11% of the total. The 18% slab will now collect an even greater share of GST revenue.

The simplification into two rates was, however, done in an asymmetric way. Most of the 12% category items were moved to 5%, and most of the 28% items moved to 18%. Very few items moved in the reverse direction to a higher tax rate. This implies that the overall tax burden or the effective tax rate of this levy will get lowered. It is thus a fiscal boost for consumption spending.

Whether this was partly necessitated by the steep tariffs imposed by US President Donald Trump is unclear. Finance minister Nirmala Sitharaman firmly refuted that the GST reform was in response to US tariffs, but some of her colleagues indicated that their imposition may have triggered the council’s decisions. Whatever the reason, this was a much-awaited reform and is greatly welcome.

Since most of the movement of items is to lower tax rates, it would mean a revenue loss for the government even as it serves as a fiscal stimulus for consumers. Initial estimates of gross revenue loss were in the vicinity of ₹1.5 trillion. The government’s estimate, however, is of a gross loss of ₹93,000 crore and net loss of ₹48,000 crore based on the consumption base of 2023-24, which is far lower than what other experts estimated. The net loss is lower because the gross loss would be offset by an increase in spending, thanks to the stimulus and consequent additional tax mop-up.

In an optimistic scenario, the fiscal multiplier of the GST rate cut stimulus is seen to be around 1.1, which implies that the reduction in tax burden will be more than offset by higher spending. This is in line with the Laffer Curve effect, under which, counter-intuitively, a rate reduction leads to an increase in tax collection. In the Indian context, this is an empirical matter, and only time will tell whether the anticipated GST revenue loss will be erased by increased spending and tax collection.

There are some procedural hurdles that need to be cleared before 22 September.

Traders, wholesalers and even factories had piled up inventory in anticipation of a festive-season spending rush. The maximum retail price (MRP)-labelling of these goods already indicates higher pre-GST reform prices. How do they manage to re-label them with new price stickers in time for festival buying? Or, if they choose to go with their earlier prices decided before the announcement, will they be slapped with anti-profiteering clauses of the GST law? What if the price cut pass-through is only partial? Will inflation be lower due to lower rates or will the attendant fiscal stimulus have an inflationary impact?

All this can be ascertained only once the relevant data becomes available.

Two issues related to the GST regime continue to bother.

One is that it is an indirect tax and regressive and hence hurts the poor more than the rich. It is especially painful for small businesses, given its heavy compliance burden. Hopefully, the latest revisions have addressed at least the ease of compliance.

The second issue is of the impact on states. Whether the gross loss due to the rate cut and rationalization is ₹1.5 trillion or under ₹1 trillion is yet to be seen, but half of it will be borne by state governments. The reimbursement promise in the original GST law expired in 2022 and the compensation cess is also going to cease. How then will states meet their budgeted expenses?

Note that India has a peculiar ‘two-thirds/one-third’ problem in its federal arrangement. Two-thirds of the spending obligation is with state and local governments, but they have only one-third revenue autonomy. (shorturl.at/fA8kr). That is one reason why petrol, diesel and electricity continue to be kept out of the GST’s purview.

The finance minister, responding to such concerns, has assured all states that the government remains committed to safeguarding their fiscal stability and economic well-being, adding that “the spirit of cooperative federalism has underpinned our deliberations.”

In this context, a feasible reform in the GST framework would be to change the sharing formula from 50:50 to 60:40 in the favour of states. In any case, since states bear two-thirds of all government expenses, this would be in line with their bigger share of budgetary commitments. The GST collected is a consolidated sum that is deemed to be collected half and half on behalf of the Union government and the states. The former has access to other resources like cesses, sovereign debt and foreign borrowings. The latter have none of these.

Surely, tweaking the formula slightly in favour of states will assuage their anxiety and further solidify the spirit of cooperative federalism.

The author is senior fellow with Pune International Centre.