Goods and Services Tax (GST) was introduced in India with a view to promoting consumption and production efficiencies with a tax system that was destination-based. The objective was to ensure that the tax incidence fell on final consumers and taxes paid on inputs were rebated. The way GST evolved in the presence of a complex compensation cess mechanism continued to suffer from multiple tax rates, inverted duty structure and considerable compliance cost.

The new rate structure, which takes effect from September 22, 2025, implies significant rate reductions for some categories of goods. In the revised GST rate structure, 12% and 28% rates have been discontinued. The rates of 0%, 5% and 18% have been continued with changes in the goods and services covered under these rates. There is also a demerit rate of 40% for sin goods and luxury items. Some other lower special rates below 5% have also been continued. Major beneficiary sectors include textiles, consumer electronics, automobiles, health and most food items. These are employment-intensive sectors where the benefits of lower prices would be quite broad based. On the production side, sectors that would benefit include fertilizers, agricultural machinery and renewable energy, where farmers would gain benefits through lower input costs.

Out of a total number of 546 goods where rate changes have been brought in, more than 80% have been subjected to rate reductions and 20% to rate increases. Rate reductions along with corresponding reduction in post-tax prices, in percentage terms, are given in the Table.

GST revenues (R) are determined as the tax rate (r) multiplied by the tax base (E), which is final consumption expenditure. Tax base is the product of pre-tax price (p) and quantity (q). Thus, R=r.E=r.(p.q). Rate changes will have two effects on revenues: one, through the tax rate change, and the other through the impact on tax base. As the tax rates are lowered, post-tax prices are expected to fall, leading to an increase in the quantity demanded. The percentage fall in post-tax price would be much less than the percentage fall in the tax rate. Calibrations indicate that for all feasible ranges of demand elasticity, revenues would fall. Where the tax rates have been brought down to nil, irrespective of the level of expenditure, revenues will be zero.

Editorial | Cuts in time: On the new GST system

There are only limited instances of increase in the tax rate. In cases where the tax rate has been increased from 28% to 40%, pertaining to demerit or luxury goods, most of this change implies only the merger of the compensation cess into the tax rate. This does not constitute a genuine increase in the tax rate. There are some instances where goods may have been moved from 12% to 18%. Overall, our assessment is that substantial revenue reduction is involved due to the multiplicative effect of the fall in the tax rate.

Various estimates of net revenue loss are available which include the one given by the Ministry of Finance -- at ₹48,000 crore for a full year. Other estimates provide higher figures.

Income augmenting effect

To the extent that the government has to bear a substantive amount of foregone revenues on account of these GST reforms, this benefit would accrue to the tax-payer and his disposable incomes would go up. Much of the benefit would accrue to consumers of goods in the 5% rate category, that are necessities. Elasticity of demand for this group of goods is low. As a result of an increase in disposable income, consumers would increase, relatively more, their demand for goods in the higher rate categories of 18% and 40% that are in the nature of comforts and luxuries. These effects would be revenue augmenting. However, the revenue loss would be immediate and revenue gains would emerge over time.

The GST impact on growth arises from avoiding cascading and promoting better resource allocation. The new rate categories do not fully avoid cascading. For all goods and services which are being placed under the exempt category, no input tax credit would be available and the taxes paid on inputs would be loaded onto the price. Where goods are zero rated or even in the 5% category, many inputs may be taxed at 18%; although input tax credit may be admissible, there may be considerable bottlenecks in claiming input tax credit (ITC). In this context, it is also important to note that the classification of goods under the various rate slabs should be determined by the nature of commodities and not by demand weakness at a certain point in time.

Macro implications

There may be some pressure on the Government of India's budgeted fiscal deficit for 2025-26. In Q1, the nominal GDP growth, at 8.8%, was well below the budgeted GDP growth assumption of 10.1%. With the Consumer Price Index and the Wholesale Price Index both remaining low, the expectation is that unless liquidity is increased in the system, nominal GDP growth may turn out to be well below the budgeted level of 10.1%. In the first four months of 2025-26, the direct taxes have contracted by (-)4.3% as compared to 33.6% growth in the corresponding period of the previous year. At the time the Budget was presented, a revenue foregone figure of ₹1 lakh crore was estimated, arising mainly from personal income-tax reforms. With substantial revenue reduction also anticipated in the GST revenues, the realised gross tax revenues may fall well short of Budget projections. To some extent, the Reserve Bank of India's higher dividends may help.

It is important to see how the government responds to the expected revenue shortfall in 2025-26. The option is to either reduce expenditure or to increase fiscal deficit. States may have to resort to higher borrowing or cut expenditures in view of the revenue losses that they may suffer. Both these options will have an adverse impact on real growth. Monetary initiatives through repo rate reductions or liquidity expansions may result in higher inflation, opening up the possibility of monetising some fiscal deficit. Clearly, there are limits to which this option can be exercised.

Any strategy to support growth through demand stimulation spurred by tax rate reductions can be done only on a few occasions. More generally, growth will be driven by saving and investment rates. In fact, the potential growth rate would depend on the investment rate and the incremental capital output ratio.

C. Rangarajan is Chairman, Madras School of Economics and, formerly, the Governor, Reserve Bank of India. D.K. Srivastava is Honorary Professor, Madras School of Economics and Member, Advisory Council to the Sixteenth Finance Commission. The views expressed are personal

GST 2.0 -- short-term pain, possible long-term gain