Context

• The Goods and Services Tax (GST), introduced with the objective of creating a destination-based tax system, sought to improve efficiency by ensuring that the incidence of taxation fell on final consumers while input taxes were rebated.
• Despite its transformative intent, the GST system initially suffered from multiple rates, inverted duty structures, and high compliance costs.
• The new rate structure, effective from September 22, 2025, represents a significant overhaul, with implications for consumption, production, government revenue, and macroeconomic stability.

Evolution of the New GST Structure and Its Revenue Implications

• Evolution of the New GST Structure
  • The 2025 reform eliminated the 12% and 28% slabs, consolidating most goods and services under 0%, 5%, and 18%, while introducing a 40% demerit rate for luxury and sin goods.
  • Special concessional rates below 5% were retained for certain essential commodities.
  • These changes particularly benefit employment-intensive sectors such as textiles, automobiles, consumer electronics, healthcare, and food products.
  • On the production side, agriculture-related industries, fertilisers, machinery, and renewable energy, stand to gain from lower input costs.
  • Out of 546 goods subjected to revision, 80% experienced rate reductions, reflecting a pro-consumer and pro-growth stance.
  • However, the economic consequences extend beyond lower prices and higher demand; they also challenge fiscal stability.
• Revenue Implications
  • GST revenue (R) is determined as the product of the tax rate (r) and the tax base (E), which itself depends on pre-tax prices and quantities consumed.
  • Rate reductions lower post-tax prices, encouraging higher demand, but the increase in quantity demanded is not proportionate to the fall in tax rates. As a result, overall revenue tends to decline.
  • Calibrations suggest that across realistic demand elasticities, revenues will fall. For zero-rated goods, revenues vanish altogether.
  • Even for goods shifted to the 40% bracket, the apparent increase largely reflects the integration of the compensation cess, rather than a genuine hike.
  • Estimates of revenue loss vary, with the Ministry of Finance projecting ₹48,000 crore annually, while other assessments suggest higher figures.

Shortcomings of GST Reform

• Income and Consumption Effects
  • A key implication of the reform is the redistribution of benefits to consumers.
  • Lower GST translates into higher disposable incomes, especially for those consuming necessities in the 5% bracket.
  • Since demand elasticity for such goods is low, households may divert additional income toward higher-rated categories (18% and 40%), such as comforts and luxuries.
  • Over time, this could augment revenues, but in the short run, the government faces a pronounced revenue shortfall.
• Efficiency and Cascading Effects
  • While GST was designed to eliminate cascading, the revised structure does not fully achieve this aim.
  • Exempt goods, by disallowing input tax credits (ITC), embed input taxes into final prices.
  • Even in the 5% category, inputs taxed at 18% create administrative bottlenecks in claiming ITC.
  • Such inefficiencies undermine the reform’s ability to fully rationalise resource allocation and improve competitiveness.

Macroeconomic and Fiscal Challenges

• The reforms also intersect with India’s broader fiscal position.
• Nominal GDP growth in the first quarter of 2025-26 stood at 8.8%, below the budgeted 10.1%. With inflation subdued, achieving revenue targets becomes harder.
• Direct taxes contracted by 4.3% in the early months of the year, contrasting sharply with robust growth in the previous period.
• The Union Budget had already anticipated a revenue forgone figure of ₹1 lakh crore, largely due to personal income tax reforms.
• Additional GST revenue losses could push gross tax receipts significantly below projections.
• While higher Reserve Bank of India dividends may provide partial relief, the government faces the difficult choice between curbing expenditure and widening the fiscal deficit.
• States, too, will encounter similar dilemmas, with potential recourse to borrowing or expenditure cuts, both of which could stifle growth.
• Monetary interventions, through repo rate cuts or liquidity injections, risk fuelling inflation and forcing monetisation of deficits, a path fraught with limitations.

Growth Prospects and Structural Limits

• Although tax rate reductions may temporarily stimulate demand, this strategy cannot sustainably drive long-term growth.
• India’s potential growth rate ultimately depends on investment and savings, alongside the efficiency of capital use (incremental capital-output ratio).
• Thus, while GST reforms may provide short-term relief to consumers and production sectors, enduring growth requires structural improvements in investment capacity and productivity.

Conclusion

• The 2025 GST reforms represent a bold attempt to simplify the tax structure and stimulate economic activity.
• They promise lower prices, higher disposable incomes, and sectoral gains, particularly in employment-intensive industries, however, the fiscal cost is substantial, with immediate revenue shortfalls threatening both central and state budgets.
• Moreover, unresolved inefficiencies such as cascading and ITC bottlenecks continue to limit the system’s effectiveness.
• Ultimately, GST reforms can complement but not substitute for broader strategies centred on savings, investments, and productivity growth.