GST rate restructuring may lead to varying revenue effects across states

The recent restructuring of the GST rates is likely to lead to varying revenue effects across Indian states. Depending on how rate cuts translate into lower prices, consumers’ behaviour is expected to shift, changing the composition of the consumption basket. GST rate structuring will probably influence economic growth and, consequently, raise household income. The rate reductions are expected to enhance consumers' purchasing power. Based on the price and income elasticities of demand for goods and services, both the scale and composition of the consumption basket will alter. States will observe the revenue impacts of GST rate structuring during the third and fourth quarters of 2025-26 (FY26). At the state level, assessment of the revenue impact may take some time, depending on how quickly revenue data passes through the auditing process. There will be revenue uncertainty in Indian state finances, and states should prepare for it.

Indian State Finances may encounter a revenue shortfall not only due to State GST collection but also because of a shortfall in Central GST collection. The extent of the shortfall in GST collection is hard to estimate because of limited publicly available data and the inability to obtain GST rate-wise tax collection figures from the current GST return system (Mukherjee, 2025a). Additionally, it is anticipated that raising the Personal Income Tax (PIT) exemption threshold to Rs. 12 lakh and adjusting the income ranges across PIT slabs in the Union Budget 2025-26 could impact revenue from PIT. The estimated tax expenditure (revenue foregone) related to the 2025-26 budget announcements was Rs 1 lakh crore in direct taxes and Rs 2600 crore in indirect taxes. Concessional Corporate Income Tax (CIT) rates for domestic and newly registered manufacturing companies have been in effect since 20 September 2019, reducing the effective CIT rate. This has led to an average annual decline of 0.5% of nominal GDP in CIT collections (Mukherjee, 2025b). Consequently, a decline in union government revenue will eventually spill over into the states through tax devolution. Narrowing the tax base by raising the PIT threshold and expanding items exempt from GST may not align with modern taxation principles. Paying taxes can be seen as participation in nation-building, where individuals contribute according to their ‘ability to pay’ and the ‘benefits they receive from public goods and services’.

Depending on each state's capacity to generate resources independently, they will overcome revenue uncertainty. Therefore, it will be essential for states to initiate reforms in taxes outside the GST system, such as State Sales Tax/VAT, taxes on alcoholic beverages, Passenger and Goods Tax, and Electricity Duty. States are cautious about increasing tax rates on non-GST fossil fuels like petrol, diesel, natural gas, and aviation turbine fuel due to fears of trade diversions. They face intense competition from neighbouring states regarding tax rates on petrol and diesel. Often, industries' bulk diesel purchases from neighbouring states reduce the tax base of the state where they are based. Furthermore, ethanol intended for blending with petrol is sometimes diverted to illegal distilleries, and illegal liquors are sold to consumers. A coordinated approach across states is needed to implement reforms in taxation and regulation to protect each state's tax base.

Effective tax rates (tax as a percentage of sales value) and per unit tax rates (either in terms of bulk litres or Alcohol By Volume Litres) vary significantly across states. States are cautious about raising tax rates on alcoholic beverages, considering the risks of trade diversions and illegal supplies. Intercepting consignments of extra neutral alcohol (ENA) meant for other states and passing through a state requires strong regulatory frameworks and interstate cooperation. Often, diversions of ENA lead to the formation of an illegal liquor supply network within a state. The enforcement of rules depends on each state's alcohol policy and the robustness of its tax administration. Therefore, states should consider establishing a forum similar to the GST Council, where consensus on coordinated tax reforms, particularly those with interstate spillover effects, can be discussed and debated.

Many states do not utilise the power of taxation through Passenger and Goods Tax (PGT). PGT is a service tax imposed on commercial vehicles to address three externalities associated with their use: pollution, damage to roads, and congestion. PGT could offer a reliable source of revenue for states. Furthermore, PGT could assist in offsetting revenue losses that states face due to the increasing adoption of electric vehicles, which involve lower taxes on fuels (electricity duty is lower than tax on petrol, diesel, and CNG, and is often exempted for EV charging stations), lower vehicle taxes (as GST rates on EVs are lower than those on conventional fossil fuel-powered vehicles), and exemptions from registration charges and road tax. With the growing penetration of EVs in passenger and goods transport fleets in India, it becomes vital to consider shifting the point of taxation from vehicle ownership (e.g., registration fees and related taxes) and fuel consumption (fossil fuels) to vehicle use (mobility). Any tax on vehicle mobility, such as Vehicle Mileage Travelled Tax, could be introduced using provisions under the PGT Act of the state governments. Additionally, a state that effectively enforces PGT can strengthen the administration of other taxes, including commercial taxes (state Sales tax/VAT, GST) and state excise duty.

To initiate reforms in state taxes requires political willingness and consensus among stakeholders. Moreover, initiating reforms in tax administrations would be essential to augment revenue mobilisation. Digitalisation of tax administration data and the development of analytical tools to handle large datasets may help tax administration to mobilise additional revenue.

{Views are personal; the author is a Professor at the National Institute of Public Finance and Policy (NIPFP)}