GST 2.0 and the states’ squeeze

By Taru Saigal, Sreedevi R S, AND Maya K 

The introduction of the Goods and Services Tax (GST) in 2017 was considered a reform that would integrate the fragmented tax system of India, enhance operational efficiency, and improve revenue generation eventually. The Centre, aware of the states’ fears of losing their finances, promised states five years of guarantee or 14% growth in their revenue as compensation, backed by a special cess. This promise ran out in June 2022. As GST 2.0 is underway, the pressing question is whether states have become more vulnerable—especially in financing welfare, health, and education. 

The intent of GST was laudable. By combining all indirect taxes into a single system, it aimed to minimise compliance costs, create a common market, and eliminate the cascading effect. For states, the main attraction was the compensation mechanism, which ensured their revenues would not fall during the transition. In the early years, the mechanism functioned as a fiscal cushion. From 2018-2019 to 2022-2023, states’ GST revenues, with compensation, were about Rs 37.7 lakh crore; of this, Rs 8.5 lakh crore was on account of compensation. Without this safety net, many states would not have been able to pay even their daily costs.

That cushion is gone. Ministry of Finance data showed that 25 states recorded GST revenue growth of 14% or more over the preceding year in July 2022, the first full month after the phase-out of compensation. However, this headline number concealed a weakness. Punjab, Madhya Pradesh, and Bihar failed to meet the benchmark owing to structural weaknesses. According to a Reserve Bank of India report, six states—Punjab, Himachal Pradesh, Goa, Uttarakhand, Delhi, and Puducherry—were classified as “particularly vulnerable,” as compensation contributed over a tenth of their tax revenue.  

The structure of GST itself has widened disparities. Because it is a destination-based tax, it benefits consumption-heavy states. Maharashtra and Gujarat -- which are manufacturing states with strong bases – have registered above-average growth. The growth in Maharashtra’ gross GST revenue in FY2024-25 was 15.6% --well over the national average of 9.7%. On the other hand, consumption states are still struggling. However, the Northeastern states posted astonishing compound annual growth of 27.5% in GST revenues since 2017 (over a low base). Results are not the same, so there is no level playing field. 

The GST Council activities further complicate the matters-- the smaller states have often complained of being excluded from decision-making, although it was intended as an instrument of cooperative federalism. Delays in settlement of dues and refunds have eroded trust. States that rely on quick income for social spending experience the greatest pain. Recent cuts in GST rates may help the political class, but they have hit the states’ coffers hard. Kerala alone estimates yearly losses of Rs 8,000–10,000 crore, while some states together predict aggregate losses of Rs 1.5–2 lakh crore for the country.

The strain is most visible in welfare spending. States, as primary providers of education, healthcare, nutrition, and rural development, are expected to maintain social sector outlays at around 2% of Gross State Domestic Product—roughly Rs 6.4 lakh crore in FY2026, according to CRISIL Ratings. But this sustained push risks widening revenue deficits, leaving little room for capital expenditure. For fiscally constrained states like Punjab and Kerala, debt rises even as development slows.

The Centre points to buoyant GST collections, which touched record highs in 2024 and grew about 12% annually between 2018 and 2023, faster than nominal GDP. Yet, excluding compensation, states’ GST growth slips to 11–12%, weaker for poorer, consumption-
light states. This asymmetry makes the end of compensation destabilising: richer states ride the buoyancy, weaker ones are exposed.

The way forward requires acknowledging the uneven fiscal squeeze and providing targeted support for weaker states. A partial compensation formula tied to welfare spending, higher state shares in divisible taxes, and greater transparency and consensus in the GST Council are essential.

GST was meant to unify India’s tax system, not fragment federalism. If GST 2.0 forces welfare and development cuts, it will undermine inclusive growth. For tax reform to succeed, it must deliver efficiency, fairness, and trust—the spirit of the original promise that cannot now be abandoned.

(The writers are assistant professors of economics at Christ University, Bengaluru)

(Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.)