GST Impact on State Finances and Fiscal Federalism

Introduction

The Goods and Services Tax (GST), introduced through the 101st Constitutional Amendment Act, 2016, reshaped India’s indirect tax system and changed the balance of fiscal powers between the Centre and states. By replacing a range of taxes with a dual-GST framework, it aimed to remove cascading, widen the tax base and create a common national market.

At the same time, GST reduced the independent tax-setting space of states, making fiscal federalism more dependent on cooperative decision-making through the GST Council.

Constitutional Changes Under GST

The constitutional architecture of GST marked a major shift in Centre-state financial relations.

• Article 246A: Conferred concurrent powers on Parliament and State Legislatures to make laws on GST.
• Article 269A: Provided for the levy and collection of Integrated GST (IGST) on inter-state trade, with proceeds shared between the Union and states as per parliamentary rules.
• Article 279A: Created the GST Council as a constitutional forum for recommendations on tax rates, exemptions, threshold limits and administrative matters.
• Subsumed state taxes: State VAT, Central Sales Tax, Entry Tax, Octroi, Luxury Tax, Entertainment Tax (except those levied by local bodies) and Taxes on Advertisements.
• Subsumed Union taxes: Central Excise Duty, Service Tax, Additional Customs Duties (CVD) and Special Additional Duty of Customs (SAD).

GST Council and Fiscal Federalism

The GST Council is the operational core of cooperative federalism under GST. Its voting structure is designed to force consensus between the Union and the states.

• Decision rule: Every decision requires at least three-fourths (75%) of the weighted votes of members present and voting.
• Centre’s weight: The Union government has one-third of the total voting power.
• States’ weight: State governments together have two-thirds of the total voting power.
• Practical effect: The Centre cannot push through a proposal without some state support.
• State leverage: A group of states holding more than 25% of the vote can block a central proposal.
• Governance style: The structure encourages negotiated, consensus-based taxation policy rather than unilateral rate-setting.

Destination-Based Taxation and State Revenue Shifts

Before GST, indirect taxation followed an origin-based system, where manufacturing states collected more revenue from production and inter-state movement. GST changed this to a destination-based consumption tax, meaning revenue accrues to the state where goods or services are consumed.

• Manufacturing states affected: Gujarat, Maharashtra, Tamil Nadu, Haryana and Karnataka saw a structural change as production-stage levies disappeared.
• Consuming states benefited: Uttar Pradesh, Bihar, West Bengal and Rajasthan gained a broader revenue base because tax collection shifted to final consumption points.
• Policy significance: The shift reduced the tax advantage of production hubs and strengthened the fiscal position of large consuming states.

GST Compensation Mechanism

To protect states from revenue loss during the transition, Parliament enacted the Goods and Services Tax (Compensation to States) Act, 2017.

• Revenue guarantee: Section 7 assured states a 14% annual compound growth rate in GST-subsumed revenues over the base year 2015-16.
• Transition period: The guarantee applied for five years, from 1 July 2017 to 30 June 2022.
• Funding source: Compensation was financed through a dedicated GST Compensation Cess on luxury and sin goods.
• Examples of cess goods: Motor vehicles, aerated drinks, pan masala and tobacco products.
• After June 2022: The compensation mechanism lapsed, but the cess continued until March 2026 to service principal and interest on back-to-back loans raised by the Centre during the COVID-19 period.

Exam point: GST compensation protected state revenues only for the transition period of 1 July 2017 to 30 June 2022.

Impact on State Fiscal Autonomy

GST narrowed the room available to states for independent tax policy, even though their expenditure responsibilities remained large.

• Loss of rate-setting power: States can no longer unilaterally change GST rates, alter slabs or introduce exemptions without GST Council approval.
• Earlier flexibility lost: Before 2017, states could adjust VAT rates or levy entry taxes during revenue stress.
• Dependence on non-GST revenues: States now rely more heavily on State Excise Duty on alcohol for human consumption, Stamp Duty and Registration Fees, taxes on petroleum products, and Electricity Duty.
• Expenditure-revenue mismatch: States handle major responsibilities such as public health, education, agriculture, police and rural infrastructure.
• Share of expenditure: States account for roughly 60% of total public expenditure in India.
• Tax assignment issue: Their direct role in collecting overall taxes declined after indirect taxes were moved into the shared GST pool.

Post-Compensation Fiscal Trends

The end of compensation in 2022 exposed differences in state fiscal capacity and GST performance.

• SGST importance: State SGST collections form the largest component of state own tax revenue, averaging over 40% of total tax receipts.
• Borrowing limits: The Fifteenth Finance Commission recommended an unconditional net borrowing limit of 3% of Gross State Domestic Product (GSDP), with an additional 0.5% borrowing allowance linked to power sector reforms.
• GST buoyancy: The Fifteenth Finance Commission projected an overall GST-to-GDP ratio of 7%, while actual national collections have averaged closer to 2.8% of GDP.
• Divergence across states: High-income and service-oriented states have benefited more from organised retail expansion and digital compliance.
• Stronger pressure on smaller states: Smaller and agrarian states face greater revenue stress after the compensation regime ended.

Key Prelims Takeaways

• 101st Constitutional Amendment Act, 2016 introduced GST and enabled the dual-GST framework.
• Article 246A gives concurrent legislative power over GST to Parliament and State Legislatures.
• Article 279A creates the GST Council, the main forum for GST-related recommendations.
• GST Council voting requires a 75% majority, ensuring Centre-state consensus.
• GST is destination-based, so revenue goes to the consuming state, not the producing state.
• Compensation to States Act, 2017 guaranteed 14% annual growth on GST-subsumed revenues for five years.
• States retain major non-GST taxes such as alcohol excise, stamp duty, petroleum taxes and electricity duty.