Impact of Gst on States’ Finances and Fiscal Federalism in India

The introduction of the Goods and Services Tax (GST) through the 101st Constitutional Amendment Act, 2016 marked a major shift in India’s fiscal architecture. By subsuming seventeen central and state indirect taxes into a unified dual-GST framework, the reform aimed to eliminate the cascading effect of taxation and create a single national market. This transition required state governments to surrender their exclusive rights to set tax rates on goods and services, fundamentally altering the dynamics of Centre-state financial relations.

Constitutional and Architectural Changes

The 101st Constitutional Amendment Act introduced Article 246A, conferring concurrent powers on both Parliament and State Legislatures to make laws regarding GST. Article 269A was inserted to govern the levy and collection of Integrated GST (IGST) on inter-state trade, with proceeds shared between the Union and states based on rules established by Parliament. Article 279A established the GST Council as a joint constitutional forum to make recommendations on tax rates, exemptions, threshold limits, and administrative rules. State taxes subsumed under the new system included State Value Added Tax (VAT), Central Sales Tax (CST), Entry Tax, Octroi, Luxury Tax, Entertainment Tax (except those levied by local bodies), and Taxes on Advertisements. The Union government subsumed Central Excise Duty, Service Tax, Additional Customs Duties (CVD), and Special Additional Duty of Customs (SAD).

Fiscal Federalism and the GST Council Voting Structure

The GST Council serves as the operational hub for cooperative federalism in India. Article 279A outlines a specific decision-making mechanism where every decision of the Council requires a majority of at least three-fourths (75%) of the weighted votes of members present and voting.

Because the Centre holds one-third of the total voting power, it retains a veto over any proposal that lacks central assent. Similarly, a group of states holding more than 25% of the total vote can prevent the passage of a central proposal, encouraging consensus-based decision-making.

Shift to Destination-Based Consumption Tax

Pre-GST indirect taxation followed an origin-based principle, where manufacturing states collected taxes on production and inter-state movement through Central Sales Tax. GST operates as a destination-based consumption tax. Tax revenue accrues to the state where goods or services are consumed rather than where they are produced.

• Impact on Manufacturing States: Industrialized states such as Gujarat, Maharashtra, Tamil Nadu, Haryana, and Karnataka experienced structural shifts as production-stage levies disappeared.
• Impact on Consuming States: Populous, net-consuming states like Uttar Pradesh, Bihar, West Bengal, and Rajasthan gained a broader revenue base, as tax realization shifted to final consumption points.

Revenue Protection and the GST Compensation Mechanism

To cushion state budgets against potential revenue shortfalls during the initial rollout, Parliament enacted the Goods and Services Tax (Compensation to States) Act, 2017. Under Section 7 of the Act, the central government guaranteed states a 14% annual compound growth rate in their GST-subsumed revenues over the base year 2015-16 for a transition period of five years, running from July 1, 2017 to June 30, 2022. The compensation was funded through a dedicated GST Compensation Cess levied on luxury and sin goods, including motor vehicles, aerated drinks, pan masala, and tobacco products. When the five-year transition period ended in June 2022, the compensation mechanism lapsed. However, the collection of the compensation cess was extended until March 2026 to service the principal and interest on back-to-back loans raised by the Centre during the COVID-19 pandemic to pay compensation shortfalls to states.

Impact on State Fiscal Autonomy

The implementation of GST altered state fiscal flexibility in several distinct ways:

Loss of Independent Rate-Setting Power

Prior to 2017, states could adjust VAT rates or levy entry taxes during revenue crises to fund local development goals. Under the GST framework, individual states cannot unilaterally alter tax rates, change tax slabs, or introduce new exemptions without the approval of the GST Council.

Reliance on Non-GST Tax Avenues

Because GST limits independent rate-setting powers, states rely heavily on the remaining non-GST revenue sources to exercise fiscal policy. These non-GST avenues include State Excise Duty on alcohol for human consumption, Stamp Duty and Registration Fees on property, Taxes on Petroleum Products (crude oil, petrol, diesel, aviation turbine fuel, natural gas), and Electricity Duty.

Asymmetry in Expenditure and Revenue Assignment

Under the Constitution, state governments execute core public delivery responsibilities including public health, education, agriculture, police, and rural infrastructure. While states account for roughly 60% of total public expenditure in India, their share in direct collection of overall taxes reduced following the transfer of indirect tax jurisdiction to the shared GST pool.

Post-Compensation Fiscal Trends

State SGST collections constitute the largest component of state own tax revenue, averaging over 40% of their total tax receipts. The ending of the compensation regime in mid-2022 exposed underlying variation across state fiscal profiles.

• Fiscal Deficit Limits: The Fifteenth Finance Commission recommended setting the unconditional net borrowing limit for states at 3% of Gross State Domestic Product (GSDP), with an extra 0.5% performance-linked borrowing allowance tied to power sector reforms.
• Tax Buoyancy Trends: The Fifteenth Finance Commission initially projected an overall GST-to-GDP ratio of 7%, though actual national collections have averaged closer to 2.8% of GDP.
• Sub-national Revenue Divergence: High-income and service-oriented states have recorded steady growth due to organized retail expansion and digital compliance, while smaller and agrarian states face greater revenue volatility.

Core Facts on GST and State Finances

• The 101st Constitutional Amendment Act, 2016 enabled the concurrent levy of GST by the Union and States under Article 246A.
• Article 279A authorized the constitution of the GST Council, chaired by the Union Finance Minister.
• Article 269A governs the levy and collection of Integrated GST (IGST) on inter-state trade and imports.
• The GST Council voting structure grants one-third voting weight to the Central Government and two-thirds combined weight to the States.
• Decisions in the GST Council require a three-fourths (75%) majority of weighted votes cast by members present and voting.
• Under the GST Compensation Act, 2017, states received a guaranteed 14% annual growth rate over base year 2015-16 revenues from July 2017 to June 2022.
• GST operates as a destination-based tax, shifting tax revenue from producing states to consuming states.
• Alcohol for human consumption is constitutionally excluded from GST under Article 366(12A).
• Five petroleum products (crude oil, petrol, diesel, natural gas, and aviation turbine fuel) remain outside the active GST umbrella.
• SGST accounts for roughly 42% of the average state’s own tax revenue.
• The Fifteenth Finance Commission set the standard fiscal deficit limit for states at 3% of GSDP.