India GST rate cut: Consumption boost vs capital expenditure dilemma
The government’s sweeping GST rate cuts promise a boost to consumer spending, but India still effectively has a five-slab system. Revenue loss could also force cuts in capital expenditure. Will this Diwali gift for consumers work out well for India’s economy?
The large reduction in goods and services tax (GST) rates from 22 September, the start of this year’s Navratri, followed an equally large increase in the exemption threshold for personal income tax six months earlier in the 2025-26 budget. In a well-publicized message, Prime Minister Narendra Modi described this as a bumper Diwali gift for consumers, especially those in the Indian middle class.
Limiting herself to the economic rationale for the rate reduction, Finance Minister Nirmala Sitharaman explained that a significant increase in the purchasing power of consumers, assuming the rate reduction is fully passed on, will jack up aggregate consumption demand and hence economic growth, apart from giving relief to small producers.
Critics have claimed that the GST rate reduction is motivated by the forthcoming Bihar elections and other state polls to follow. That may well be true. However, this column will confine itself to the economic implications of the GST rate reduction.
Introducing a value added tax (VAT) like GST in a large federal system like India was exceptionally challenging because of many conflicting interests, such as between producers and consumers, between the central government and states, and between producing and consuming states. Hence, the launch of GST in India took a very long time.
The idea of introducing a VAT in India was first mooted by the Indirect Tax Enquiry Committee (under L.K. Jha) in 1977. The GST Council of State Finance Ministers, chaired by Union finance minister Arun Jaitley, was finally able to roll out the GST 40 years later in 2017, thanks to what came to be known as Jaitley’s grand bargain: his assurance to states that they would be compensated for 5 years for any revenue loss, computed using a very generous formula.
However, once the states were on board, GST was introduced in a great hurry without proper preparation. GSTN, the electronic tax information network, had not fully stabilized, nor were the required administrative arrangements in place, such as the training of officials, etc.
Most importantly, GST was rolled out with multiple rates, which led to problems of tax-gaming and relative price distortion. Undoubtedly, it was India’s most important tax reform after 1991, but it required a lot more to be done.
Though there were some rate adjustments earlier, the latest rate rationalization is by far the most significant, covering around 450 goods and services.
Of these, about 400 goods and services have had their rates lowered, while a small number, about 50 items, have had rates increased. The 12% and 28% rate slabs have been abolished. Most items earlier taxed at 12% will now be taxed at 5%, while a handful will be taxed at 18%. Most items taxed at 28% earlier will now be taxed at 18%. Thus, virtually all items will now be taxed at either 5% or 18%.
A handful of non-merit or luxury goods (and services) will be taxed at 40%. At the lower end, a few items taxed at 5% will now not be taxed at all, while a few high-value items like gold jewellery will continue to be taxed at only 2-3%.
Thus, despite the abolition of two GST slabs and most items now being taxed at 5% or 18%, we still effectively have a five-slab rate structure in place, compared to the single- or two-rate structure in most of the 175 countries that have a VAT. Rate rationalization remains a work in progress.
What will be the macroeconomic impact of this rate rationalization? Clearly, private consumption expenditure will get a boost. But what does it imply for government expenditure?
To assess the revenue impact of the rate rationalization, it is useful to keep in mind that those items taxed at 5% or not taxed are mostly necessities with price-elasticity and income-elasticity of demand compared to those items taxed at the 18% rate. There is therefore likely to be some shift in the share of private consumption expenditure away from 0% or 5% GST rated goods towards those rated at 18%.
But the main point to note is that there will be a significant revenue loss, at least in the short run. The finance ministry has estimated this (on the basis of 2023-24 data) at ₹48,000 crore for the current fiscal year, which would be about ₹96,000 crore for the full financial year 2026-27. How will the government handle this revenue loss?
If it aims to achieve its fiscal deficit target of 4.4% of GDP in 2025-26 despite the GST revenue loss, this will probably entail a significant cutback in capital expenditure. Committed items under revenue expenditure make it difficult to further trim revenue expenditure, which was already compressed during 2023-24 and 2024-25.
However, a reduction in government capital expenditure is likely to offset the expected positive growth impact of the boost to private consumption expenditure due to GST rate reduction. There is much evidence that government capital expenditure has a very strong impact on growth.
Alternatively, the finance ministry can focus on its new monitoring target for fiscal consolidation, namely reducing the debt-to-GDP ratio from 55% to 50% (+/- 1%) by 31 March 2031. This will allow more flexibility in managing the fiscal deficit and enable the government sustain its commitment to high capital spending as it adjusts its aggregate spending path over the next 4-5 years.
The logic spelt out here for the central government also applies to state governments, which will suffer a similarly large GST revenue loss.
These are the author’s personal views.
The author is chairman, Centre for Development Studies.
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