GST rates, compensation and the 2025 rationalisation

Detail

1. Basic terms

• GST (Goods and Services Tax) is one tax on the supply of goods and services. It started on 1 July 2017 and replaced many older Central and State taxes.
• GST rate slab is one fixed tax rate. A group of goods or services is placed in it, for example "all these items pay 18%".
• GST Council is the body of the Union Finance Minister and the State Finance Ministers (Article 279A). It recommends GST rates, exemptions and rules.
• Input Tax Credit (ITC) works like this: a business pays GST when it buys inputs. It then subtracts that amount from the GST it owes on its own sales. So each stage pays tax only on the value it adds.
• Sin goods / luxury goods are harmful products (tobacco, pan masala, sugary drinks) or costly products (big cars, yachts). They are taxed heavily to earn revenue and to discourage their use.

2. The 2017 rate structure

• Main slabs: 0, 5, 12, 18 and 28%.
• Special rates:
• 3% on gold.

• 0.25% on rough diamonds.

• Compensation cess was charged on top of 28% for sin and luxury goods. A cess is an extra tax collected for one stated purpose.

• Example (2017 structure): a large car paid 28% GST plus a compensation cess. So its total tax was well above 28%.

• Problem with many slabs:

• Similar goods often fell in different slabs.
• This led to classification disputes, where the business and the tax officer argued over which slab an item belongs to.
• It also created inverted duty structures (see Section 6).

3. NCERT is outdated here

• NCERT (Class 12, Government Budget and the Economy, Box 5.3) says there are "6 standard rates … 0%, 3%, 5%, 12%, 18% and 28%". It also says there is "one rate for one type of goods".
• Correction 1: from 22 September 2025 there are only two main slabs (5% and 18%) plus a 40% special rate. The 3% and 0.25% rates continue.
• Correction 2: "one rate for one type of goods" was not true even in 2017. The same type of good could fall in different slabs depending on its value or kind. For example, cars were taxed differently by engine size and length.

4. The 56th GST Council (3 September 2025) and "Next-Gen GST"

• The Council moved from four slabs (5%, 12%, 18%, 28%) to two main rates: 5% (merit rate) and 18% (standard rate), plus a 40% special rate for sin and luxury goods. The new rates took effect on 22 September 2025 [2][4].

• Merit rate is a low rate for goods of common use. Standard rate is the normal rate for most goods and services.

• The meeting also approved measures to help the common man and the middle class, and steps to make trade easier under GST [5].

Slab	Covers
Nil	Many staples. Individual life and health insurance exempted
5% (merit)	Common-use goods and services
18% (standard)	Most goods and services
40% (special)	Pan masala, tobacco, aerated and sugary drinks, mid-size and large cars, yachts, private aircraft
3% / 0.25%	Kept for gold and rough diamonds

• Guiding principle: similar goods should pay the same rate, so that there is less wrong classification and fewer disputes [4].
• Examples of the changes (2025):
• Small cars: 28% → 18% [4].
• Mid-size and large cars: 40%. These are cars with an engine above 1500 cc or a length above 4000 mm [4].
• Drones: one uniform rate of 5% for all drones [4].
• Plant-based milk drinks and soya milk drinks: cut to 5% [4].

• Staple foods became tax-free and processed foods moved to 5% [6].

• Coal:

• GST rose from 5% to 18%.
• The ₹400/tonne compensation cess was removed [3].
• PIB says this benefits both coal producers and coal users [3].

• Why: under the old system, cess plus 5% GST gave a high total tax, but only a small part of it could be used as ITC. At 18% GST with no cess, the whole tax flows through the ITC chain.

• Still outside GST: petroleum (crude, petrol, diesel, ATF, natural gas) and alcohol for human drinking. States still tax these with VAT, and the Centre with excise.

Worked example: why the 40% slab replaced "28% + cess"

• Old system: a car worth ₹10 lakh paid 28% GST (₹2.8 lakh) plus a cess on top.
• New system: the same car pays one rate of 40% (₹4 lakh). There is no separate cess.
• Result: one simple rate, and the whole amount goes into the shared GST pool, not into a cess fund with a fixed purpose.

5. Compensation to states

Why states needed compensation

• GST took away many state taxes (VAT, entry tax, entertainment tax and others).
• GST is a destination-based tax: it is collected where goods are consumed, not where they are made. So states that make a lot of goods feared losing revenue.

The legal guarantee

• The GST (Compensation to States) Act 2017 promised states 14% annual revenue growth over the 2015-16 base for five years, until June 2022.
• Protected revenue is the amount a state is guaranteed. It grows at 14% compounded every year.
• Formula:
• Protected revenue in year n = Base revenue (2015-16) × (1.14)^n

• Compensation = Protected revenue − Actual GST revenue

• Worked example:

• A state's base revenue in 2015-16 = ₹10,000 crore.
• Protected revenue for year 5 (2021-22) = 10,000 × (1.14)^5 ≈ ₹19,254 crore.

• If the state actually collects ₹15,000 crore, it gets ≈ ₹4,254 crore as compensation.

• Funding: the GST compensation cess on luxury and sin goods paid for this guarantee.

The COVID shortfall

• The problem:
• Protected revenue kept growing at 14% compounded, but cess collections did not grow at the same pace.

• COVID-19 widened this gap further [7].

• Size of the gap in 2020-21:

• States needed about ₹3 lakh crore in compensation.

• The Centre expected less than ₹70,000 crore from the cess [7].

• Two options: states were offered two options to cover the gap. In October 2020, the Centre raised its own borrowing target by ₹1.1 lakh crore to give back-to-back loans. All states and UTs chose Option 1 [8].

• Back-to-back loan means the Centre borrows from the market and passes the same money to states as a loan. States do not pay interest or repay the principal from their own funds. Future cess collections repay it.
• ₹1.1 lakh crore in 2020-21, paid in weekly instalments. For example, the 9th instalment was ₹6,000 crore [9][10].

• ₹1.59 lakh crore in 2021-22. This included a release of ₹40,000 crore and a balance of ₹44,000 crore [11][12].

• Dues cleared: the Centre paid the entire GST compensation due as of 31 May 2022, just before the five-year period ended [13].

• Cess extended: the cess was extended to March 2026. Cess collected after June 2022 is used to repay the 2020-21 and 2021-22 loans [14].

End of the compensation cess (2025)

• The 2025 rationalisation ends the cess on all goods except tobacco. Tobacco keeps the cess only until the loans are repaid.
• What replaces it:
• The Central Excise (Amendment) Act 2025 keeps the tax burden on tobacco through Central excise duty.
• The Health Security se National Security Cess Act 2025 does the same for pan masala. It taxes the machines or processes used to make pan masala.

• The aim is to keep sin products costly after the cess ends (verify current effective dates).

• Revenue effect for states:

• Excise and cesses are not shared with states through the divisible pool. The divisible pool is the part of Central taxes that the Finance Commission shares with states.
• Money in the 40% GST slab, however, is split between the Centre and states like all other GST.

6. Inverted duty structure

• Definition: an inverted duty structure exists when inputs are taxed at a higher rate than the finished product.
• What goes wrong:
• The seller's GST on sales is lower than the GST already paid on inputs.
• So unused ITC piles up in the business's account.

• This blocks working capital, the cash a business needs for day-to-day running.

• Worked example:

• A garment maker buys yarn worth ₹100 at 12% GST and pays ₹12.
• It sells garments worth ₹150 at 5% GST, so it owes ₹7.50.

• Its ITC is ₹12, so ₹4.50 is left unused and stays stuck until it is refunded.

• Sectors: textiles (fibre and yarn vs garments), footwear, fertilisers, pharma.

• Refund formula (Rule 89(5), CGST Rules):

• Maximum refund = (Turnover of inverted-rated supply × Net ITC ÷ Adjusted total turnover) − [Tax payable on that inverted-rated supply × (Net ITC ÷ ITC availed on inputs and input services)]

• 2025 fixes:

• Man-made fibre: 18% → 5%. Man-made yarn: 12% → 5%. This corrects the inversion in textiles [5].
• Where inversion still remains, the stuck credit can be refunded [5].
• 90% of inverted-duty refunds will now be paid provisionally (paid first and checked later), so they reach businesses faster [5].

7. Anti-profiteering

• Definition: anti-profiteering (Section 171, CGST Act) means a business must pass on GST rate cuts and ITC benefits to buyers as lower prices.
• Example: if GST on an item falls from 12% to 5%, a ₹112 item (₹100 + ₹12 tax) should now cost ₹105, not stay at ₹112.
• Who enforces it:
• National Anti-profiteering Authority (NAA) from 2017.
• Competition Commission of India (CCI) from December 2022.

• No new applications are accepted from 1 April 2025.

• Why it matters in 2025:

• The large rate cuts of September 2025 had to reach consumers.
• Without an anti-profiteering body taking new cases, this depends on market competition and on the government watching prices.

8. Debates

• More spending vs lost revenue: lower rates should make goods cheaper, so people buy more, which supports GDP growth. The net revenue loss from the 2025 changes is estimated at about ₹48,000 crore (verify current figure).
• States' revenue worries:
• Compensation has ended.
• The rate cuts reduce the GST pool that states share.

• States have less power over their own taxes because of GST. See the Fiscal Federalism note.

• Bringing in petroleum, electricity and real estate:

• It would complete the ITC chain and end "tax on tax" for industry.
• But states would lose their largest remaining own tax (VAT on fuel).

Prelims Hooks

• 56th GST Council met on 3 September 2025. New rates took effect on 22 September 2025. Main slabs are now 5% (merit) and 18% (standard), plus 40% (special). The 12% and 28% slabs are gone.
• 3% (gold) and 0.25% (rough diamonds) still exist. Trap: "GST now has only three rates" is wrong.
• Coal: GST went from 5% to 18% and the ₹400/tonne compensation cess was removed. This is a trap because it is a rate increase inside a reform that mostly cut rates.
• Car at 40%: engine above 1500 cc or length above 4000 mm. Small cars moved from 28% to 18%.
• GST (Compensation to States) Act 2017: 14% compounded growth on the 2015-16 base, for 5 years, until June 2022.
• Back-to-back loans: ₹1.1 lakh crore (2020-21) and ₹1.59 lakh crore (2021-22). They are repaid from cess collected after June 2022, not from state budgets.
• Inverted duty structure: input tax rate is higher than output tax rate. In 2025, man-made fibre went to 5% (from 18%) and man-made yarn to 5% (from 12%). 90% of inverted-duty refunds are now paid provisionally.
• Section 171, CGST Act covers anti-profiteering. Enforcement moved from NAA to CCI (December 2022). No new applications from 1 April 2025.
• Outside GST: petroleum products and alcohol for human drinking. Trap: electricity is also outside GST.

Mains Points

• Fewer slabs:
• Two main rates reduce classification disputes and inverted duty. They make compliance easier for MSMEs.
• They also move India closer to the "good and simple tax" ideal.

• The cost is revenue. The loss is estimated at about ₹48,000 crore, and states share this loss.

• Fiscal federalism:

• The compensation guarantee ended in June 2022, and the cess ends for all goods except tobacco.
• States now depend on a smaller GST pool and on Finance Commission transfers.

• The shift of tobacco and pan masala taxes to Central excise and a new cess keeps that revenue out of the shared GST pool.

• Health taxes vs revenue: the 40% slab and the post-cess excise laws try to keep sin goods costly for public-health reasons while also protecting Central revenue.

• Unfinished GST agenda:
• Bring petroleum, electricity and real estate into GST.
• Pay refunds faster.
• Keep checking that rate cuts reach consumers now that no new anti-profiteering applications are accepted.