GST Rate Rationalisation (Two-Rate Structure)

GST rate rationalisation means cleaning up the rate structure of the Goods and Services Tax (GST): fewer tax slabs, lower rates on common goods, and fixing cases where similar items are taxed differently. In September 2025, India moved from four main GST slabs (5%, 12%, 18% and 28%) to two main slabs, 5% (merit rate) and 18% (standard rate), plus a special 40% (demerit rate) for a short list of "sin" and luxury goods. This is the biggest change to GST rates since GST began in 2017.

Why was it needed?

When GST started, it had many rates: 0%, 5%, 12%, 18% and 28%, plus an extra compensation cess on some goods. Many rates caused three big problems:

• Classification disputes: If two similar products sit in different slabs, businesses and tax officers fight over which slab applies. A famous type of fight was whether a food item is "plain" (lower tax) or "processed" (higher tax).
• Inverted duty structure: Sometimes the tax on raw materials was higher than the tax on the finished product. Then a business pays more tax on its inputs than it collects on its sales, and its money gets stuck as unused credit.
• Complexity: More rates mean more paperwork, more mistakes and higher compliance costs, especially for small firms.

A simpler structure with fewer rates is closer to the idea of "one nation, one tax" and is easier to follow.

Where did it come from?

• 2015: A committee led by Chief Economic Adviser Arvind Subramanian studied GST rates. It suggested a revenue neutral rate of 15% to 15.5% and a standard rate of about 17-18%, with a low rate for essentials and a high rate for demerit goods.
• 1 July 2017: GST began with four main slabs (5%, 12%, 18%, 28%) plus compensation cess on luxury and sin goods.
• 2017-2019: The GST Council cut rates on many items. By September 2019, the effective weighted average GST rate had fallen from 14.4% at launch to about 11.6% (RBI data).
• September 2021: The GST Council set up a Group of Ministers (GoM) on rate rationalisation, first led by Karnataka Chief Minister Basavaraj Bommai. It was asked to study slab mergers and the inverted duty structure, but for years it did not agree on merging slabs.
• 15 August 2025: The Union Government announced "next-generation GST reforms" with three pillars: structural reforms, rate rationalisation and ease of living. The Centre sent a detailed proposal to the GoM, which discussed it on 20-21 August 2025.
• 3 September 2025: The 56th GST Council meeting approved the two-rate structure. New rates took effect from 22 September 2025.

How does the new structure work?

• 0% (nil or exempt): many essentials. For example, individual life and health insurance policies were made fully exempt (they were taxed at 18% before).
• 5% (merit rate): everyday goods and essentials. Most items that were at 12% moved down to 5%.
• 18% (standard rate): most other goods and services. Most items at 28% moved down to 18%, such as cement, air conditioners, televisions, small cars and motorcycles up to 350cc.
• 40% (demerit rate): a short list of harmful or luxury goods, such as pan masala, cigarettes and other tobacco products, sugary and aerated drinks, bigger cars and motorcycles above 350cc.
• Special low rates for a few sectors (such as precious metals) continue outside the main slabs.

What happened to the compensation cess?

When GST began, states were promised compensation for any revenue loss for five years, until June 2022, under the GST (Compensation to States) Act, 2017. The money came from a compensation cess on luxury and sin goods. During COVID, cess collections fell short, so the Centre borrowed ₹2.69 lakh crore (2020-21 and 2021-22) and passed it to states as back-to-back loans.

The cess was continued until March 2026 to repay these loans. Under GST 2.0, the cess was merged into the 40% rate for most goods. For tobacco and pan masala, the cess ended on 1 February 2026. From then on, they attract 40% GST plus a new central excise duty (on tobacco) and a Health Security se National Security Cess (on pan masala). Biris stay at 18%.

Fixing inverted duty

The reform cut tax on several inputs to match the finished goods. Examples: man-made fibre went from 18% to 5% and man-made yarn from 12% to 5%, matching fabric and garments. Fertiliser inputs such as sulphuric acid, nitric acid and ammonia went from 18% to 5%, matching fertilisers.

Can lower rates bring in more tax?

At first, a rate cut means the government loses some money on each sale. But lower prices can increase demand, and simpler rules can bring more businesses and sales into the tax net. If this happens, total collections can still grow. Economists call the link between tax growth and economic growth tax buoyancy. The effective weighted average rate was expected to fall to about 9.5% after GST 2.0 (SBI Research estimate).

India compared with other countries

Many countries with a VAT or GST, such as Australia (10%) and Singapore (9% since 2024), use a single standard rate. India's federal structure, wide income gaps and need to protect essentials make a single rate harder. That is why India chose a two-rate system with a separate demerit rate.

Commonly confused concepts

• Slab vs effective rate: A slab is the official rate written in the law (5%, 18%). The effective weighted average rate is the average tax actually paid across all goods, weighted by how much is consumed.
• Revenue neutral rate (RNR) vs standard rate: The RNR is the single rate that would raise the same revenue as the old system. The standard rate is the rate on most goods. The two need not be equal.
• Compensation cess vs 40% demerit rate: The cess was a temporary extra levy to compensate states. The 40% rate is a permanent GST slab whose revenue is shared between the Centre and states like other GST.
• Exempt vs nil-rated vs zero-rated: Exempt and nil-rated supplies carry no GST, and the seller cannot claim credit on inputs. Zero-rated supplies (mainly exports) carry no GST, but the seller can still claim input credit or a refund.

Issues, criticism and the way forward

• Revenue for states: States collect about half of GST revenue and depend on it heavily. Rate cuts raised worries about state finances, especially after compensation ended.
• Passing on benefits: Rate cuts help consumers only if businesses lower prices. The earlier anti-profiteering system was wound up, so monitoring now depends on general oversight and market competition.
• Items still outside GST: Petroleum products, alcohol for drinking and electricity remain outside GST, so their taxes cannot be set off, and some cascading continues.
• Remaining special rates: Separate rates for precious metals and a few sectors keep some complexity.
• Way forward: Experts suggest keeping rates stable for some years, completing process reforms (registration, returns, refunds, disputes), making the GST Appellate Tribunal work smoothly, and building consensus on bringing petroleum and electricity into GST.

Concepts to Know

• Tax slab: A fixed rate band in which goods are placed, such as 5% or 18%.
• Merit goods and demerit goods: Merit goods are useful for society (like food and medicines), so they are taxed lightly. Demerit goods are harmful (like tobacco), so they are taxed heavily to discourage use.
• Inverted duty structure: When tax on inputs is higher than tax on the final product, so the business keeps paying more tax than it collects and its money gets stuck.
• Revenue neutral rate: The tax rate at which the government would collect the same amount as before a reform.
• Back-to-back loan: Money borrowed by the Centre and passed on to states, with repayment made later from a specific source (here, the compensation cess).
• Tax buoyancy: How fast tax revenue grows compared with the economy. If GDP grows 10% and tax grows 12%, buoyancy is above 1.
• Anti-profiteering: A rule that businesses must pass on the benefit of tax cuts to buyers through lower prices.