Union Budget: The hidden cost of GST 2.0 - India faces potential tax shock as compensation cess ends - Times of India

Transition away from the compensation cess has exposed the unfinished edge of reform.

By Nilanjan BanikIndia’s indirect tax journey reached an important milestone in 2025. With the completion of GST 2.0, the full removal of the GST compensation cess, and Parliament’s approval of a new excise framework for demerit goods, the post-GST transition phase can now be said to be formally closed.

From a structural standpoint, this is a success. The temporary scaffolding that once supported GST has been dismantled, and the system has demonstrated its capacity to generate stable revenues without extraordinary instruments.Indeed, the data is unambiguous. Even as GST rates were pruned on a wide set of mass-consumption items—moving several goods from higher slabs to lower ones—gross GST collections remained buoyant.

Monthly collections in late 2025 consistently exceeded ₹1.7–1.9 lakh crore, posting positive year-on-year growth despite rate rationalisation. This outcome validates a central proposition of public finance: in economies with high informality, compliance elasticity often dominates rate elasticity.

Simplification and predictability expand the effective base, allowing revenues to hold even when statutory rates fall.

However, the transition away from the compensation cess has exposed the unfinished edge of reform—what might be called the “elephant’s tail” of GST 2.0. The notification of excise rates on demerit goods, particularly cigarettes, has triggered sharp reactions from multiple quarters, and not without reason.The first response has come from tobacco farmers in southern India, especially Andhra Pradesh and Karnataka, who grow Flue-Cured Virginia (FCV) tobacco used almost exclusively in the legal cigarette industry.

These farmers argue—correctly—that they already operate under a disproportionately heavy tax burden. On a per-unit basis, tobacco used in cigarettes is taxed many multiples—often estimated at 30 to 50 times—higher than tobacco grown for bidis or chewing products, which dominate production in northern states.

A sudden excise shock would hit FCV tobacco growers the hardest, as their regulated, auction-based crop is tied directly to the legal cigarette chain; with export demand already muted, any fall in domestic demand would push farmers and farm labour into severe distress.The second concern comes from small retailers. Cigarettes, uncomfortable as the category may be, form a high-value, sticky component of sales for millions of kirana stores, pavement sellers, and micro-retailers. These sellers operate on thin margins and limited working capital. A sharp tax-driven price increase risks pushing legal cigarettes beyond the reach of many consumers, redirecting demand toward cheaper illicit alternatives.

When enforcement tightens, it is often the smallest retailer who becomes the visible face of the offence, even as organised smuggling networks remain insulated upstream. For the retailer, this is not a moral choice but a survival dilemma.Third, retail investors have reacted swiftly. Cigarette manufacturers and their long-term institutional investors—insurance companies, pension funds, and mutual funds—are traditionally regarded as stabilising anchors in volatile markets.

Sudden uncertainty around excise policy has eroded market capitalisation, affecting not just corporate balance sheets but household wealth routed through financial intermediaries.

The estimated erosion in market cap was about Rs. 80,000 crore for these entities as soon as the news unfolded. In an era marked by global geopolitical shocks, such as conflicts in the Middle East or financial tightening in advanced economies, these stocks often act as buffers.

Policy-induced volatility in this segment therefore has wider financial implications.

The fourth—and perhaps most analytically compelling—concern comes from industry bodies and researchers who track illicit trade. Organisations such as FICCI, which have studied smuggling for over a decade, consistently show a strong correlation between sharp tax hikes on cigarettes and the expansion of illicit markets.

India’s own experience is instructive. Between 2012 and 2020, periods of repeated excise increases coincided with a rise in illicit cigarette share from around 17% to nearly 28% of total consumption.

After 2021, when duty rates stabilised, the illicit share plateaued and marginally declined to about 26%. This is not coincidence; it is economics.Once illicit trade becomes embedded, it develops scale economies, logistics networks, and institutional corruption that make reversal extremely difficult.

A comprehensive international study by Alvarez & Marsal, covering over 70 countries and more than 80% of global cigarette volumes, reaches a clear conclusion: enforcement alone cannot dismantle entrenched illicit markets if taxation and affordability pressures continue to push consumers out of the legal system.This is where economic theory provides clarity. Standard tax-incidence analysis shows that when demand is price-inelastic—as it is for addictive goods—tax shocks are largely passed through to prices.

The Becker–Murphy model of rational addiction further explains that consumers adjust how they consume before deciding whether to consume. When legal prices rise beyond affordability thresholds, substitution occurs—not necessarily to cessation, but to cheaper, often illegal, alternatives.

In trade theory, this creates arbitrage opportunities, especially in countries with porous borders and large informal retail networks.

India fits this description all too well.The deeper concern, therefore, is not taxation per se, but its calibration. Parliament has already approved peak excise rates, providing the legal headroom the government needs. The critical decision now lies in how notified rates are set and sequenced. A sudden quantum jump risks creating a classic tax shock—one that raises revenues briefly but erodes the base over time as consumers and suppliers migrate to the parallel economy.

The Laffer-curve intuition is relevant here: beyond a point, higher rates reduce effective collections.A more graded approach would have served better. Phasing adjustments over two to three years would allow farmers, retailers, firms, and consumers to adapt while preserving compliance. Crucially, it would align excise policy with the central lesson of GST 2.0: do not chase revenues through rate hikes; widen the base, reduce friction, and let formalisation do the work.India has shown rare fiscal maturity in 2025 by successfully concluding GST 2.0 and retiring the compensation cess—gains that now need to be protected. An abrupt excise shock on demerit goods risks reversing this progress by fuelling illicit trade, hurting livelihoods, unsettling markets and flattening revenues over time. Sound taxation is not about signalling toughness but about sustaining systems; applying the same moderation and predictability to excise policy that guided GST reform will strengthen India’s fiscal architecture and secure long-term stability over short-term revenue illusion.(Nilanjan Banik is a professor at Bennett University's School of Business)