Last year, the government took a decisive step towards rationalising GST slabs. The GST 2.0 exercise was always expected to strain state finances. The shifts in the indirect tax regime announced in September 2025 sharpened the tension between national objectives and subnational budgets. Revenue erosion has pushed the fiscal burden disproportionately onto states that depend on GST flows to fund health, rural development and other core services.
In FY26, these risks have become tangible. A recent CareEdge Ratings analysis of 22 states, accounting for about 94% of India’s GDP, points to mounting stress. During the first eight months of the year, aggregate revenue receipts grew by 7.2% year on year, sharply lower than the 12.1% growth recorded in the same period last year.
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Tax revenues, the anchor of state budgets, slowed to 9.2%. State GST grew by a modest 5.2%, well below the double-digit rates seen earlier. These trends coincided with one-off effects of GST rationalisation, including adverse IGST settlements and rate changes pushed towards the latter part of the year. Third-quarter collections underline the loss of momentum.
States set to miss fiscal deficit targets
States had budgeted an aggregate fiscal deficit of around 3.3% of gross state domestic product for FY26. That target now looks stretched. Capital expenditure is picking up, as it usually does towards the end of the fiscal year. While this supports long-term growth, it also widens the timing gap between inflows and outflows. The result is familiar: higher borrowings or pressure to compress revenue expenditure.
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The squeeze reflects a deeper asymmetry in India’s fiscal architecture. The Centre has a wider revenue base and greater shock absorbers, including dividend transfers from the Reserve Bank of India. States remain far more exposed to swings in consumption and investment. CareEdge has noted that higher RBI dividends could offset part of the GST shortfall at the national level. That cushion is uncertain and unevenly shared.
An additional factor sharpens this strain. FY26 is the first full year in which states are managing GST volatility without any compensation framework. The GST compensation cess ended in June 2022, and no successor mechanism was put in place. This marked a structural shift in risk-sharing within the GST system. Revenue shortfalls that were earlier smoothed through guaranteed compensation are now borne entirely by states. GST rationalisation has therefore landed on budgets already exposed to demand swings and settlement volatility, amplifying the fiscal impact even when headline growth decelerations appear modest.
Wide disparities in state finances
Recent state-level data underline this divergence. Punjab reported a 21.5% increase in net GST collections between April and October 2025, outperforming the national trend and highlighting the gains from tighter compliance and administration. Kerala has taken the opposite view. Its finance minister has estimated a revenue loss of around Rs 8,000 crore due to rationalisation, arguing that this has constrained spending on welfare and infrastructure. Karnataka, too, has flagged shrinking fiscal space, pointing to GST growth slowing from about 12% to near 5%.
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The promise of GST 2.0 was simplicity, higher compliance and a broader base, with the expectation that consumption would follow. The fiscal outcome so far is mixed. A cleaner rate structure may support spending over time. In the short run, it has reduced buoyancy when states face expanding responsibilities in health, education, social protection and infrastructure.
FY26 also coincides with elections in several large states. Experience suggests that fiscal discipline weakens in such years. Subsidies and welfare outlays tend to rise, crowding out capital spending and complicating deficit control. Each quarterly revenue miss therefore carries political weight alongside fiscal cost.
Macro conditions add to the pressure. Consumption growth has softened, nominal GDP growth has moderated and inflation has eased, all of which weigh on tax collections. Committed expenditures—salaries, pensions and interest—continue to dominate state budgets, leaving little room to absorb shocks. The temptation to lean on off-budget borrowings and guarantees will be strong.
The lesson from FY26 is not that reform should slow, but that sequencing and federal impact matter. Measures that are sound in isolation can strain a complex fiscal union. Revenue forecasts built on optimism can unravel quickly. Fiscal discipline depends not only on targets, but on credibility, transparency and timely adjustment. The coming months will test both the arithmetic and the resilience of India’s federal public finances.