The launch of GST 2.0 has marked a significant turning point in India’s indirect tax system. Among the most notable reforms is the removal of the Compensation Cess, which had been levied on certain goods since GST was introduced in 2017. This change simplifies the tax structure, but its impact differs across sectors and stakeholders, affecting both businesses and consumers in distinct ways.
Why Compensation Cess Was Introduced
When GST replaced multiple state taxes on 1st July 2017, states were concerned about potential revenue losses. To address these concerns, the government promised that state revenues would grow at a 14% annual rate over the first five-year period, from July 2017 to June 2022. To fund this guarantee, a Compensation Cess was imposed on select “luxury and sin” goods, including automobiles, coal, aerated drinks, and tobacco.
Due to the economic impact of the COVID-19 pandemic, the original five-year compensation period was extended. In June 2022, the GST Council decided to continue the levy and collection of the Compensation Cess until 31st March 2026. The additional collections are earmarked to repay loans raised by the Centre to compensate states during the pandemic, ensuring states continue to receive their due revenues.
Earlier Regime: Before Removal of CESS (GST 1.0 – Till Sept 2025)
Prior to GST 2.0, the tax burden on certain goods was particularly high due to the combined effect of GST and the Compensation Cess. Luxury cars and SUVs attracted 28% GST plus up to 22% cess, resulting in an effective tax rate of nearly 50%, while aerated drinks faced 28% GST plus 12% cess, making the total tax 40%. Coal was taxed at 5% GST plus a per-tonne cess, and tobacco products were subject to one of the highest cess rates to discourage consumption.
For businesses, input tax credit (ITC) on the Compensation Cess was highly restrictive. ITC could only be utilized if the output supply was also liable to cess—for instance, a car manufacturer paying cess on SUV components could use that credit only against the cess payable on the final vehicles. Refunds were generally not allowed except for exports or in very limited cases of inverted duty. As a result, most cess ITC remained blocked, leaving businesses with stranded credits and creating liquidity and compliance challenges.
Transition Phase: After Removal of CESS (22nd Sept 2025 onwards)
Under GST 2.0, multiple levies on luxury and sin goods will be consolidated into a flat 40% GST slab. For example, a ₹20 lakh SUV that previously attracted 28% GST plus 22% Compensation Cess (i.e. 50% Tax) will now incur ₹8 lakh in taxes, reducing the final price to ₹28 lakh. This provides an immediate benefit for consumers, particularly in the luxury car segment.
Businesses, however, face transitional challenges. Dealers, especially in the automobile sector, hold large unutilized cess credits that cannot be offset against the new GST, creating cash flow pressures. Companies must pay the new GST in cash while stranded credits remain inaccessible, complicating working capital management.
Certain sectors, such as tobacco and pan masala, continue under the old cess system because collections are used to repay COVID-era loans. These goods will transition to the 40% GST slab once the loans are fully cleared.
Across affected industries, including automobiles, beverages, and coal, businesses are seeking transitional provisions to utilize stranded ITC, clear guidelines on existing inventory, and temporary support measures to ease the transition. Such measures will help companies manage working capital efficiently, maintain pricing stability, and avoid sudden cost adjustments for consumers.
Long-Term Outlook (22nd Sept 2025 onwards)
Once the transitional challenges are resolved, GST 2.0 promises a simpler, more transparent tax system. In the long term, the removal of the separate Compensation Cess on inputs and outputs will eliminate the need for a separate cess ledger. This means that the historical restrictions where cess ITC could only be used against cess liability or refunded in limited cases, will largely disappear. Businesses will enjoy seamless ITC flow, reduced compliance burdens, and more predictable pricing, which enhances planning and financial management. Consumers, especially in sectors like automobiles and energy, will enjoy a more straightforward tax environment, potentially with lower costs. Tobacco remains the only exception until government loans are fully repaid.
Conclusion
The removal of Compensation Cess under GST 2.0 illustrates a case of short-term adjustment for long-term gain. Businesses may face liquidity and compliance challenges during the transition, but long-term efficiency and predictability improve. Temporary relief measures and clear transition guidelines will be critical to ensure smooth adaptation. Consumers see immediate relief in high-value segments like luxury cars, with gradual benefits extending to everyday goods as the system stabilizes.
Ultimately, while transitional challenges exist, the removal of the Compensation Cess under GST 2.0 paves the way for a more equitable, efficient, and growth-aligned indirect tax framework in India.
