High Petrol Prices

Are higher fuel taxes a bad economic policy?

In India, fuel prices have always been at the centre of political and social debates. The recent surge in fuel (Petrol & Diesel) prices have yet again sparked debate over – high fuel prices despite lower crude(It even fell below $0), fuel prices impact on inflation and fuel tax policies of the government. This blog will try to put arguments in this brewing debate.  

Before we indulge in economic details, let’s understand why & how fuel prices impact political fortunes. Since the majority of Indian are poor and lower middle class, Indians are always concerned over the rising cost of living (inflation). Theoretically, rising fuel prices create secondary spiral effects on food prices and other consumer products, leading to higher general inflation. Secondly, India has a history of regulated fuel prices i.e. fuel prices were not dictated by market forces but by Delhi political circle. Governments used to manage fuel prices (by providing subsidies) to garner votes. In 2002, Atal Ji’s government first tried to deregulate fuel prices, but petrol prices remained regulated until 2010 when it was deregulated by UPA 2. Diesel prices were finally deregulated by Modi Government in 2014. Although fuel prices are not regulated any more, adaptive tax changes continue to be a major factor of retail fuel prices.

Anatomy of Fuel Prices

The retail petrol prices in Delhi can be bifurcated as base price (Actual cost of petrol including dealer commission) and excise duty (central govt tax) and VAT (state government tax). As depicted in the chart below- Petrol prices in Delhi on July 1 was INR 80.43, out of which actual cost of petrol is just INR 28.89 and central govt taxes nearly INR 32.98 per litre and state govt tax nearly INR 18.56 per litre. In percentage terms, taxes (centre and state combined) constitute nearly 64% of the selling price.

Breakup of Retail Petrol Prices in Delhi

Ever wondered, why diesel retail prices in India remained cheaper than petrol prices?

Over the years, governments have levied lower taxes on diesel than petrol because diesel is considered a major factor in food & goods supply chain and diesel also utilized by farmers. Recently, the Central government narrowed the excise duty on petrol and diesel. In fact, in Delhi diesel costs more than petrol as Delhi government now charges more VAT on diesel (18.83) than petrol (18.56). Clearly, taxes play a crucial role in retail fuel prices.

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Are higher fuel taxes a bad policy?

Crude oil prices have been a key barometer of India’s macro-economic health. Before July 2014, when crude prices used to be above $100 per barrel, higher crude oils used to translate into higher current account deficit, higher fuel subsidy lead to higher fiscal deficit and rising petrol prices lead to higher inflation and an ultimately weaker rupee. Since then, oil prices have remained under check due to various factors such as higher US shale gas production, supply tussle b/w oil-producing nations and slowing oil demand due to weaker economic activity. Under this backdrop, lower crude prices have rendered support to India’s macro-economic factors. For instance, India reported current account surplus in Jan-Mar-20 quarter, India’s CPI inflation has remained under check (Read more here) and the Indian government have successfully taxing more on fuel products rendering fiscal support. This brings us for final question – Is higher fuel taxes a bad policy? To answer this let’s consider these factors.

Higher fuel tax translated into inflation?

Fuel prices constitute nearly 8% of CPI basket, thus higher fuel prices lead to high inflation. Moreover, higher fuel prices translate to secondary effect (Transportation) on food and goods inflation. Interestingly fuel prices have witnessed deflation over 6 years before COVID-19. As the infographic shows, petrol prices have decreased from INR 71.41 to INR 69.87. Hence, higher taxes have not led to higher inflation, the government has been proactive in capturing fall in crude oil prices to its benefit without inducing inflation.

Relatively Inelastic Fuel Demand

Elastic goods witness significant changes in demand due to an increase in prices. On the other hand, inelastic goods witness little change in demand due to an increase in prices. Non-discretionary nature of fuel products makes them relatively inelastic; thus, they are efficient tax sources. The demand for crude oil remains stable despite increase tax component. Thus, excise duty on fuel products is an efficient choice for fund government finances.

High Fiscal Deficit

During the first term, the Modi government was fairly prudent on the fiscal front. But economic slowdown and election year splurge have put considerable strain on fiscal math. The slump in crude oil prices has yielded into a consistent tax source for the government. If the government allows passing the cheaper crude benefit to end consumer, it needs to find another way to tax the same population given constraints on the fiscal front.

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Government finances in times of pandemic

Pandemic, like Covid-19, puts a considerable strain on the fiscal situation. On one hand, Government announced INR 20 trillion Atmanirbhar Package (Read Here) to support economic activity and less privileged population. On the other hand, tax collections are all set to take an unprecedented beating due to little economic activity. In such times, it’s prudent to levy higher taxes on fuel products.

Finally, there could be multiple arguments in favour of pass-through of fall in crude oil prices. For instance, one can argue that lower input fuel cost can boost economic activity and profit margins in fuel-intensive industries like paint and airline. Moreover, the lack of fall in fuel prices (due to higher taxes) can arguably reduce export competitiveness.

But, these arguments are best answered by IMF working paperExport competitiveness – Fuel Price Nexus in Developing Countries: Real or False Concern? “This paper investigates (relative) fuel prices increase on export competitiveness in a sample of 77 countries. The resulting policy implication is that countries seeking to increase domestic fuel prices (whether it is in the context of a subsidy removal plan or it is driven by higher international oil prices) should not be overly concerned about the impact on export competitiveness.”.

At last, India’s current macro-economic conditions low inflation, aggravated fiscal situation (due to pandemic) and relatively inelastic nature of fuel products are in favour of higher taxes on fuel products. Thus, higher fuel taxes do not seem to be a bad policy.

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