Thursday, July 3, 2008

Inflation, Fuel Prices & Taxes

Shyam Ponappa / New Delhi July 3, 2008

Revive growth by taxing fuels less and lowering interest for productive loans.

Let's hope India's growth prospects are not obliterated by oil-price induced inflation and attempts to control it. It is necessary, though, to develop ways to properly address these issues, including fuel pricing and taxation. Separately, lack of fiscal rectitude — unfunded loan waivers, oil bonds, etc. — has no remedy other than responsible behaviour.

A Senior Fellow at the Brookings Institution offers this caveat for China's inflation: ‘In these circumstances, continuing to raise borrowing costs would be a mistake.'* We should pay attention.

Not the RBI's stock response of raising interest rates and the CRR to reduce inflation by squeezing demand. To be fair, many academics and journalists condone the RBI's actions. However, there are two contra-indications:

a) Higher rates and less credit do not alleviate imported fuel prices.

b) Similar reactions to previous oil shocks in India led to economic disaster followed by radical political fallout.

Policy makers should consider this before the situation becomes irretrievable.

Oil Shocks & Inflation
Our major problem is an oil shock. Leave food pricing aside, as well as metals and cement. These are additional complications, but considering them together confuses rather than clarifies analysis in the first instance.

Hammering imported fuel price-rise with high interest rates, tight liquidity and lower credit lowers inflation only by crushing the economy. As long as fuel prices are high, overall inflation will stay high. A simple simulation with short-run demand for fuel remaining inelastic demonstrates this.

The two charts represent monthly average indices (like the WPI) of food, fuel and metals, starting at 100 in January, rising to a maximum between August and November to approximate India's seasonal pattern. Chart 1 shows high inflation in fuel and metals, with an average annual increase of 25 percent (an illustrative pass-through of international prices for fuel). Food shows an ‘acceptable' rise of 5 percent. Total annual inflation (Chart 1) works out to over 18 per cent.

Chart 1

Now assume the RBI acts so that inflation in metals is reduced to 5 per cent also (Chart 2). Fuel prices remain the same because of imports. The resulting annual inflation is still well over 11 percent (Chart 2). In fact, the cascading inflationary effect of fuel prices may render 5 percent inflation in food and metals to be unrealistically low.

Chart 2

So, what are the ways out? The problems are slowing growth (a self-induced recession), compounded by high fuel prices, limited bank credit with crowding out by loans to oil marketing companies, and slowing FDI. Good solutions must address these.

Directed Bank Credit, Lower Rates

A real effort is needed to direct credit at low rates for productive purposes, e.g., primary housing, construction and manufacturing investments, with tighter margins, interest, and CRR for more speculative activities, e.g., other housing and commercial development. The aim should be to rebuild economic momentum to collect taxes from profits, rather than through high imposts that restrain profits, while discouraging speculative investments.

Fuel Pricing and Taxation

Fuel is heavily taxed by the Center and the states. One report puts excise from the petroleum sector at 48 percent of total collections. Most states reportedly earn 25 percent of their tax revenues from fuel taxes. Until the reductions in early June, these imposts comprised customs and excise by the Center (of which states get 30.5 percent), plus state taxes ranging from 20 to 33 percent. These amounted to 52 percent of the petrol price and 32 percent for diesel.

When duties were cut, states like Kerala cut sales tax/VAT, then rolled back cuts because airlines were not reducing prices. The airlines, hit by prohibitive fuel prices, needed the cuts to survive. Efforts to apply a uniform 4 percent on aviation turbine fuel across states stalled, with the states demanding that the Center cut excise. So, while there is professed concern for consumer interests, they're really fighting over the spoils. (On their part, consumers must expect to pay reasonable charges for utilities.)

Indian consumers pay very high prices for fuel in purchasing power parity terms. Also, because of the high prices of petrol and diesel, more than half of India uses dirtier fuels like coal and wood.

In place of sophistry, we need a balance between reasonable, transparent Central and state taxes and commercial viability, with well-planned subsidies for fuel for freight and public transport, including aviation. To the extent fuel for private transport is reasonably priced, it will support a healthy automotive industry as an engine of growth, along with housing, construction, manufacturing and services.

Concomitantly, we need well-planned development of all forms of public transport, combined with conveniences like bicycles and electric cars for hire. Subsidies such as Delhi's offer on electric cars can help, but radical changes are needed in diesel pricing/incentives for cars.

Differential pricing for personal and public transport can be collected periodically, e.g., with periodic pollution certification, while point-of-sale smart cards would be capital-intensive but efficient. Cards also enable surcharges for larger vehicles on city streets, into demarcated areas, and better traffic management.

* "The right way to beat Chinese inflation", Wing Thye Woo, Senior Fellow, International Trade and Economics, the Brookings Institution (BS June 27, 2008)