Thursday, June 7, 2018

Petrol & Diesel Pricing


We need to rethink whether arbitrary levies that effectively double fuel prices improve public welfare.

Why do we pay so much for petrol and diesel in India?  Essentially, because of taxes and levies. The government seems to treat containing the fiscal deficit as the highest priority, with other public interest criteria being less important. Let’s explore this assumption to see if it is reasonable. The question is, what is the net effect on public welfare from arbitrary costs/levies that effectively double the price of fuel, compared with the benefits.
Rising petroleumprices in India are causing significant distress, both at the macro level in terms of slowing growth as well as in living conditions for most people, excepting those at the highest income levels. This is primarily because of India’s dependence on imported fuels without commensurate strength in exports. Additional factors are: The value of the rupee against the dollar, and the effect of the extent of taxes on petrol and diesel on living conditions.
To recap briefly, when the price of crude dropped from 2014, the government increased taxes nine times through January 2016. But when prices rose thereafter, taxes were not reduced. This has resulted in exorbitant retail prices, and much higher government revenues. Chart 1 shows the price of India’s crude basket in dollars per barrel, and petrol prices in rupees per litre.

For every additional in tax, the government gets Rs 130 billion more revenue (as reported by PTI) while according to the 2017-18, for every $10 per barrel increase in prices, growth is reduced by 0.2-0.3 per cent. It was estimated to be more than double that by the Institute of Energy Economics, Japan, in May 2012.

Chart 2 shows the effects of rising oil prices on importing nations. 


Both producers and consumers suffer the ill effects of rising oil prices. In India’s present circumstances, these negative effects need to be set off against the positive effect of containing the deficit to some extent, which will presumably temper inflation and so on.
This set of factors reduces nominal GDP ($2.65 trillion in 2017) by an estimated 0.2 to 0.3 per cent at least ($5.3-7.95 billion, or if it is indeed nearer 0.7 per cent, by $18.55 billion). Another set of factors is the rationale that people who use vehicles must pay high taxes for these reasons:
  • As a disincentive to restrict the use of petroleum products, to control pollution as well as the level of imports.
  • As a source of revenue for other beneficial public use.

On the other hand, the rationale for passing on the benefits of lower taxes and prices to users is:
  • To restrict inflation by keeping input costs low, which is presumably important in terms of lower financing, input and transportation costs for the economy.
  • To boost consumer demand, thereby also contributing to growth.

Perhaps there needs to be a rethink from the ground up — an ab initio approach to define critical objectives in the public interest. Should higher taxes be imposed on inputs such as transportation fuel in the absence of public transport alternatives? Are there other effective ways of curtailing pollution and excessive consumption (apart from the necessary and systematic development of public transport), while retaining the enabling aspects of inputs such as transportation?
A study of the energy cost share of GDP in the US from 1950 to 2013 found that expensive energy was a drag on the economy. If the cost share was higher than a threshold (above 4 per cent of GDP for the US data), the economy was likely to do less well. In India, petrol and diesel costs as a percentage of GDP are far higher than in many other countries. While retail petrol is priced about the same in India, China and Brazil (see, a litre of petrol is nearly 20 per cent of daily per capita GDP in India, whereas in Brazil and China, it is only a fifth of that, at about 4 per cent.
From a completely different perspective, consider how keen political parties and candidates are in election mode to appease or cajole voters. This happened in the run-up to the Karnataka Assembly elections in April. Local newspapers ran headlines about petrol and diesel prices held steady for nearly three weeks until May 14 despite rising international prices. Only then were prices allowed to soar (Chart 3).  

Since keeping fuel prices in check is recognised as a palliative for elections, what could be the reason for avoiding a decrease in taxes and levies when the price of crude rises? Presumably, concern about the deficit. Perhaps what needs to be thought through is the benefits of reducing input costs to increase collections from higher growth.
The management and use of petroleum for energy is one dimension of our multifaceted requirements that has to be addressed. Other necessary dimensions include emphasis on the development of renewable fuels such as cellulosic ethanol for transportation2, of electric batteries for vehicular use, and apart from transportation, of solar power generation, and for large plants, integral solutions such as association with pumped storage power where possible.
Above all, rational pricing of inputs by reducing taxes is a desirable beginning that can be acted on immediately.

Shyam (no space) Ponappa at gmail dot com
1. Michael Aucott and Charles Hall:

Added later:
For related material, see:
Extractive Charges on Spectrum & Petroleum
Are government levies on these critical inputs beneficial or detrimental?
March 6, 2014

Counter argument - added later:
Rathin Roy, BS June 8, 2018 - 'Oil price volatility: Policy options'
Given the random walk, changing oil prices impact short-term macroeconomic stabilization.

Oil industry forecasters and economists have been trying to predict future oil prices for over 70 years. The major analytical conclusion (see thisfor a summary) is that the best predictor of future oil prices is the present  Technically, this means oil prices move akin to a random walk without drift.
In India, analysts in the private sector and media commentators appear ignorant of this. Like central planners, they read supply-demand forecasts to make predictions about future prices and use this as a basis to advocate government intervention. This leads to accusatory hysteria about government doing nothing to temper the effect of rising oil prices on purchasing power.
Given the random walk, changing oil prices impact short-term stabilisation. The only medium-term factor that needs to be kept in mind is that oil prices will fall as technology reduces demand for fossil fuels. A random walk, therefore, means that government policy must be to select a benchmark price for oil, and then devise policies that stabilise short term oil prices (or a derivative set of prices for petroleum products) around this price, consistent with stabilisation objectives.
The major policy implication of fluctuations is on the (BoP). In India, this is complicated by the fact that India imports oil and exports refined petroleum products. The difference between the two, net oil imports, halved between the first quarters of 2014 and 2015. That trend has reversed since the second quarter of 2017. In value terms, exports have stagnated while imports have increased by 39 per cent. Exports are now 36 per cent of imports compared to 32 per cent in Q2, 2017, in turn, down from 42 per cent in Q1, 2015. This is a structural trend and must be dealt with as such by petroleum experts, as it affects the impact of changes in oil prices, not price formation.
For management, it is desirable that consumption growth is tempered when oil prices fall, but is constant, or falls, when prices rise. This would mean that, having set a benchmark consistent with management, government should tax oil (and its derivative products) when market prices are lower, (and do as little as possible when market prices are higher), than the benchmark price.
This government has so far (without explicitly saying so) done exactly this, for which it is to be commended. However, it has to be mindful of the impact of rising oil prices on the voiceless poor and vulnerable. But the political noise comes not from them, but from commentators whose clientele are an elite addicted to oil, that constantly needs to top up its fuel tanks to meet western lifestyle aspirations. For both these reasons, government may need to consider policies to limit the impact of rising oil prices on purchasing power.
There are four policy options. First, to hedge against future price rises. This is unfortunately costly, both in terms of capacity to hold and to store petroleum products, and because the cost of financial hedging instruments is high — precisely because oil prices are a random walk! Second, to tax when prices are low, save a part of the proceeds, and use these to balance the fiscal books and reduce taxes when prices rise. This is difficult to do in India where the central government has expensive development obligations, but is also in a long term fiscally constrained situation. Third, tax petroleum products, especially luxuries, so that consumption falls, and aggregate purchasing power is maintained by changing consumption patterns. This takes time and requires cooperation of the elites, which is not forthcoming. As long as automobile and FMCG sales growth is considered a leading indicator of economic health, this is off the table. Fourth, subsidise oil prices/reduce taxation of petroleum products until prices fall.
The first three options all have a positive impact in ameliorating the impact of rising oil prices on the  The fourth has a negative impact as it leaves demand for petroleum products unchanged even as prices rise. Even the expectation that such an intervention will happen (reasonable considering India’s past record on petroleum subsidy), means that the value of oil imports continues to rise as prices rise. Clearly, this is undesirable.
Based on the above reasoning, my professional view is that the pressure on government to intervene to moderate domestic oil prices is unwarranted and not in the public interest. But I understand that government may be politically compelled to contemplate the undesirable fourth option. If this is inevitable, then I recommend that government announces a time- and price-bound policy intervention. Thus, government could commit to maintain oil prices at or below a specified level, until a specified future date. This would be an explicitly limited intervention, and would promote economy of consumption and temper expectations, as consumers and markets use the transition space to adjust to a higher oil price future. This would minimise fiscal costs, moderate the skittish reactions of our immature bond markets, and silence the garrulity of commentators pandering to middle-class sentiments in the name of the common man. The government could introduce simultaneous measures to protect the poor and vulnerable through income support using the Direct Benefit Transfer (DBT) modality (which can be done even if price subsidies / tax cuts are not executed).

The writer is Director, National Institute of Public Finance and Policy. Views are personal

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