Upsetting oil pricing conundrum
Earlier post on the subject: Oil Pricing in India
Vikram S Mehta, chairman of the Shell Group of companies in India, provides the structure of the price build up for petrol and diesel by the public sector companies in India.
Indian Oil Corporation (IOC) calculates inter alia the landed import duty paid price of petrol and diesel every fortnight. This calculation is based on a formula that is linked to international prices. IOC’s landed price of petrol in Mumbai for the second fortnight of May was, for instance, Rs 38.1 per litre and for diesel Rs 48.8 per litre. The marketing companies had to, in other words, pay this amount to the refiners to buy the products. Next, the Central government imposes an excise and educational cess on the purchase cost. In May, this was Rs 14.4 per litre and Rs 0.4 per litre for petrol and Rs 4.6 per litre and Rs 0.1 per litre for diesel respectively. The total cash required by the marketing companies to purchase petrol and diesel in May was, therefore, Rs 52.9 per litre for petrol and Rs 53.6 per litre for diesel. The companies then sell these products at the ministry of petroleum mandated price of Rs 49.7 per litre for petrol and Rs 35.6 per litre for diesel (Mumbai prices). As such, they lose Rs 3.2 and Rs 18 for every litre of petrol and diesel sold respectively.
That, however, is not their total loss. They have to also pay sales tax to the state governments. In Mumbai, this tax is Rs 10.6 per litre and Rs 7.1 per litre for petrol and diesel respectively. Thus, the total cash loss suffered on account of the sale of 1 litre in Mumbai is Rs 13.7 and Rs 25.1 for petrol and diesel respectively. This is, in other words, the amount by which prices would have to be increased at the retail outlet for the companies to simply break even on a cash basis. Such a hike is, of course, out of the question.[Indian Express]
Many in the public domain believe that the imbalance can be redressed by reducing the central and local taxes to make the public sector oil companies profitable. However, it is actually not about reducing the taxes to bring the prices down. That is just an indirect way of maintaining the subsidies. On one hand, the balance sheets of the oil companies might look healthier and higher profits might allow them to disburse handsome dividends. On the other hand, the government revenues would come down and higher revenue deficits will bring the finance ministry into the FRBM dragnet. It is not a Morton’s fork but a Hobson’s choice for the government — to link the retail rates of petroleum products with the market rates.
In case of most other commodities, the high consumer price checks demand. This helps restore the supply-demand balance. As prices are not linked to the rising market rates, oil demand is not checked commensurate with the price change. It obviously creates an asymmetry in the supply-demand balance which can be only restored at much higher prices. By then, it might be already too late for the Indian economy.
Now let us look at two sensible, yet nonparallel, viewpoints on resolving this pricing conundrum. In the same piece, Vikram Mehta prescribes the policy framework for a comprehensive petroleum policy.
First, we should accept that high oil prices are here to stay. This does not mean we will not see sharp declines from present levels. What it does mean is that we will not see prices stabilising at levels significantly below a triple digit number. Second, we must create a mechanism that leads to a ‘graduated’ reduction in subsidies, an orderly alignment of domestic prices to international levels and a more efficient disbursement of financial support to the poor. Third, we must reverse ‘dieselisation’. And finally, we must recognise that the sine qua non of energy security is a robust and competitive domestic petroleum and energy sector.
Fellow blogger Atanu Dey has a much simpler, but more innovative solution to redress this perverse subsidy for the rich.
The basic economic truth is that there is really no such thing as a free lunch. Today’s subsidy comes at a cost that will only grow larger the longer the delay in pricing petroleum products at full cost. It is fairly simple to remedy the situation. Raising the price at the pump is the simplest but the most politically risky. The UPA government knows that and will definitely not risk losing power even if raising prices is for the larger benefit of the economy.
But those subsidies have to be reduced, if not totally abolished overnight. A start could be made immediately to reduce the subsidy to the rich while continuing it for the poor. A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use. Depending on the size of the engine and average fuel consumption, an annual fee could be assessed which has be paid to maintain registration. So if a particular make and model of car typically consumes, say, 1,000 litres of petrol a year, the tax could be Rs 10,000.
This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched. Since it is usually the common man who uses public transportation, the common man would continue to enjoy the subsidy.[Deeshaa]
One can only wonder if Rs 200,000 crore in oil subsidies, nearly 2% of India’s GDP, is not alarming enough for the government to pay heed to such sensible opinions.
Cross posted at The Indian Economy Blog
[...] ozman wrote an interesting post today onHere’s a quick pericope [...]
Pragmatic,
I am all for abolishing subsidies on oil prices and I support the government’s fuel price hike.
However, I do believe that there is a case for revising local sales tax rates. They range from 20-40% and are remnant of an era when India followed a high-tax regime. Now, when taxes are being rationalized generally, it makes sense to bring them down gradually to say 10-15%. It might affect government budgets initially but they also have been taking advantage of the virtually inelastic nature of oil demand (at least till now) to raise easy money. That is not prudent economic management.
Btw, FBRM is only applicable to central government. So rationalizing sales taxes won’t fall foul of that.
“On the other hand, the government revenues would come down and higher revenue deficits will bring the finance ministry into the FRBM dragnet.”
Couldn’t agree with you more.
“It obviously creates an asymmetry in the supply-demand balance which can be only restored at much higher prices. By then, it might be already too late for the Indian economy.”
Price rise/fall has nothing to do with supply – demand (im)balance. Major consumers of petro products are institutions (Government/PSUs being the major consumer followed by the corporates). They are largely insensitive to price fluctuations. Retail consumers in any case form a minuscule percentage.
“Second, we must create a mechanism that leads to a ‘graduated’ reduction in subsidies, an orderly alignment of domestic prices to international levels and a more efficient disbursement of financial support to the poor..”
Couldn’t agree more. Enough of free lunches. High time the country rises above vote bank politics and removes all subsidies/ quotas….well there is nothing like ‘gradual’. It has to be abrupt. Few will commit suicide and the rest will get mentally hardened to accept the harsh reality.
“A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use.”
@ Atanu Dey
Can you elaborate on this concept?
Situation 1: I am a lower middle class citizen. With great financial planning, I managed a Maruti Van. For me it is more of a status symbol. I take it out for family outing once in a fortnight/ month since I cannot afford more than that.
Situation 2: I am a businessman. I have invested in a Maruti Van. I use it to transport goods from the wholesaler to my retail shop. It does at least 200 Kms everyday.
Question: Please calculate the individual annual usage for the entire population of Maruti van holders?
well, if you talk in terms of slotting, then a better idea (not the best) would be to impose different petro cess for different IT slabs.
“This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched.”
Again free lunches!
@Rohit:
I think the government has already done some tax reduction. More may be in the offing.
@Veeru:
Price rise/fall has nothing to do with supply – demand (im)balance. Major consumers of petro products are institutions (Government/PSUs being the major consumer followed by the corporates). They are largely insensitive to price fluctuations. Retail consumers in any case form a minuscule percentage.
Hmmm… that’s a new angle. I don’t have the data for public sector and private sector consumption but it would be worth checking out. The very obvious economic theory will fail in that case. Thanks and let me mull over this one.
[...] in a comment on a Pragmatic Euphony post objected saying in essence that the scheme will penalize car owners who drive less than the average [...]
I have responded to the issue raised by Veeru above in a post Fuel surcharges for Private Cars on my blog.
Here’s only a bit from the post (which also addresses a related objection from another commentator.)
Fixed costs do not enter in the picture ex post but do enter ex ante. If the flat-tax is imposed on me after I have bought the car, it will not substantially change the number of miles I drive. But note there is an “income effect” — by paying that fixed cost, I have less money and therefore I will drive a little less.
Nor will my decision to buy or to buy a particular car (or even any car at all) be affected if I did not know that such a flat-tax may be imposed. However, if I know before hand that I will be paying a flat-tax as a fuel surcharge, it will affect my decision to buy or not, and also affect how much I actually drive. The last thing I would do is to increase my driving so as to creep as close to the average miles driven: it would be akin to cutting off my nose to spite my face.
Oops, I posted the wrong excerpt in my comment above. I should have posted this bit:
Sure, in a world where it would be costly to figure out exactly how many liters of subsidized fuel every car driver uses (and then impose a tax calculated to negate the subsidy), one is forced to go with averages, and that immediately forces a cross-subsidy. But here’s the point: if you know that you are a low mileage user, knowing that you are subsidizing others will enter into your calculation on whether to keep that car or not. It is up to you whether you wish to keep the infrequently used car which on average is used extensively by others.
Imagine that I like to drive the tractor of an 18-wheeler once a year for 100 kms just for kicks. So I own one. But, on average those tractors rake up 100,000 kms a year and (suppose) that the annual fuel surcharge is Rs 20 lakhs. It is up to me to decide I want to belong to that club.
One cannot base policy on outliers.
@ Atanu Dey
Thanks! I am really touched that you came out of your blog and commented on this one.
I am regular at INI and never fail to go through ‘Pragati’, ever since its launch, however I didn’t notice your post. Maybe my fault.