The Oil shock

Published : Jul 29, 2011 00:00 IST

In Chandigarh, aprotest on July 3 against the increase in the prices of diesel, kerosene and cooking gas. - AJAY VERMA/REUTERS

In Chandigarh, aprotest on July 3 against the increase in the prices of diesel, kerosene and cooking gas. - AJAY VERMA/REUTERS

The increase in the prices of petroleum products is the UPA's way of signalling that the logic of the markets will drive the system.

ON June 24, Petroleum Minister S. Jaipal Reddy announced a package of measures relating to oil prices. Prices of the more sensitive oil products, diesel, kerosene and cooking gas (liquefied petroleum gas, or LPG), were raised, while customs and excise duties on them were reduced or scrapped. The latter was ostensibly aimed at reducing the impact of the price increase on the final consumer by absorbing a part of the increase in the form of reduced government revenues. Yet, in the city of Delhi, for example, prices of diesel rose from Rs.37.75 a litre to Rs.40.75 a litre, that of kerosene from Rs.12.73 to Rs.14.73 a litre, and that of LPG from Rs.345.35 a cylinder to Rs.395.35 a cylinder.

This could not have occurred at a worse time. Inflation is already running at close to double-digit levels. Oil is a universal input that directly and indirectly enters into the cost of production of every other commodity. So the increases announced would have direct and indirect cost-push effects that are likely to aggravate inflationary trends.

It is to be expected that the direct and indirect impact of these increases would substantially erode the real (inflation-adjusted) income of the common man. As far as the ordinary citizen is concerned, oil price increases, which have little to do with costs of production, are a tax the government uses to adjust to an international shock. Since that tax falls even on the poor, it is regressive. The refusal to look for alternative measures to protect the real incomes of the poor and to persist with the desire to follow prices in global markets at any cost is reflective of a deep policy inertia that damages the less well-to-do. This is not a government that seeks to govern on behalf of its people, but merely one that follows the dictates of those who control and manipulate markets.

By opting to increase oil prices, the United Progressive Alliance (UPA) sent out many implicit messages. The first is that despite the government's complete failure to bring inflation under control, the economists that run it are unwilling to give in to their conviction that domestic oil prices must be calibrated to reflect international market prices. Those market prices are, of course, influenced by a whole host of factors that textbook markets are not supposed to harbour. These include: price setting by a cartel that tries, however unsuccessfully, to control global supply; political and strategic developments in West Asia that are not unrelated to the fact that the region houses much of the world's oil reserves that countries like the United States covet; and, the growing presence of speculators, whose activities in futures markets affect the spot prices of crude and oil products.

The second message comes from the timing of the increase. The government clearly knew that these measures would be unpopular and would intensify inflationary trends. Hence, it chose to wait until the Assembly elections in four important States had been completed before adopting them. That is, the government is making it clear that measures such as these were in its view unavoidable even if they are damaging and unpopular. Policy inertia in the face of inflation is not because the government disagrees with opposition assessments of the outcome of its actions, but because it seriously believes that there is no alternative to adjusting oil prices upwards when world prices rise.

It must be noted here that if the action is presented as one of merely adjusting oil prices to keep pace with changes in international prices, then prices should be adjusted downwards when international prices fall. This does happen occasionally, but there is an element of asymmetry involved. The government is very keen on raising domestic prices when international prices rise but less so on reducing them when global prices fall.

Even if it is true, as it argues, that the government cannot avoid responding to the large increases in international oil prices, the question remains whether a sharp hike in retail prices is the best response. It is true that government inaction would mean that the burden of the divergence between the international price of oil and the domestic prices of oil products would fall solely on the three oil-marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited). While estimates vary, official projections of losses owing to revenue shortfalls from the sale of diesel, kerosene and domestic LPG place them at Rs.166,172 crore. The oil-marketing companies claim that they lose Rs.15.44 a litre on diesel, Rs.27.47 a litre on kerosene and Rs.381.14 on the sale of every 14.2-kg domestic LPG cylinder. If they are not compensated in some way, their viability will be at stake.

Five options

The real issue is the degree to which the government should rely on any of the five different alternatives available to it when adjusting to what is an oil shock generated by a combination of conflict-induced supply shortfalls, rising demand and rampant speculation. These alternatives are that of: (i) raising retail prices; (ii) reducing customs and excise duties even with unchanged retail prices, so as to transfer the benefits of the duty reduction to the oil marketing companies; (iii) generating revenues by taxing the super profits of the oil companies that are involved in the production and export of crude at the current high prices, so as to compensate the marketing companies; (iv) generating resources through additional taxes on or lower tax concessions for India's super-rich individuals and the corporate sector, so as to pay for subsidies that protect the ordinary consumer against the effects of the global oil price shock; and (v) borrowing money by issuing oil bonds to compensate the oil marketing companies for their losses.

The principle to determine which agency or agencies should bear the burden of an increase in international oil prices, and to what extent, was examined by a committee headed by C. Rangarajan. The committee spent much of its energies on the different stages through which imported and domestic crude is converted into petroleum products supplied to the consumer, and the cost escalation that arises as the raw material passes through these stages.

Through that analysis it found that the upstream oil companies (or oil companies other than the oil-marketing companies, such as Oil and Natural Gas Corporation Limited, Oil India Limited and GAIL (India) Limited) had recorded significant profits in some years; that the oil industry contributed substantially to the Central exchequer through duties, taxes, royalty, dividends, etc.; and that the petroleum sector alone contributed around two-fifths of the total net excise revenues of the Centre. In Delhi, for example, Central and State taxes amounted to 38 and 17 per cent respectively of the retail price of petrol and 23 and 11 per cent respectively of diesel. The incidence of taxes as a proportion of the retail price in India was higher than in the U.S., Canada, Pakistan, Nepal, Bangladesh and Sri Lanka, though it was lower than in many countries in Europe known for their higher average level of prices, the committee found.

In sum, there was an adequate buffer to shield domestic consumers from the effects of the increase in international prices, so long as segments that can afford to take a cut in petroleum-related revenues because they have alternative sources of resource mobilisation are willing to accept such a reduction. By all accounts, it is the Centre and firms controlled by it that are currently in such a position.

The government claims that it is relying on a combination of available measures to reduce the burden imposed on the consumer. Thus, according to its calculations, the modest price increases would reduce under-recoveries by just Rs.29,000 crore, while the loss to the government because of the duty cuts was as much as Rs.49,000 crore, consisting of Rs.26,000 crore from customs duties and Rs.23,000 crore from excise duties.

The difficulty is that the price hike finally imposed is by no means modest and its effects come when the ordinary citizen is already shouldering the burden of rising inflation. It would have been more sensible and fair to opt for a combination of the other four means of adjusting to the oil shocks, so as to keep prices constant.

The government did reduce duties on petroleum products, but only by a small amount. But this was not any special manoeuvre. Since the government imposes ad valorem or duties specified as a proportion of the landed cost of imports (in the case of customs duties) or of the price of the product (in the case of excise duties), when those prices rise so do the government's revenues, delivering a bonanza to the state.

Thus, when official spokesmen quote a figure of Rs.49,000 crore as revenue loss, it is only a notional loss. It reflects the revenue forgone relative to that which would have been garnered had duties not been cut. It does not necessarily reflect a shortfall in revenues relative to some normative target. In fact, revenues are likely to be higher than any such target since the reduction in duties does not wipe out the additional taxes that the government collects because of the price increase. Not surprisingly, one of the recommendations of the C. Rangarajan Committee was that the Centre shift out of ad valorem excise duties (revenues from which rise with prices) and fix the Central excise duty at a specific rate. This recommendation has been largely ignored.

In the past, too, the government has adjusted duty downwards when prices rose. Thus, a few years back, the government dropped the then prevailing 5 per cent customs duty on crude oil and reduced the customs duty on petrol and diesel from 7.5 per cent to 2.5 per cent and on other petroleum products from 10 per cent to 5 per cent. But, as noted, in order to benefit from the revenue buoyancy induced by increases in oil prices, the government has most often not cut back on duty rates adequately or has avoided such cuts. Further, taxes are reintroduced or revised upwards when prices fall.

Sources of tax revenue

The use of petrol and diesel as sources of tax revenue has meant that the retail prices of these products include a substantial duty component. Prior to the 2008 duty adjustment and price hike, the tax component in the retail prices of petrol and diesel was placed at 53 and 34 per cent respectively. If the government had, in the past, chosen to forgo this revenue completely, but kept the retail price at its earlier tax-inclusive level, the losses of the oil marketing companies would have been much less. These losses could have been compensated for substantially with additional taxes and a dose of borrowing in the context of an emergency.

The real issue then is whether the government can afford to lose the windfall revenues it obtains in the form of taxes on oil. Could those losses have been compensated with additional taxes on and reduced tax concessions to those companies, businesses and individuals who have benefited hugely from the high growth of recent years? The argument of the opposition is that this could have easily been done and they have offered many suggestions. They are indeed right. If the government chose to ignore their suggestions it must be because it believes that taxing the rich to pay for protection against oil shocks for the poor and the middle classes is not acceptable.

Rather than look to such options, the UPA government has adopted a cynical position. It has called upon cash-strapped State governments to reduce the sales taxes they impose on oil products to moderate the impact of the price hike on retail prices. This would involve a reduction in specific or ad valorem sales taxes levied on diesel and LPG. With many Congress State governments being forced to comply with what for them is a Central directive, and UPA partners such as the Trinamool Congress reducing duties to sell their pro-poor image, pressure builds on other States to do the same.

This amounts to getting State governments to implement policies that the Central government is unwilling to adopt itself. Moreover, it amounts to the Congress using the control it exercises over a few State governments to create a political atmosphere where popular anger against the price hike is turned against Opposition-controlled State governments and deflected away from the Centre.

Thus, at the margin it is the consumer and the State governments who have been called upon to carry the additional burden. Neoliberal policymakers at the Centre must have their way even if that badly damages the economic position of the already beleaguered States and the ordinary citizen. The reason, clearly, is to appeal to sections such as finance, which want constant reassurance that the logic of markets will drive the system. The argument used is that if economic rationality is violated, capital will leave the country. What is forgotten is that inflation, which market-friendly pricing unleashes, erodes the real value of financial assets. So finance capital may choose to exit anyway.

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