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End Fuel Subsidies

Fuel subsidies play havoc with the fiscal deficit number & create distortions within the economy…

With Brent crude trading at $111 per barrel (March 15), the spectre of an oil shock looms large over the Indian economy once again. What is disconcerting about the current price spiral is that it comes barely two years after the 2008 episode. Given the frequency of these flare-ups and India's 80 per cent dependence on imported crude, the government of India needs to end fuel subsidies at the earliest.

The first reason is fiscal consolidation. The amount allocated for petroleum subsidy in the Budget (Rs23,640 crore) factored in (according to estimates by broking houses) an average price of around $76 per barrel for crude in FY12. If the average price rises to $105 per barrel or higher, containing the fiscal deficit at 4.6 per cent of GDP will prove impossible.

The second reason is the need to encourage conservation practices. Only when consumers feel the pinch of higher prices will they consume less oil and adopt conservation-related practices. High fuel prices will also provide a fillip to alternative fuels.

The third reason is that subsidies have led to a number of distortions within the economy that do more harm than good. And the fourth reason is that subsidised fuel isn't really cheap: it's just that the costs are borne indirectly by everyone. I intend to elaborate on these last two points a little later.

The price of petrol has already been linked to international crude prices. But it has not been revised for some time in view of the upcoming state elections. However, the major policy leap that needs to be taken is to link domestic diesel prices with international crude prices since diesel accounts for about 56 per cent of under-recoveries (LPG 25 per cent and kerosene 19 per cent).

Subsidies create distortions
Diesel subsidies have created several distortions. India is already a water-stressed country. Ideally, in dry regions farmers need to shift to crops that require less water and deploy water-efficient irrigation practices such as drip irrigation. But in India none of this happens because subsidised diesel allows farmers (mostly rich farmers) to overdraw ground water. The rapid depletion of ground water, especially in north India and the Gangetic belt, will lead to severe shortages in the not-too-distant future.
The price differential between petrol and diesel leads more car buyers to opt for diesel variants of sedans and SUVs. If subsidised diesel were not available, people would pay more attention to fuel-efficiency at the time of purchasing cars instead of opting for large gas guzzlers. They would also engage in car pooling, use public transportation, or make greater use of telecommuting. Instead in the metros one is treated to the all-too-common sight of one person travelling in one car. The price is paid by everyone in terms of a more polluted environment and jammed roads.
Kerosene is the poor man's fuel and hence can be said to deserve a subsidy. But the blanket subsidy leads to it being used to adulterate costlier fuels like petrol and diesel. Besides the pollution and damage to engines, we pay a cost in terms of human lives: conscientious officials who have tried to end this malpractice have been put to death by the oil mafia. Kerosene is also smuggled from India to other countries in the neighbourhood where it costs three to four times as much.
In any case, with the help of the Unique Identity Card (UID) card, a bank account and a BPL (below poverty line) card, we will soon have the wherewithal for direct cash transfers to those who deserve the subsidy. Thereafter, the rationale for continuing with subsidised kerosene will cease to exist.
In case of LPG, research shows that urban households in the top three income deciles consume 40 per cent of LPG and hence the bulk of the subsidies. Subsidised LPG that is meant only for household use is often misused for commercial purposes (say, in restaurants).

Costs unfairly redistributed
The positive aspect of having market-linked prices is that actual users bear the brunt of higher prices. When the government subsidises fuels, the entire economy bears the costs while the benefits often go to the undeserving. Thus it is a fallacy to think that subsidised fuel is cheap.
A higher subsidy burden plays havoc with the government's finances. The government then responds by either levying more taxes or borrowing more. Higher government borrowings crowd out private-sector borrowings (the latter are unable to borrow as much as they would like to). They also exert upward pressure on interest rates, thereby making capital more expensive. Many projects (corporate capex plans as well as infrastructure projects) are then rendered unviable. When corporates don't expand capacity, all of us pay the price in terms of higher costs of manufactured goods. And poor infrastructure is only too evident at every turn in our daily lives for me to belabour its significance here.

Make a calibrated move
Fuel subsidies are among the relics of our faux-socialist economic system wherein policies were adopted ostensibly for the benefit of the poor but ended up benefiting the rich. The sooner we jettison them, the better. However, in view of inflation which is already reining high, a calibrated decontrol of prices would be better than doing so at one go.
According to estimates by Citi, if the average price of crude for FY12 were to be $105 per barrel, a 100 per cent transmission of costs would raise WPI inflation by 3.38 percentage points. An increase of such a high magnitude at this juncture, when WPI inflation is already at 8.3 per cent, would be unpalatable (a 10 per cent transmission would, on the other hand, raise WPI inflation by only 67 basis points).
Lastly, taxes constitute a very high proportion of the retail prices of petroleum products: about 38.8 in case of diesel and 50.8 per cent in case of petrol (see table: Fuel tax structure in India). If petroleum products are brought under the purview of Goods and Services Tax (GST) customers would be saved from the impact of state-level taxes. But recent newspaper reports suggest that petroleum products may be kept out of GST. For the present, the central government must sacrifice some of its levies (customs or excise) on petroleum products to ease customers' pain as they undertake the transition to free-market prices. If it loses some money by way of duties, it will gain some by way of a lower subsidy burden. In the longer run, the government must bite the bullet and end subsidies entirely.

Fuel tax structure in India
  Gasoline  % of retail  Diesel  % of retail
  (Rs/litre)  price  (Rs/litre)  price
International price US$/bbl  121.8  129.6 
1. International price  35.2 55.7 38.1 90.6
2. Import Duty - Notional (6% of FOB)  2.1 3.3 2.3 5.4
3. Transportation/dealer commissions  1.3 2 1.1 2.6
4. Marketing Margins - Adjustment factor  -5.5 -8.7 -13.5 -32.1
5. Ex-storage price (1+2+3+4)  33.1 52.4 28 66.6
6. Excise duties  14.4 22.7 4.6 10.9
7. State charges & sales tax  15.6 24.8 9.4 22.5
8. Retail price (Mumbai) (5+6+7)  63.1 100 42.1 100
Source: Citi Investment Research and Analysis