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Politics of Fuel Tax: Better Late than Never!

India
4 Jul 2011

Given the alarming rise in under-recovery of fuel prices for oil marketing companies (OMC), the Government has taken bold and meaningful steps to assuage the ailing petroleum sector - price revision and duty rationalisation. Taxand India considers the latest fuel price increases, and the Government's position on fuel subsidisation.

Past months has witnessed two rounds of fuel price hikes - in May, the retail price of petrol was hiked by almost 9% and later in June, prices of diesel, kerosene and LPG revised roughly by 8%,16.5%, and, 14.3%. Simultaneously, duties on sensitive petroleum products were rationalised; with customs duty on crude oil abolished (earlier 5%), import duty on other petroleum products reduced to 5% and excise duty on diesel revised downward by Rs 2.6 / litre. In addition, certain state governments have lowered VAT levies under a directive from MOF to alleviate the impact of price increases.

With consecutive fuel price hikes, coupled with ad-hoc duty rationalisation, the question to be debated is whether the Government needs to deal with this sensitive sector any differently than resorting to short term measures and is it missing an opportunity for reforms?

A back-of-the-envelope calculation indicates that the recent hikes would bring down the under recovery of OMCs in the full financial year by 35 per cent or Rs 63,000 crore from an earlier estimate of Rs 170,000 crore. The perturbing part is the path walked by the Government, which once again seems faltering and dubious. Despite the recent move, OMC's will continue to incur substantial under-recoveries - almost Rs 5 / litre on diesel, Rs 24 / litre on PDS-kerosene and Rs 300 / cylinder of domestic LPG. This positions India amongst the highest fuel subsidised nations, even ahead of our neighbours' Pakistan, Nepal and Bangladesh. This couldn't have been worse from an economic theory standpoint as the underlying philosophy of government is driven by 'left pocket - right pocket 'theory when it comes to governance of OMC's. Essentially, it defies the arm's length principle when dealing with OMC's!

No serious attempts to reform
Under-recoveries due to subsidy of petroleum product have spiralled four-fold in the past 6 years due to growth rates, spiralling international crude prices and procrastination in pursuing structured reforms. Yet, over past years, the Government has done little to deal with issue of petroleum pricing with meaningful reforms.

The first attempt for petroleum sector reforms was made by the United Front Government to dismantle administered regime in a 4 year phase out. Interestingly, the NDA alliance supported the road map, and the pricing mechanism was formally dismantled in 2002. However, ad hoc government intervention by way of price moderation and tinkering with the customs and excise duty structure continued thereby causing a finite problem to snow-ball into a multi-dimensional crisis, effects of which has become evident as the Government is struggling to save OMC's from virtual bankruptcy, managing fiscal deficit and expectation of the common man on inflation. Successive expert committee recommendations - Rangarajan committee on pricing and taxation of petroleum products, Chaturvedi Committee on financial position of OMC's; the Expert Group led by Dr. Kirit Parikh on viable and sustainable system on pricing of petroleum products, have either been ignored or implemented in a piecemeal fashion. All the committees with near unanimity have recommended market-linked pricing.

The second attempt to reform the sector in 2002 was by way of partial privatisation of select OMC's as such moves have served as an instrument of economic policy globally. However, the divestment initiative hit a road block in 2003, when the Apex Court ruled that PSU divestment without prior legislative sanction was contrary to and in violation of various Acts of the Union. In pursuance to judicial directives, the law makers should have carried out legislative changes to deal with it.

Given the financial crisis on oil PSUs, last year, the PM constituted an Empowered Group of Ministers ("EGoM") to look into the issue of fuel pricing. Whilst initial recommendations brought out the need to decontrol fuel pricing, the two central issues deliberated by the EGoM were (a) degree of decontrol; and (b) the timing of implementing. The EGoM decided to deregulate only petrol prices and maintained a status quo on other petroleum products.

Pain will continue unless wholesome reforms are pursued
Almost, 93% of the Government's subsidy bill falls under three F's - food, fertilizer and fuel. In the last decade, the total subsidy cost to the exchequer has increased nearly five-fold; from Rs 31,500 cr to Rs 150,000 cr in FY 2010-11. Fuel subsidy accounts for 24% of the total subsidies. If one considers under recoveries borne by OMC's in last year, the fuel subsidy doubles to 46%. Amongst sensitive petroleum products, diesel, LPG and kerosene account for over 85% of the total consumption. With these three products under the pricing regime, loss to the OMC's looks deeper and constitutes a sizeable portion of the government deficit.

Further, the relief provided by way of duty rejig to the tune of Rs 49,000 cr. is only a procrastination of the real underlying issue. Until the prices are deregulated, the challenges would merely resurface within the four corners of the system. The recent change is expected to recoup part of the losses of OMC's, at the same time it will bring down tax collections for FY 2011-12 by 7%; and widen fiscal deficit by 0.5%. The under recoveries by OMC's this fiscal have not been factored in the FY 2011-12 budget. Assuming, the Government would contribute 50% of under recoveries, the fiscal deficit could widen by 1.1% solely due to petroleum pricing.

Since the last fiscal, international oil prices have surged over 40% and governments across the globe have been forced to revise the prices. The Petroleum sector comprises of a major source of revenue and by and large tax rates (barring some jurisdictions in the EU) have been low to moderate. Current gasoline prices in the Indian subcontinent (despite subsidy) are around Rs 45 compared to almost 64/litre. Even prices in the US are 33 % cheaper compared to prices in India.

Clearly, our tax and duty structure is faulty and a significant contributor to oil price inflation - the overall petroleum duty rates in India range from 25-45% as compared to 11-12% in the US. This is further compounded by the fact that tax levy is an added cost due to lack of suitable credit mechanism. Besides, state governments have constitutional freedom to determine the rate of VAT and legislate ad hoc levies such as entry tax, octroi, etc.

Taxand's Take


Clearly, an era of moderate crude prices is a thing of past and India has to face the stark realities of unpredictable prices. As a first step, the Government should free diesel pricing immediately and progressively phase out subsidies on LPG and PDS kerosene; the move will benefit the economically weaker section that is indeed the intended strata for subsidised fuel. Decontrol will automatically revive interest of private (domestic & international) investors in the marketing activity and this will also address inefficiencies in the present supply chain.

Our tax system needs predictability in all areas and requires a serious re-look for the petroleum sector. Excise duty, customs and other levies besides being moderate should not be altered to suit the fiscal deficit math. States should pursue a consistent moderate VAT rate and refrain from levying other forms of tax. Finally, petroleum goods should be brought in the mainstream GST to facilitate credits and prevent political manoeuvring.

*First published in the India Business Standard column, 4 July 2011.

Your Taxand contacts for further queries are:
Mukesh Butani
T. +91 124 339 5010
E. mukesh.butani@bmrlegal.in

Kiran Mehra
T. +91 124 339 5010
E. kiran.mehra@bmrlegal.in

Sumit Singhania
T. +91 124 339 5010
E. sumit.singhania@bmrlegal.in

Taxand's Take Author