There is an urgent need to reduce the subsidy burden with price hikes across fuels, but politics might not allow it
The recent hike in petrol prices by the oil marketing companies is in line with the Union Budget proposal to reduce the overall fuel subsidy. Going by the recent trend of ?policy reversals?, one can only hope that this will not be rolled back. But this is just a minor part of the overall oil sector and has the smallest under-recoveries compared to other products. Petroleum Planning & Analysis Cell numbers for 2010-11 show that the under-recoveries in diesel are R34,706 crore while for petrol it is R2,227 crore, with overall oil sector under-recoveries at over R78,000 crore. This means a lot more is expected from the government in order to reduce the oil subsidy and to achieve the target of bringing the overall subsidy to under 2% of GDP.
There is no second opinion about the negative impact that the oil subsidies pose on overall macro-fiscal balances. As the oil subsidy bill has bulged to an unsustainable level, governments (both Centre and state) are forced to take measures that align domestic prices with international prices through deregulation. But there is ambiguity regarding the impact that proposed oil price deregulation could have on important indicators such as inflation. This needs to be analysed in a broader perspective, since such policy actions could have differential impacts in different time horizons as well as on different economic indicators. There is also a need to have an analytical framework through which simultaneous impacts of such deregulation on the overall economy can be assessed. Unfortunately, at the moment, policymaking appears to depend on partial analysis.
One of the apprehensions about the hike in domestic fuel prices, apart from being politically sensitive and unpopular, is that it could worsen the inflationary situation and prolong the current high inflationary regime for some more time. As the current price pass-through ratio for the whole of the fuel group is just around 65%, aligning the domestic prices to international prices requires substantial adjustment to domestic prices. But whether this deregulation in oil prices will become generalised inflation is an empirical question. At the moment, based on historical behaviour, the spin-off effects of such policy interventions on other commodity prices in the past (although those interventions are relatively small compared to what is currently intended in diesel prices) are short-lived, with little impact on core inflation.
Our analysis shows that a full pass-through indeed spikes inflation quite sharply in the short-term, but this effect is not prolonged as it has a negligible impact on generalised inflation in the medium- to short-term as headline inflation reverts back to close to the so-called ?new normal? inflation. Even in the short term, to reduce the burden on the people, governments (state governments, in particular) could absorb these shocks to some extent by reducing the sales tax, which is very high in some states, and also providing significant revenue to the exchequer (for the year 2010-11, oil sector contribution to the state exchequer was nearly R89,000 crore, which is almost the revenues from excise and customs to the central government). In the recent episode of petrol price hikes, some of the state governments indeed reduced their share of taxes to mitigate the extent of the price hike.
In sum, it is clear that there is no further fiscal space to continue the oil subsidy and, in fact, there is an urgent need to reduce it by passing on to the consumers and provide fiscal space for capital expenditures. This is not only to reduce the fiscal deficit and stimulate private investments, but also to reduce the price distortions and to encourage the efficient use of fuel. But one would doubt whether this is possible, given the current political context. Recent statements by the petroleum minister only strengthen these apprehensions. The government may need to look for other feasible alternatives. Moving to a defined subsidy regime in the interim could be the most plausible option available at the moment. There are also efforts to improve the public delivery mechanism through direct cash transfer systems. These measures will hopefully improve efficiency and reduce leakages.
The author is professor, NIPFP, New Delhi. These are his personal views