Here?s why auto fuels need higher taxes

Retail prices were raised for gasoline and diesel a fortnight ago, but not by enough to neutralise cost increases on account of crude oil. There seems to an influential view that it is incumbent on government to keep retail selling prices of petroleum products as low as possible, even if oil companies, particularly those in the state sector, continue to absorb financial punishment. Why, after all, should the public sector exist but to serve the public good; and many tend to err when they confuse national interest with the electoral conveniences of the peoples? representatives.

More than two decades after the first oil shock, it is imperative to restate the problem. The fossil fuel resource that nature has blessed us with is limited, and this is particularly true for oil and natural gas. First, the resource is a depleting one, and second, the rate at which costs rise as we try and raise production is very steep. Thus, it is true that the pure production cost in some of the onshore oilfields in the Middle East is just a few dollars per barrel. It rises steeply as we move the production frontier to include onshore fields in far more difficult terrain and even more as we move to shallow offshore fields to deeper fields. It also rises as we try and recover more and more oil from the reserve in-place.

The supply response that an increase in crude prices has, works pretty well, but it takes some time to produce tangible results. If consumer prices are raised sharply, it also produces energy-saving technology and other kinds of choice that reduces the pace of demand for refined petroleum products. In the years after the first and second oil shock (1973 and 1980), on the one hand, exploration and developmental activities expanded, and recovery efforts from existing fields turned more intensive. With high fuel taxes in most Europe and Japan, great savings in terms of oil efficiency, both in automotive and domestic heating, were achieved.

Both of these responses were indeed so strong that by the mid-1990s, exacerbated by oil flooding in from the former Soviet Union and the Asian currency crisis, crude oil prices crashed through 1997 and early 1998, threatening to breach $9 per barrel. This development had two singularly bad outcomes. First, it threatened the financial viability of high-cost existing oilfields and encouraged oil companies to cut back on exploration and development expenses. Second, it generated the completely false expectation amongst a section of policy-makers and other players in the theatre of life to believe that cheap oil ($20?25/bbl) was going to be around for quite some time to come. For instance, the shutting down of the 1,200 MWe Superphoenix in France, the largest breeder reactor extant, was a direct casualty of anti-nuclear groups riding on the oil slick of $10 per barrel (bbl) oil.

US policy never subscribed to the idea of taxing petroleum fuels as a matter of public policy and as crude prices stayed below $30/bbl, meaning thereby that in inflation adjusted terms, gasoline was as cheap as it had been in the ?70s, fuel efficiency in the car business took a backseat.

Many countries in the developing world, albeit for very different reasons, chose to keep prices at the pump very low. This list obviously included oil exporters such as Saudi Arabia, Iran, Indonesia, Venezuela and Nigeria, and one not-so-obvious inclusion, nam-ely, China.

In the Opec area, pump prices were much less than (international) cost. For, where most of the population was too poor to own a car, this perhaps made splendid patriotic (in the Boswell-Johnsonian sense that is) sense. Today, per litre retail selling prices of gasoline is highest in Norway at Rs 89 (incidentally, a large exporter of oil and gas from the North Sea), followed by Holland (Rs 72), the UK (Rs 69), Germany (Rs 68), France (Rs 64), Spain and Japan (about Rs 53 each). The US trails way behind this list at an average price of Rs 28, a trifle higher than the price in Russia, one of the world?s largest producers and exporters of oil and gas.

Much behind this is China, where the retail price for gasoline is about Rs 19 per litre even after a series of price increases over the past year amounting to a total of 33%. Not only is there no tax component in the price, but the government is planning to postpone the imposition of a tax that it had originally scheduled to bring in at the end of 2005.

China is a large importer of crude oil and has, in fact, been the major contributor to incremental oil demand over the past few years. It is unclear why the Chinese government chose not to impose taxes on automotive fuels but till recently, when there were few cars to buy and insufficient domestic capacity to purchase, the consumers must have been restricted to the patriotic upper layer and the public policy choice that emanated from it is, perhaps, the natural one in authoritarian circumstances. Diesel and other refined products are priced at about the same level and the government has recently stated that it does not want to bring in a tax since it fears it might adversely impact growth prospects.

Indonesia, which prices gasoline (and other products) at about Rs 8 per litre, has been shelling out huge subsidies from its budget. This largest of the Southeast Asian oil exporting nations faces a severe crisis. High oil prices, that used to be regarded as a boon, are now viewed as a calamity. To paraphrase the country?s finance minister: ?The country is now planning to raise retail prices by 40%,? which will still leave a long road to cover. Iran continues with the lowest retail price of Rs 5 per litre; with not much of an automotive sector, it can afford it for a while perhaps.

Considering these fine examples, Indian policy has been relatively sensible so far.

The writer is economic advisor to Icra