While high fuel prices may earn more revenue for the government, it can also lead to a rise in headline inflation.
The government is faced with a new domestic trade-off between fiscal stability and sticky inflation.
The government has a tough choice on whether to keep petrol, diesels prices high or low, as in either case, the retail fuel prices will hurt the economy in their own ways. While high fuel prices may earn more revenue for the government, it can also lead to a rise in headline inflation. Similarly, the low fuel prices can keep the inflation under check but it can hit the Centre’s revenue.
Faced with plunging revenues in the initial weeks of the coronavirus pandemic, the central government had used the collapse in global crude oil prices to raise excise duty on fuel. However, rising oil prices are feeding into already-elevated inflation now. Consequently, the government is faced with a new domestic trade-off between fiscal stability and sticky inflation, said a report by Barclays.
It is estimated that a $10 per barrel increase in the price of crude oil implies a Rs 5.8 per litre increase in the retail prices of petrol or diesel. This would add nearly 34 basis points to the headline inflation over three to six months if the government doesn’t cut taxes on petroleum products. However, a cut of Rs 5.8 per litre in petrol and diesel taxes to offset rising crude oil prices would result in a loss of revenue to the tune of Rs 87,200 crore, which is nearly 0.39 per cent of GDP. The Barclays report suggested that this would raise inflation by around 56 basis points, given the current level of inflation and size of the fiscal deficit.
The government could cut fuel taxes by an amount equivalent to the impact of the oil price change, but that may raise the fiscal gap while capping prices, Barclays added. It is further believed that the government’s priorities are firmly in favour of supporting the post-COVID recovery and it would thus be more likely to opt for lower inflation and a higher fiscal deficit in the short term.
Further, while the government may be able to counteract the short term inflationary impact of higher oil prices by cutting excise duties, the impact over the medium term is likely negligible. Hence, the decision is not how to stop inflation, but about when it should be faced.