Making oil prices less taxing: Under the prevailing policy, it is the oil price that fluctuates

Published: December 4, 2018 1:12 AM

Under the prevailing policy, it is the oil price that fluctuates; the tax revenues from oil are stable for the government. Under the proposed policy, it is the tax revenues on oil that can fluctuate; the oil price can rise gradually at a steady rate.

If the tax on oil is reduced drastically, there is a need for alternative sources of tax revenues.

By Gurbachan Singh

The price of oil has fallen somewhat in the recent weeks in India, but that fall—relatively small and possibly temporary—is from a very high level. So, the topic of high price of oil very much remains. There are two issues related to oil in India.

First, a huge tax continues to be imposed on oil (by some accounts, almost half of the price is tax). This adversely affects economic activity, and welfare more generally.
Second, given the huge and somewhat fixed tax, as the international price of oil varies, the domestic price of oil fluctuates around the high average price. These fluctuations have implications for macroeconomic stability. There is, as we know, considerable adverse effect on current account deficit, exchange rate, inflation rate, interest rates, and nominal and real returns on not only risky assets, but also, what are supposed to be, fixed return assets. This matters; this is particularly true for the less affluent and for the less sophisticated savers. So, there are egalitarian considerations as well.

Is it possible to do something about these two aspects of the oil story?
Let us first consider the issue of tax revenues.
If the tax on oil is reduced drastically, there is a need for alternative sources of tax revenues. These may not seem to be in sight, but it is important here to consider the broader perspective and go a little beyond the economics of oil per se.
There is considerable tax evasion and wasteful expenditure in India. The need to reduce both these can hardly be overemphasised. It is worthwhile repeating this yet again even if it is a very familiar story. But there are some other aspects that are not even very familiar. These are the stories of tax exemptions, which lead to low tax revenues. There is a need to remove such exemptions (for example, the government of India could abolish the tax exemption under the equity-linked savings scheme, or ELSS, which is no longer needed now that equity markets have become quite popular).

One can think of various ways of raising taxes so that the huge tax on oil can be realistically avoided. This tax need not be reduced to zero, but it can certainly be reduced to a more reasonable level. Also, the tax rate need not be constant over time; it can be high in some periods and low in others. In fact, this brings us to the second issue of dealing with fluctuations in the price of oil.

The accompanying graphic shows the real price of oil in the international market over more than 70 years till very recently. Three observations follow from this figure. First, there have been a few big oil shocks, like the ones in 1973-74 and 1979-80. Second, there have been considerable fluctuations in the price of oil. This, rather than standalone large oil price shocks, is more the story of recent times. Third, there is a small long-term trend in the real price of oil over the time-period covered; the rate of average appreciation is about 1.5%.

How can these observations help?
The government of India (along with state governments) can consider implementing a somewhat stable path for real oil price over time such that it rises at the rate of about 1.5% per annum in India. To implement this, the government needs to impose tax at a rate that is above a predetermined average rate, if the international price of oil is below the long-term trend value. This will have the effect that the domestic price at any time gets close to the long-term trend value of oil at that time. On the other hand, if the international price of oil is above the trend value, the government needs to reduce the tax rate to a below the average tax rate. The further away the actual international market price of oil from the trend value, the greater the deviation from the average tax rate.

All this is about the real price of oil. What about the nominal price (which incorporates general inflation as well)? After all, in the marketplace, it is the nominal price that matters. As we know, the Reserve Bank of India (RBI) targets 4% inflation rate. Given that the long-term rate of appreciation in the real domestic price of oil is 1.5%, it follows that the nominal price needs to increase at about 5.5% per annum. This works out to be about 0.4% rise in the price of oil per month—regardless of the international oil price movements. It is true that even a steady 0.4% rise per month in oil price can hurt, but at least it is not uncertain and disruptive.

The proposed plan has a precedent. In 2013, the government of India had decided on raising the price of diesel by 50 paise per month so that the then prevailing subsidy on diesel could be reduced substantially, or even eliminated. That plan worked very well. Although the purpose then was different and it applied to diesel only and for a relatively short duration, a similar plan can be used now more generally, for a different purpose and on a long-term basis.
Under the prevailing policy, it is the oil price that fluctuates; the tax revenues from oil are stable for the government. Under the proposed policy, it is the tax revenues on oil that can fluctuate; the oil price can rise gradually at a steady rate.

Although the tax revenues from oil are high, these are nevertheless a small fraction of the total revenues of the government—more so if the government, as is suggested here, reduces the average tax rate on oil. So, the fluctuations in government revenues will not matter much.
For this exercise, I have considered the real price of oil in the international market and the long-term inflation in India. The simple methodology in this exercise for the long-term obviates the need to consider exchange rate considerations separately.

The figure of 0.4% rise in oil price per month in the analysis is illustrative. The actual figure may be debated. Also, it can be varied to some extent as and when there are reasons to believe that the long-term trend rate in international price of oil has changed. This, obviously, is not a perfect plan. In any case, as the Prussian general Carl von Clausewitz famously said, “…the greatest enemy of a good plan is the dream of a perfect plan.”

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