Pulled by economic compulsions but held back by political considerations, the central government has recently taken the much-awaited half-step towards de-administering diesel by allowing public sector oil marketing companies to partially increase prices for retail consumers and charge full market-determined prices from bulk consumers like the railways. The immediate gain to the government is reduction in the fiscal deficit through lower subsidies , but there are significant issues regarding inflation and long-term growth strategies.
Fiscal Policies and Petroleum Products
In handling petroleum products that include petrol and diesel, the central government uses all three instruments available to it – namely taxes, subsidies, and administered prices – and still does not get it right as most of these instruments work at crosspurposes.
Tax revenue is undone by the subsidies; the incidence of fiscal intervention becomes difficult to determine; and there is long-term damage to growth due to resource misallocation for satisfying perceived short-term considerations.
Through a differentiated treatment of diesel and petrol, the government has created, unlike in many other countries, an unnecessary and large artificial wedge in their prices. This has resulted in relatively high demand for diesel. The share of highspeed diesel in the total consumption of petroleum, oil, and lubricants products has increased from about 32 per cent to 38 per cent and that of petrol from nearly seven to nine per cent between 2003 and 2011.
If you compare international prices of diesel and unleaded petrol, the typical pattern is that in most oil producing countries such as Iran, Saudi Arabia, Russia and the US, prices of petroleum products are relatively lower than that in countries which depend largely on imported petroleum. Also, in many countries the difference in petrol and diesel prices is minimal. Sometimes it is diesel that is priced higher, as in the UK where a litre of petrol costs $2.16 while the corresponding cost for diesel is $2.27.
In the US, Israel and Norway as well, diesel costs more than petrol. In Sweden, the price of a litre of diesel and that of unleaded petrol is exactly the same.
Diesel and Electricity Shortages
Underpricing of any product leads to excess demand, lower investment, and lower supply. Linked to diesel in many ways is electricity, which has also historically been subjected to administered or regulated underpricing. The result has been inadequate investment in the sector, and low, poor quality and unreliable supply. To overcome these, many people have invested in diesel generators, taking advantage of the lower diesel prices.
The same reason has persuaded farmers to use diesel gensets for irrigation. Diesel cars are preferred by the rich in comparison with petrol cars. One step towards market-determined diesel prices may lead to only a limited substitution of diesel-based products with other fuels. But when the entire gap is made up, there could be a significant impact.
There is no doubt that prices of fuel and energy group would go up as diesel prices are lifted to market-determined levels. There would also be an impact on prices of manufactured articles and food products through the impact on transport costs. However, there are signs that wholesale price index-based inflation of manufactured articles is coming down. It may be possible to absorb the incremental effect of the diesel price hike without reversing the downward trend in inflation that has become visible only recently.
Road to Full Reforms
The path to reforms has often witnessed reversals. In 1997, the Ministry of Finance had brought out a white paper on subsidies. Around that time, the oil pool accounts were abolished and the administered price mechanism for petroleum products was dismantled. But administered pricing was reintroduced prior to the 2004 general elections. From 2003 to 2012, we saw a massive upsurge in international crude oil prices, resulting in a significant increase in government oil subsidies. The rising international prices delayed the return to a market-determined pricing regime. The right time to de-administer oil prices is when international crude oil prices are softening. Given the recessionary world economic situation, there may be such a window over the next one to two years. This may be the right time to genuinely deadminister the entire sector.
It would be ideal to limit petroleum subsidies only to targeted users of kerosene. With an increase in petroleum tax revenue net of subsidies, tax rates on other goods and services can be reduced. This would facilitate the introduction of a goods and services tax at a low standard rate for goods and services other than the group of demerit and polluting goods that includes petrol and diesel.