India's fuel taxation dilemma - why the federal government will have to take the hit if fuel prices have to come down

The rising fuel prices aid inflation, jack up subsidy bill and make it difficult for the government to meet mandated fiscal targets. They stress households’ budget directly through increased prices of diesel, petrol and cooking gas, and indirectly through the rise in freight charges that feed into higher prices of most consumable products and services. Higher fuel prices also impact the operating margins of businesses and in turn, government tax revenue. That caps government’s ability to spend on its key social and infrastructural projects.

The upcoming state and national elections have added to the complications. The opposition parties have started blaming the ruling party for inefficient management. The fuel consumers, on the other hand, are outraged and clamouring for lower prices if needed through a reduction in taxes. In the last few days, international crude prices have corrected a bit due to announcement by Russia and Saudi Arabia to increase production by 1.5 million barrel/day. However, supply continues to be constrained in Libya and Venezuela...so the price correction may be a temporary relief at best.

Given India’s heavy dependence on import, the fuel prices are rising due to i) increase in international prices of crude oil, ii) weakening of rupee against US dollar, and iii) high domestic taxes.

India can’t really do anything about the rising international prices of crude oil. To make matters worse, 80% of its requirements are met through imports. The policymakers have limited control over how the rupee behaves vis-à-vis US dollar in a largely market-determined exchange rate regime when the trade deficit is rising, foreign investment inflows are slowing and hawkish US Fed is hell-bent on hiking interest rates. Thus, the only thing India can do to rein in surging fuel prices is to reduce taxes and one of the suggested ways to do that is to bring petroleum products under GST. That will also enable businesses to reduce their effective tax liabilities through input tax credit and that will help contain producer price inflation.

However, given the precarious condition of their financials, both the Centre and states are advising each other to play ball on this. Though, not much action has happened so far except Kerala which has reduced sales tax by a meagre 1 rupee per litre.

Many newspaper editorials have been arguing that Centre imposes a fixed excise duty of INR 19.48/litre on petrol and 15.33/litre on diesel, while states impose ad valorem duties on the pre-tax fuel price plus central excise. Since the Centre’s duties are specific while those of the states' ad valorem, it’s the states which will have to walk the talk on reducing fuel taxes. Such arguments have several flaws:

First, states lose more of their sales tax revenue if international crude oil prices correct. Centre’s excise tax collection, however, is largely immune from global price volatility.

Second, the sales tax or VAT on petrol wildly varies across states. For instance, it’s around 40% in Maharashtra but a meagre 6% in Andaman and Nicobar islands. The sales tax on diesel varies between 6% and 30%. Thus, the GST inclusion will mean same tax rates and prices of fuels throughout the country. That, in turn, would mean raising taxes in some states while pruning them down in others. If that really happens, the states with lower sales tax rates at present, will witness a sharper increase in fuel prices, and accepting that will be ‘political suicide’ for the parties in power especially in the run-up to major state elections this year and the general election next year.

Third, if diesel and petrol are included under GST, the Revenue Neutral Rate (RNR) could be as high as 100% including the dealers' commission of INR 3.63/litre. So, either the GST will have to be raised to that level which will defeat the whole purpose of the exercise. Otherwise, both the Centre and the states will lose substantial tax revenue at a time when their finances are already stressed by the burden of loan waivers and pay hikes.

Fourth, post-GST the states have almost surrendered their taxation power except those with respect to alcohol and fuel which is now their fallback option to meet any shortfalls in revenue. They will naturally be opposed to the proposal when most of the states are struggling with containing revenue deficit. Some background is needed here.

Indian constitution provides the bulk of taxation power to the centre, but the responsibility to provide most of the basic public goods such as drinking water and sanitation, municipal roads and schools among others have been left to the states. Yet, two-thirds of the pre-devolution tax revenue has been going to the Centre and states get only one-third. That explains why most Indian states run perpetual revenue deficits. The 14th Finance Commission tried to address this anomaly by increasing the states’ share in the central tax pool to 42%.

However, the 15th Finance Commission has been asked by the Centre to consider reducing states’ share in Central taxes and do away with the provision of revenue deficit grants – relied upon by the states to meet any expenditure-revenue gap. That is not all, though.

As shown above, India's Central or Federal government is now increasingly relying on cess and surcharges that it doesn’t share with the states. In 2014-15, 40% (INR 400 billion out of 992 billion) of the Centre’s fuel revenue came from cess and surcharges. That ratio has now jumped to 65%. Thus, in the current financial year, INR 1490 billion out of 2300 billion of the Centre’s fuel tax revenue is budgeted to come from cess including the restructured road and infrastructure cess that it won’t be sharing with states. That makes it harder for the states to reduce fuel sales taxes. Obviously, states will resist any further attempt to limit their taxation power.

One would argue that won’t the collection from the GST be shared with states – then how are the states going to lose if fuel (or alcohol for that matter) is brought under GST. Bringing GST doesn’t necessarily mean states will lose tax revenue at least in the long run and depending upon the tax rates, but it certainly means less flexibility for states to increase sales tax on fuels if they really need.

To cut the long story short, it's the Centre which will have to take the hit if we really want to bring down fuel prices even though it’s the states which benefit more from surging crude oil prices.

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This article is first published by The Financial Express here