The promise and peril of regulation, Indian energy version

Rachel! | July 20, 2010

Aside from the new symbol adopted for the rupee, the big economic news in India lately is the national government’s deregulation of petroleum prices. In the face of rising food prices, naturally there are concerns about whether deregulated (read: higher) oil prices will fuel inflation. Is this policy not anti-poor? What will happen if oil prices keep rising? How will the growing economy of India, with its growing energy demand, adjust to a future of oil-price volatility?

The success of Bhart Bandh (All-India Strike) on July 5th shows that the Aaam Admi (common man) did not take this new price deregulation kindly. People like having their energy subsidized, particularly people who are struggling financially. What’s more, administered prices—with their resulting distortion in the use of resources and corresponding economic loss—are not a visible, measurable macroeconomic variable like the inflation or interest rates. So no one cares if the distortion continues doing great harm to the economy for the simple reason that it’s invisible. It’s the old story: the costs are spread widely and hard to perceive, while the benefits are focused and tangible.

But one needs to take a dispassionate view to examine this new policy of energy deregulation and its implications for everyone. What you discover, when you take such a view, is that energy price regulation in India was a mess—one that illustrates the economic and political hazards of such market interventions, however well-intentioned.

A recent study by my colleagues and me at India’s National Institute of Public Finance and Policy found that the petroleum subsidy in our country is highly regressive. As estimated in this study, for the fiscal year 2006-07, while the average per-capita petroleum subsidy for major states was Rs. 450, it was only Rs. 226 for Bihar while as high as Rs. 623 for Maharashtra. In other words, subsidies are benefiting the regions where consumption is higher—and consumption is higher in regions where income is also high. By default, it is the richer regions of the country that benefit more from the petrol subsidy.

Then there is the issue of taxation. There is an urgent need for rationalization of the tax structure on this sector.  What comprises oil prices in India we really do not know, because there are multiple taxes on petroleum which make estimation of pre-tax oil prices a nightmare. Currently, national and state governments  together levy as much as 14 different types of taxes on the petroleum sectors. Take, for example, the imposition of octroi (entry) taxes by Maharashtra, Madhya Pradesh, Uttar Pradesh, Karnataka, Orissa and Bihar on gasoline and diesel fuel. Haryana has a local area development tax on crude oil at 4 percent.

Despite the high taxes on this sector and the fact that oil is an intermediate input, it remains outside the VAT system and thus ineligible for the input tax credit. This results in cascading taxes across sectors—and a big inflationary impact. The remedy here lies not in opposing deregulation, but in reforming the system of petroleum taxes. Before we pronounce deregulation to be inflationary, we really need to figure out how much inflation is due to the market price of oil and how much is due to the heavy taxes on it. One can safely say that, with proper tax reforms, oil price deregulation won’t be as inflationary as it is made out to be.

All of that said, we must also acknowledge that energy isn’t like telecom. Deregulating oil prices has to be thought through with extreme care so that the poor and vulnerable are protected. One cannot deny the fact that, despite leakage and corruption, subsidised kerosene and liquefied petroleum gas benefit the poor (a large section of the population in India), and eventual decontrol of the entire oil sector needs to be calibrated very carefully so that those who genuinely need this subsidy are not hurt. An alternative strategy should be put in place to insulate those who deserve protection from the volatility of oil prices.

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One Response to “The promise and peril of regulation, Indian energy version”

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  1. Comment by Surajit Das — July 21, 2010 at 12:37 am   Reply

    The value of multiplier increases with lower tax rate. True. However, the deficit financed multiplier is higher than the balanced budget multiplier. Moreover, the value of multiplier also comes down with higher savings rate. Would you then argue in favour of consumption-led growth (like Minsky, Bhaduri etc.) in order to reach near full-employment situation?

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