Expedite oil price reform
Replace pricing based on trade parity with a cost-plus formula
The pressure on the Union government to reduce the retail prices of petrol and diesel is understandable. The price of the Indian basket of crude oil has gone up to $55 a barrel, almost 96 per cent higher than $28 a barrel in January 2016. The retail prices of petrol and diesel, which have been linked to the markets, have also been rising, though by smaller margins of 18 per cent and 33 per cent, respectively, in the same period. That, however, is no cause for comfort as what consumers are fretting about is that the price of the Indian basket of crude oil ruled at $107 a barrel in May 2014 and is today almost half of that level. So why have retail prices already breached levels that prevailed in May 2014?
Such a question has arisen because of the Union government’s tax initiatives, which between May 2014 and January 2016 saw the central excise duty go up by 127 per cent on petrol and by 387 per cent on diesel. Most state governments took some time to see this fiscal opportunity but later latched on to it by raising sales tax and value-added tax rates on these products. In 2016-17, the Centre’s excise revenue from petroleum products increased by 35 per cent on top of a higher increase of 80 per cent in the previous year. The states’ tax revenue from the same sector increased by 16 per cent last year compared to a modest rise of 4 per cent in 2015-16.
The fiscal move was unexceptionable, justified as it was by the need to tax a scarce imported resource, raise revenues to bridge fiscal deficits and reduce the Centre’s oil subsidy bill. The need for shoring up the finances of the Centre as well as the states is even greater today with rising shortfalls in revenues, increasing expenditure on account of higher government wages and higher demand for capital outlays in order to revive growth. Cutting tax rates on petrol and diesel, therefore, might help reduce their prices for the present, but the damage and risks to public finances will be significant and, therefore, should be avoided. For the same reasons, the inclusion of petrol and diesel in the goods and services tax should be sequenced in a manner that the effects of a consequent reduction in tax rates on revenues can be absorbed gradually.
What the government can, instead, do is to move ahead on petroleum product pricing reforms. Linking the retail prices of petrol and diesel to the markets and making them dynamic, subject to change on a daily basis, have been the right steps. But to introduce greater cost efficiency and increased competition among the oil companies, it is now necessary to move away from the pricing formula based on trade parity and embrace a cost-plus pricing system. The formula based on trade parity fixes the landed cost of petrol and diesel at a level that is slightly higher because of the inclusion of customs duty in it. The logic of an 80 per cent weight in favour of imports in the formula is questionable with negligible imports of petrol and diesel taking place at present. It also discourages oil refining companies from achieving greater operational efficiency since their cost of petrol or diesel is pre-determined by a formula irrespective of their actual refining costs. A cost-plus pricing formula will also introduce transparency and help reflect a more reasonable and correct picture of the oil companies’ under-recoveries, which, in turn, could help reduce the government’s subsidy bill and even reduce retail fuel prices.