Themes > Current Issues
08.07.2008
Engineering Stagflation
C.P. Chandrasekhar
The
Indian economy has been at tipping point for some time now, poised to
enter a period characterised by slow growth and high inflation. The decision
of the government to hike the prices of petrol, diesel and LPG could well
be the final push. In the government’s view the hike was inevitable, given
the sharp increase in the international prices of crude and India’s dependence
on imports to meet much of its consumption. If the hike came only when
it did it was only because electoral compulsions and the opposition had
forced the government to hold back for long.
The government has argued that since “under-recovery” by the oil marketing companies (OMCs)—or the shortfall in the price at which certain petroleum products were being sold relative to their costs of acquiring and distributing those products—was leading to huge losses, the government had no option. It could for a time compensate the oil companies with tradable oil bonds on which interest was paid by the government. But that merely postponed the problem and increased its dimensions. A price hike was inevitable.
By opting to hike petrol and diesel prices by more than 10 per cent and those of LPG by more than 15 per cent the government has transferred a significant share of the burden of increased international oil prices onto the domestic consumer. This could not have occurred at a worse time. Inflation is already running at more than 8 per cent. Since oil is a universal input that directly and indirectly enters into the cost of production of almost every other commodity, the increases announced would have effects that are likely to take inflation to double digit levels.
In different circumstances, the government may have chosen to sharply reduce its own expenditures to cool the system and dampen inflation. It could have argued that, even though this would reduce the rate of growth of the economy, with GDP growth running at 9 per cent a year, such a reduction is an acceptable trade-off to keep prices in check. But reduced government expenditure would trigger a recession, increase unemployment and curtail allocations to crucial social sectors, worsening poverty and deprivation. That would unfairly affect the poor extremely adversely. Given that this is an election year, the government’s expenditures are likely to rise rather than fall, which is one cause for comfort. But this also means that although growth may not collapse, inflation may soar even further.
Obviously, the government cannot avoid responding to the huge rise in international oil prices, which has been generated by a combination of conflict-induced supply shortfalls, rising demand and rampant speculation. The question is whether a sharp hike in retail prices is the best response. Since the weighted average price of the basket of crudes imported by India has risen to above $130 a barrel, as compared with $30 plus-a-barrel four years back and $60 plus-a-barrel just two years ago, some action was inevitable. Inaction meant that the burden of the divergence between changes in the higher international price of oil and in the domestic prices of oil products would fall solely on the three oil marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited). But action need not mean just a price hike.
The under-recoveries or losses suffered by the oil companies are computed by assuming that these companies access the petrol, diesel, LPG and kerosene they market at prices that reflect international crude prices, international conversion costs and margins in the refineries and current international transport costs. But it is only when oil is actually imported, processed domestically and then marketed to the oil marketing companies at a cost plus price defined by international standards that the latter suffer such losses. To the extent that crude is not imported, the losses are only notional. In 2006-07, India’s consumption of crude oil was around 147 million tonnes, of which 34 million tonnes (or just short of a quarter of crude consumption) was being produced domestically. If it is assumed that domestically produced crude and products derived from domestically produced crude are being supplied to the oil marketing companies at “international prices” then two other implications follow. First, it is being assumed that the oil producers are making huge “super-profits” because of the global rise in crude oil prices and the refineries are earning margins comparable with international producers, which would make them extremely profitable too. If the upstream oil companies and the refineries are made to share the burden of adjusting to the current oil shock, then the price at which products would be available to the oil marketing companies would be lower than assumed, which indeed is the case.
Second, , projections of under-recoveries and losses are based on the assumption that the level of consumption remains more or less what it would have been prior to the price increase. Aside from the fact that the price increase itself could reduce demand (even if only marginally), what this ignores is the policy alternative of directly curbing consumption. As is argued by Prabhat Patnaik in an accompanying article in this issue, the most reasonable policy option in the face of the steep increase in oil prices is a curb on aggregate consumption and the use of rationing to allocate the targeted volume. That would obviously reduce imports and the notional losses of the oil marketing companies.
The government, given its predilections, has chosen to ignore this policy option, resulting in under-recoveries that are estimated to rise to as much as Rs, 2,50,000 crore in 2008-09, as compared with Rs.77,000 crore last year . Even if the actual figure was lower (say, Rs.2,00,000 crore as claimed by some), it is true that if the OMCs were not compensated in some way, their viability would be at stake.
But posing the problem in this way obfuscates the real issue, which is the need to curb consumption. As a result, the discussion gets diverted to assessing how the government should share the burden imposed by the increase in international prices. There were at least six other alternatives available to the government in terms of adjusting to the oil price shock. These alternatives were : (i) raising retail prices; (ii) reducing customs and excise duties even with unchanged retail prices, so to transfer the benefits of the duty reduction to the oil marketing companies; (iii) generating revenues by taxing the super profits of the oil companies that are involved in the production and export of crude at the current high prices, so as to compensate the marketing companies; (iv) generating resources through additional taxes on or lower tax concessions for India’s super-rich individuals and the corporate sector, so as to pay for subsidies that protect the ordinary consumer against the effects of the global oil price shock; (v) borrowing money through the issue of oil bonds to compensate the oil marketing companies for their losses; and (vi) getting the state government to reduce sales taxes so as to partly neutralise the impact of increases in prices charged by the oil companies to retailers. These different alternatives reflect varying answers to the basic question of how the burden of financing the additional cost of import was to be shared.
The central government claims that it is relying on a combination of some of these measures (price increases, duty reductions and oil bonds) to reduce the burden imposed on the consumer. Many state governments have pitched in with sales tax reductions that have compensated the consumer at the expense of their already limited revenues. The difficulty is that, despite these claims and efforts, the price hike finally resorted to is by no means “moderate” and its effects come when the ordinary citizen is already shouldering the burden of rising inflation. What would have been more sensible and fair was to opt for a combination of the other means of adjusting to the oil shocks, so as to keep prices constant.
The government did reduce duties on petroleum products, but only by a small amount. While the 5 per cent customs duty on crude oil has been scrapped, the customs duty on petrol and diesel has been reduced from 7.5 per cent to 2.5 per cent and the customs duty on other petroleum products from 10 per cent to 5 per cent. But the heaviest taxes on petrol and diesel, namely the excise duties of Rs.14.45 per litre on petrol and Rs. 4.60 per litre on diesel have been reduced by just Re. 1 per litre in both cases.
The use of petrol and diesel as sources of tax revenue has meant that the retail prices of these products include a substantial duty component. Prior to the recent duty adjustment and price hike the tax component in the retail selling price of petrol and diesel was placed at 53 and 34 per cent respectively. As a result in 2006-07, out of the proceeds from sales of petroleum products at the retail level, as much as Rs.10,043 crore accrued to the government as revenues from customs duty and another Rs.58,821 crore as revenue from excise duty.
After the changes, in the retail price of Rs. 50.52 per litre, the actual price (Rs. 27.96) still accounted for just 55.3 per cent of the price paid, the excise duty (Rs. 13.45) for 26.6 per cent and state level sales taxes, dealers’ commission and delivery charges for the balance 18.1 per cent . State level sales taxes accounted for the bulk of the last, and were reduced to neutralise part of the price increase. (The relevant proportions in the case of diesel (price Rs. 34.76) were 77.5, 10.4 and 12.1 per cent respectively.)
It hardly bears stating that if the government had chosen to forego its oil revenues completely, but the retail price had been kept at its earlier tax-inclusive level, the losses of the oil marketing companies would have been much less. These losses could have been substantially compensated for with direct payments financed by additional taxes and a dose of borrowing in the context of an emergency.
What is more, there could have been a far greater share of the burden that could have been borne by the oil companies. The President of the Centre of Indian Trade Unions and CPI(M) Central Committee Member, M.K. Pandhe had written to the Prime Minister advancing the following argument: "With crude oil prices now exceeding $100/bbl, it is necessary that windfall gains be recovered from private oil and gas producing companies like M/s Cairns, Reliance etc who are contractors extracting oil and gas in India through Production Sharing Contracts (PSC). When these contractors participated in the famed NELP policy, none of them could have envisaged crude oil prices beyond $30/ bbl. It would be a failure on the government's part to allow such upstream contractors additional gains of $70/bbl - $80/ bbl in the name of import parity without any link with actual production cost. " In support of his case that these windfall profits should be taxed and the proceeds used to compensate the oil marketing companies directly, he quotes the view of Senator Patrick J Leahy, chairman of the US Senate Committee on Judiciary who reportedly argued: “Of course, the bottom line is very simple: People we represent are hurting. Your companies, the foreign oil interests, are profiting. And we need to get this somehow into balance. We look at the past profits of oil companies and what they're making on previously discovered oil; oil that was very profitable for them at $55 to $65 a barrel is obviously making them windfall profits at $130 a barrel."
But that is not all. Many of the refineries in India are charging conversion costs that are far in excess of what is warranted by economic costs based on best-practice technologies. Normative costing would help to reduce prices as well as force these companies to reduce costs and accept reasonable returns.
The government can afford to lose more of the revenues it obtains in the form of taxes on oil. Further, the losses of OMCs could have been compensated with additional taxes on and reduced tax concessions to those companies, businesses and individuals who have benefited hugely from the high growth of recent years. The argument of the opposition too is that this could have easily been done and they have accordingly offered many suggestions. They are indeed right. If the government chose to ignore their suggestions, it must be because it believes that taxing the rich to pay for protecting the poor and middle classes from the effects of an unprecedented oil shock is not acceptable. What also seems to have been ignored is that this biased belief could cost this government a victory in the next election.
The government has argued that since “under-recovery” by the oil marketing companies (OMCs)—or the shortfall in the price at which certain petroleum products were being sold relative to their costs of acquiring and distributing those products—was leading to huge losses, the government had no option. It could for a time compensate the oil companies with tradable oil bonds on which interest was paid by the government. But that merely postponed the problem and increased its dimensions. A price hike was inevitable.
By opting to hike petrol and diesel prices by more than 10 per cent and those of LPG by more than 15 per cent the government has transferred a significant share of the burden of increased international oil prices onto the domestic consumer. This could not have occurred at a worse time. Inflation is already running at more than 8 per cent. Since oil is a universal input that directly and indirectly enters into the cost of production of almost every other commodity, the increases announced would have effects that are likely to take inflation to double digit levels.
In different circumstances, the government may have chosen to sharply reduce its own expenditures to cool the system and dampen inflation. It could have argued that, even though this would reduce the rate of growth of the economy, with GDP growth running at 9 per cent a year, such a reduction is an acceptable trade-off to keep prices in check. But reduced government expenditure would trigger a recession, increase unemployment and curtail allocations to crucial social sectors, worsening poverty and deprivation. That would unfairly affect the poor extremely adversely. Given that this is an election year, the government’s expenditures are likely to rise rather than fall, which is one cause for comfort. But this also means that although growth may not collapse, inflation may soar even further.
Obviously, the government cannot avoid responding to the huge rise in international oil prices, which has been generated by a combination of conflict-induced supply shortfalls, rising demand and rampant speculation. The question is whether a sharp hike in retail prices is the best response. Since the weighted average price of the basket of crudes imported by India has risen to above $130 a barrel, as compared with $30 plus-a-barrel four years back and $60 plus-a-barrel just two years ago, some action was inevitable. Inaction meant that the burden of the divergence between changes in the higher international price of oil and in the domestic prices of oil products would fall solely on the three oil marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited). But action need not mean just a price hike.
The under-recoveries or losses suffered by the oil companies are computed by assuming that these companies access the petrol, diesel, LPG and kerosene they market at prices that reflect international crude prices, international conversion costs and margins in the refineries and current international transport costs. But it is only when oil is actually imported, processed domestically and then marketed to the oil marketing companies at a cost plus price defined by international standards that the latter suffer such losses. To the extent that crude is not imported, the losses are only notional. In 2006-07, India’s consumption of crude oil was around 147 million tonnes, of which 34 million tonnes (or just short of a quarter of crude consumption) was being produced domestically. If it is assumed that domestically produced crude and products derived from domestically produced crude are being supplied to the oil marketing companies at “international prices” then two other implications follow. First, it is being assumed that the oil producers are making huge “super-profits” because of the global rise in crude oil prices and the refineries are earning margins comparable with international producers, which would make them extremely profitable too. If the upstream oil companies and the refineries are made to share the burden of adjusting to the current oil shock, then the price at which products would be available to the oil marketing companies would be lower than assumed, which indeed is the case.
Second, , projections of under-recoveries and losses are based on the assumption that the level of consumption remains more or less what it would have been prior to the price increase. Aside from the fact that the price increase itself could reduce demand (even if only marginally), what this ignores is the policy alternative of directly curbing consumption. As is argued by Prabhat Patnaik in an accompanying article in this issue, the most reasonable policy option in the face of the steep increase in oil prices is a curb on aggregate consumption and the use of rationing to allocate the targeted volume. That would obviously reduce imports and the notional losses of the oil marketing companies.
The government, given its predilections, has chosen to ignore this policy option, resulting in under-recoveries that are estimated to rise to as much as Rs, 2,50,000 crore in 2008-09, as compared with Rs.77,000 crore last year . Even if the actual figure was lower (say, Rs.2,00,000 crore as claimed by some), it is true that if the OMCs were not compensated in some way, their viability would be at stake.
But posing the problem in this way obfuscates the real issue, which is the need to curb consumption. As a result, the discussion gets diverted to assessing how the government should share the burden imposed by the increase in international prices. There were at least six other alternatives available to the government in terms of adjusting to the oil price shock. These alternatives were : (i) raising retail prices; (ii) reducing customs and excise duties even with unchanged retail prices, so to transfer the benefits of the duty reduction to the oil marketing companies; (iii) generating revenues by taxing the super profits of the oil companies that are involved in the production and export of crude at the current high prices, so as to compensate the marketing companies; (iv) generating resources through additional taxes on or lower tax concessions for India’s super-rich individuals and the corporate sector, so as to pay for subsidies that protect the ordinary consumer against the effects of the global oil price shock; (v) borrowing money through the issue of oil bonds to compensate the oil marketing companies for their losses; and (vi) getting the state government to reduce sales taxes so as to partly neutralise the impact of increases in prices charged by the oil companies to retailers. These different alternatives reflect varying answers to the basic question of how the burden of financing the additional cost of import was to be shared.
The central government claims that it is relying on a combination of some of these measures (price increases, duty reductions and oil bonds) to reduce the burden imposed on the consumer. Many state governments have pitched in with sales tax reductions that have compensated the consumer at the expense of their already limited revenues. The difficulty is that, despite these claims and efforts, the price hike finally resorted to is by no means “moderate” and its effects come when the ordinary citizen is already shouldering the burden of rising inflation. What would have been more sensible and fair was to opt for a combination of the other means of adjusting to the oil shocks, so as to keep prices constant.
The government did reduce duties on petroleum products, but only by a small amount. While the 5 per cent customs duty on crude oil has been scrapped, the customs duty on petrol and diesel has been reduced from 7.5 per cent to 2.5 per cent and the customs duty on other petroleum products from 10 per cent to 5 per cent. But the heaviest taxes on petrol and diesel, namely the excise duties of Rs.14.45 per litre on petrol and Rs. 4.60 per litre on diesel have been reduced by just Re. 1 per litre in both cases.
The use of petrol and diesel as sources of tax revenue has meant that the retail prices of these products include a substantial duty component. Prior to the recent duty adjustment and price hike the tax component in the retail selling price of petrol and diesel was placed at 53 and 34 per cent respectively. As a result in 2006-07, out of the proceeds from sales of petroleum products at the retail level, as much as Rs.10,043 crore accrued to the government as revenues from customs duty and another Rs.58,821 crore as revenue from excise duty.
After the changes, in the retail price of Rs. 50.52 per litre, the actual price (Rs. 27.96) still accounted for just 55.3 per cent of the price paid, the excise duty (Rs. 13.45) for 26.6 per cent and state level sales taxes, dealers’ commission and delivery charges for the balance 18.1 per cent . State level sales taxes accounted for the bulk of the last, and were reduced to neutralise part of the price increase. (The relevant proportions in the case of diesel (price Rs. 34.76) were 77.5, 10.4 and 12.1 per cent respectively.)
It hardly bears stating that if the government had chosen to forego its oil revenues completely, but the retail price had been kept at its earlier tax-inclusive level, the losses of the oil marketing companies would have been much less. These losses could have been substantially compensated for with direct payments financed by additional taxes and a dose of borrowing in the context of an emergency.
What is more, there could have been a far greater share of the burden that could have been borne by the oil companies. The President of the Centre of Indian Trade Unions and CPI(M) Central Committee Member, M.K. Pandhe had written to the Prime Minister advancing the following argument: "With crude oil prices now exceeding $100/bbl, it is necessary that windfall gains be recovered from private oil and gas producing companies like M/s Cairns, Reliance etc who are contractors extracting oil and gas in India through Production Sharing Contracts (PSC). When these contractors participated in the famed NELP policy, none of them could have envisaged crude oil prices beyond $30/ bbl. It would be a failure on the government's part to allow such upstream contractors additional gains of $70/bbl - $80/ bbl in the name of import parity without any link with actual production cost. " In support of his case that these windfall profits should be taxed and the proceeds used to compensate the oil marketing companies directly, he quotes the view of Senator Patrick J Leahy, chairman of the US Senate Committee on Judiciary who reportedly argued: “Of course, the bottom line is very simple: People we represent are hurting. Your companies, the foreign oil interests, are profiting. And we need to get this somehow into balance. We look at the past profits of oil companies and what they're making on previously discovered oil; oil that was very profitable for them at $55 to $65 a barrel is obviously making them windfall profits at $130 a barrel."
But that is not all. Many of the refineries in India are charging conversion costs that are far in excess of what is warranted by economic costs based on best-practice technologies. Normative costing would help to reduce prices as well as force these companies to reduce costs and accept reasonable returns.
The government can afford to lose more of the revenues it obtains in the form of taxes on oil. Further, the losses of OMCs could have been compensated with additional taxes on and reduced tax concessions to those companies, businesses and individuals who have benefited hugely from the high growth of recent years. The argument of the opposition too is that this could have easily been done and they have accordingly offered many suggestions. They are indeed right. If the government chose to ignore their suggestions, it must be because it believes that taxing the rich to pay for protecting the poor and middle classes from the effects of an unprecedented oil shock is not acceptable. What also seems to have been ignored is that this biased belief could cost this government a victory in the next election.
© MACROSCAN 2008