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Petrol, diesel prices reduced by Rs 2.50: Duty rates have been cut on fuel, but how long can this be sustained?

The decision to cut the excise duty on petrol and diesel came as a surprise as the view taken so far was that the government would not relent on its revenue collections. In fact, the Centre has been asking states to lower their duty rates to bring down prices. The logic was compelling. The Centre charges a fixed duty rate which is impervious to the price of crude oil and exchange rate. In the case of states, it is an ad valorem tax which automatically earns more revenue when either the crude oil price goes up or the rupee falls. On an average basis, states have a VAT of 29 percent which does not change with the price of fuel.

For clarity,  the price build-up of petroleum in Delhi on 1  October can be used as an example here.

 Petrol, diesel prices reduced by Rs 2.50: Duty rates have been cut on fuel, but how long can this be sustained?

It can be seen that the Centre imposes a tax of 45 percent while the states charge 27 percent on a litre of petrol. The retail prices have changed continuously with crude crossing the $85/barrel mark. In case of any increase in the price of crude or the rupee falling further, the 27 percent rate which is imposed in Delhi would yield higher revenue automatically to the state. As all budgets were drawn upon the assumption of crude oil being in the range of $65-70/barrel, the increase in the price of $15-20/barrel would have automatically yielded higher revenue for the states while the Centre would not get more than Rs 19.48 per litre.

Based on this logic, the Centre has taken a positive step to lower the duty by Rs 2.50 which will bring down the price by this amount. The government would take a hit of Rs 1.50 on its revenue while the OMCs would take absorb the balance Re 1. The suggestion to states is to reduce their VAT by an equal amount, which will not really affect their revenue which has gained sharply this year on account of a weak rupee and high price of crude. The government has stated that the Centre will lose Rs 10,500 cr of revenue which is just 0.05 percent of GDP and hence the fiscal deficit will not be affected. For the states, there would only be moderation in their surplus revenue growth.

What about the inflation impact? These two products have a combined weight of around 4.6 percent in the WPI and hence assuming states also reduce their duty rates, the overall price must come down by 5-5.5 percent depending on the region which in turn should reduce inflation by around 0.25 percent. This is not significant and may get enmeshed in the significantly higher price of crude oil and weaker rupee.

The efficacy of this move will depend on how much further will these twin problems go. It is felt that crude oil should revert to the region of 75-80 once the Iran sanctions effect is fully known. But, what in case it continues to climb northwards? In that case, this reduction in prices may not really help and will only partly counter the increase in prices.

The second part is the rupee. Will the rupee go down further towards the 75-mark, or will it mean-revert? Here too, while it is felt that it should normalise, the timing is still unknown. Under these conditions, it does seem that the present move of lowering duties on petrol products will have only a short-term effect.

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This is a gamble which the government has taken because if prices move up further, it would not be possible to sustain these reductions as both the Centre and states are walking the tight fiscal rope. Therefore, this move can be seen as the first and last intervention where the assumption is that things would normalise. It must be remembered that higher crude oil price and weaker rupee has already pushed up the subsidy on fuel – LPG and kerosene (the amount is not known as yet) and hence further taking a cut on revenue would get challenging.

The government, however, must have a contingency plan in place to counter the question – what if crude crosses $100/barrel and the rupee goes beyond $ 75/$? No intervention will definitely push up inflation and come in the way of growth. Farm product prices are bound to increase due to the higher MSPs and the non-food non-fuel prices, i.e. core inflation is above 5 percent. With the other two components increasing, there will be greater challenges posed to policy-making. Having a contingency plan would be advisable. Maybe a blend of further tax cuts and reintroduction of subsidy can be thought of as rationing is not a feasible solution in the current context.

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Updated Date: Oct 04, 2018 22:52:40 IST