Let's make diesel price hike palatable

The recent hike in diesel prices and cap on the number of subsidised lpg connections for each household has led to much political and public dissatisfaction. But the rising burden of subsidies, the resultant fiscal deficit and the impact of oil subsidies on the petroleum sector are a cause of concern. In order to have an objective understanding of this complex issue and possibly look towards a more palatable solution in the Indian context, it is important to carry out a careful examination of the pricing mechanism of diesel and the implications that a price rise will have on economic parameters.

Diesel prices are determined using a trade parity formula that is a weighted average of import and export parity prices in the ratio of 80:20. Import parity refers to the price that would be paid for the commodity if it was imported, that is, the cost of freight, insurance and customs duty are added to the price of the product. Likewise, export parity prices refer to the price charged when the product is exported. The price build-ups for diesel (as well as petrol, domestic lpg and pds kerosene) are published on a fortnightly basis by the Petroleum and Analysis Cell. A closer look at this information throws up some interesting facts.

The current price of diesel - Rs. 46.95/litre in Delhi includes central government duties of Rs. 4.79/litre and sales tax of Rs. 5.47/litre. Sales Tax - which makes up the largest tax component - is determined and levied by the state governments. So the sales tax rate on diesel varies from 9.08 percent in Punjab to 25 percent in Chhattisgarh. This is in contrast to the taxation on petrol where Punjab has the highest tax rate at 32.61 percent, while Goa has the lowest rate at 0.1 percent. Therefore, center-state dynamics play a significant role in the process of diesel price regulation.

Even though diesel is not directly subsidized, the central government regulates its price. Despite the dismantling of Administered Pricing Regime in 2002 where it was decided that prices of petroleum products will be decontrolled and the June 2010 announcement that diesel pricing would be deregulated, the government has not been able to do much in the matter. This has led to large under recoveries for oil marketing companies (omcs). Of the total under-recoveries of Rs. 1,38,541 crore in 2011-12, almost 60 percent was on account of sale of subsidized diesel. These under-recoveries have had a substantial impact on the oil plus. As per the latest figures available, under-recovery on diesel is Rs. 13.86/litre. The recent hike in prices has raised the final price by Rs. 5/litre of which Rs. 1.5 is on account of increase in excise duty and the remaining 3.5 is to reduce the per litre under-recovery of the omcs. This is expected to decrease the under-recovery on diesel by approximately Rs. 15,000 cores in the remaining part of 2012-13. It appears that the decision to increase excise duty of diesel may be to offset the revenue losses to government on account of reduction in excise duty on petrol by Rs 5.3/litre.

This increase in diesel prices is expected to cause a general increase in the inflation rate in the country since a large part of consumption (in freight and public transport) is likely to feed into higher costs for other products as well. However, a reduction in the subsidy bill of the government, and therefore an improvement in the fiscal deficit will also lead to a reduction in deficit financing and a general reduction in the inflation rates of the economy in the longer run. The relative extent of these two impacts will determine the long-term effect of this price rise on the economy.

At A sector level, the short to medium term impact is likely to be the highest on account of the freight road transport industry that consumes nearly half the total diesel consumed in the country. The recent increase in prices is a first step towards addressing the issue of rising subsidy burden. To support the long-term move towards deregulating diesel pricing, a clear and well-designed road map for reforms is needed. A more acceptable way could be to introduce small increases in prices over an extended period of time to bring the final price at par with the export parity prices. Although the increase in diesel price would still lead to a rise in inflation, the effects would be distributed over time and the macroeconomic impact of a sudden increase would be somewhat dissipated. Further, since the state level taxation forms the largest component of product prices, uniform tax rates could also be introduced. In the long run, the government could even consider alternative pricing regimes to make the sector more competitive and efficient.