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Analysts say letting oil price rise may be most efficient thing to do
June, 03rd 2008

 No, oil products are not subsidised in India. The central government could earn 0.8% of GDP in oil revenues in FY09 at current global prices, even after accounting for oil bonds for under-recoveries. The reason petroleum product prices in India are higher than the average in tax-free retail markets is because of heavy taxes. Indian central and state governments earn over 20% of revenues and the equivalent of about 3.5% to 4% of GDP by taxing oil.

It is proposed that the government should cut excise and custom duties on oil and hold the product prices to reduce the burden on oil companies. This would mean a fiscal deficit rise by up to 1.6% of GDP. Instead of oil bonds, the state would need to issue treasury bonds of similar amount. Or, more realistically , the government would need to increase income tax. Custom duty removal requires corporate tax collection to go up 10%. For oil excise removal, all income taxes must rise 20%.

All high oil price scenarios are negative for the economy. But, we think, the most efficient would be to allow the product price rises. When we talked about the rapid rise in relatively hidden oil, fertiliser, food deficits, or falling savings rate, or crowding out at the beginning of the year, most of the arguments were hypothetical. Spiking oil prices have made them a clear and present danger at a scary pace.

We receive many queries on oil subsidies. It is difficult to say to what degree Indian consumers pay less for oil products compared to others. It surprises many that Indian consumers, on average, pay more than consumers in tax-free markets . Many arguealong the lines of the governments coalition partnerson why the government cant just cut the onerous tax on oil products to contain inflation and save growth.

Lets restart: India does not truly have subsidised oil prices. The government receives more in revenues from the oil product chain than what it gives out from other pockets or account heads in the name of subsidies. The government taxes oil through custom, excise, as well as sales tax. It also receives dividends and income tax from oil companies. But the prices it sets for oil marketing companies do not allow the latter to recover all these taxes along with their costs. This is why oil companies have under-recoveries .

Part of the under-recovery is funded by the government through oil bonds not accounted in the fiscal budget. However, if the government cuts customs and excise duty on oil to counter under-recovery, revenue shortfall and fiscal deficit will rise over 1.5% of GDPsomething unacceptable for the government.

We believe there are four ways to reduce the plight of oil companies, or these companies could soon run out of cash. First, the government issues more oil bonds. This would only hide the real level of fiscal deficit. The solution has future inflation, private sector crowding out, oil company cash crunch, and lower return for financial sector implications.

Second, the government can cut excise and/or custom rates. Such an action could raise fiscal deficit by the same extent to which it will solve oil bond issuance problem. Identical implications as in above. Third, the government could cut oil duties and raise income tax to contain fiscal deficit. This would simply be a reallocation of higher oil price induced losses to corporate India and/or consumers with additional tax cess of up to 10% to 20%. Affected parties tax bills would go up, hurting growth and setting another reregulation trend.

And fourth, the government could let prices rise, hurting inflation and growth prospects. Yet, it is the only way the economy would truly bear the current burden in current times. In the worst scenario, the government does nothing and lets the problem aggravate. This would let oil companies losses reach other public sector entities , followed by an economywide funding crunch, higher rates, and a slowing economy.

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