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India: Selected Issues

Author(s):
International Monetary Fund
Published Date:
February 2006
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Overview

1. After three years with growth averaging about 7 percent per year, it is clear that India is an emerging economic power. However, the current rapid growth is presenting new challenges to macroeconomic policy, while ensuring the sustainability of this growth requires broad-based fiscal and structural reforms. The six papers presented here discuss both the progress made in meeting these challenges and the road still ahead.

2. Higher world oil prices present risks in both the near and medium term. In the short-run, higher oil prices combined with robust domestic demand threaten to push inflation higher. Over the longer-run, permanently higher oil prices can depress growth and widen fiscal imbalances, in particular if the economy is not allowed to adjust to new price levels. Chapter I analyzes India’s response to higher world oil prices thus far and points to the need for a gradual move to full pass-through, with targeted protection for the poor.

3. India’s continued economic ascendance will depend in large part on its ability to benefit from globalization. India’s recent rapid growth has gone hand in hand with a gradual opening of its economy and it is critical to ensure it can continue to thrive in a globalized economy. Chapter II examines India’s competitiveness, finding that India’s export performance, while solid, can be greatly improved with enhanced infrastructure, lower tariffs and an improved business climate. However, the exchange rate is not seen as an obvious bar to competitiveness, with no evidence that the rupee is misaligned at present.

4. Despite real progress over the last several years, India’s fiscal position remains a barrier to even more rapid growth. Chapters III and IV examine two key aspects of the government’s medium-term fiscal strategy—tax base broadening and reform of center-state relations. In both cases, recent moves by the government are important positive steps, and the analysis points to further potentially important measures. On tax reform, there is considerable scope to generate increases in revenue, but difficult choices will be required. States have been provided with more resources and incentives for adjustment, but more conditionality on transfers and tighter borrowing controls would provide a further impetus for reform.

5. Recent growth in India has been accompanied by increased financial intermediation. Chapter V analyzes the rapid credit growth of the last few years, finding it to be a generally positive development, but one that bears close monitoring. In particular, while credit risks are seen as manageable, further tightening of prudential regulations could play a role in minimizing these risks.

6. Improved statistics are key for enhancing economic policy-making. India’s main inflation measures exclude services. Chapter VI uses implicit prices to examine trends in services inflation and argues for the need to develop broader price measures in India.

I. Dealing with Higher Oil Prices in India1

A. Introduction

1. High oil prices are increasingly viewed as a reality for the near and medium term, prompting governments and economic agents to adjust their behavior accordingly. The Government of India, which maintains controls over the prices of some petroleum products, is no exception and is considering the reinstatement of an automatic pricing formula and assessing the appropriateness of the system of petroleum subsidies and taxes.2 This chapter provides some considerations that could help guide these reforms. Section B provides some background on the reasons behind the rise in oil prices and why the impact of high oil prices on economic growth has been thus far relatively muted. Section C analyzes the government’s response to higher oil prices (mainly increased implicit subsidies) and the costs associated with it. Section D, which forms the core of the chapter, presents some considerations regarding price, subsidy and tax reforms. The final section concludes.

B. The Rise in Oil Prices

2. Crude oil prices have doubled since 2003, rising by about $30/bbl. The average price of the Indian basket of crude oil (a 57:43 percent mix of Dubai and Brent crudes) rose by $11 or 39 percent in 2004/05 to an average of $39/bbl.3 More recently, prices have climbed to around $60/bbl. Futures markets suggest that oil prices could remain around $55-60/bbl in coming years, underscoring the need for economies to adjust to higher oil prices.

3. The main reasons for the increase in oil prices have been surprisingly strong demand, especially from China, and heightened perceived risks of supply disruptions. Global demand outstripped expectations in 2003 and 2004 by a wide margin (Figure I.1). More recently, concerns about possible supply shocks appear to have been the main drivers of price increases. The impact of both of these factors on prices has been magnified by historically low spare capacity owing to low investment in the 1990s (when crude oil prices averaged less than $20/bbl). In addition, capacity constraints in the refining sector have added upward pressures to petroleum product prices. Based on current investment plans, production capacity is unlikely to grow fast enough to create adequate spare capacity in the oil market, leaving oil prices vulnerable to spikes in response to supply and demand shocks.

Figure I.1.

Oil Price and World Oil Demand Actuals vs. Projections

Source: Oil Market Reports, International Energy Agency.

4. India has accounted for a relatively small portion of the increase in world demand. While many commentators tend to couple India with China as the largest contributors to increased oil demand, China’s contribution over 1999–2004 has been more than five times larger than India’s (Figure I.2). Even the United States’ contribution has been double that of India.4 Nevertheless, India has become the world’s sixth largest consumer of oil and its share of world consumption has risen to 3.2 percent in 2004 from 2.9 percent in 1999. As regards its role as a supplier of refined products, it is worth noting that the expansion of refineries in India has accounted for almost 25 percent of the total increase in world refining capacity in the last decade.

Figure I.2.

Accounting for the Increase in World Demand for Oil, 1999–2004

Sources: BP Statistical Review of World Energy June 2005 ; and staff estimates.

5. India’s intensity of oil consumption also remains relatively low. In 2004, oil consumed per unit of GDP (in PPP) was roughly unchanged from a decade earlier and remained low compared to other countries (Table I.1). In recent years, the growth in consumption of petroleum products has been about half as fast as real GDP growth, given the importance of services as a driver of growth relative to manufacturing and the still low rates of vehicle ownership.

Table I.1.Oil Consumed per $1,000 of GDP at PPP, 2003
Barrels
India0.30
China0.35
Philippines0.36
Pakistan0.40
South Africa0.42
France0.46
Brazil0.50
Japan0.59
Indonesia0.61
Thailand0.69
USA0.71
Mexico0.78
Malaysia0.79
South Korea1.03
Source: BP Statistical Review of World Energy, June 2005; World Bank, World Development Indicators; and staff estimates.
Source: BP Statistical Review of World Energy, June 2005; World Bank, World Development Indicators; and staff estimates.

6. Looking forward, however, oil demand in India is projected to grow as fast as in China. The increase in vehicle ownership and the expansion of manufacturing will be key drivers of this growth. International experience suggests that at India’s income levels (more than $3,000 of GDP per capita in PPP terms) vehicle ownership rates are likely to grow much faster than GDP (until the latter reaches about $10,000). Thus, the International Energy Agency projects India’s oil demand to reach 5.2 mbd in 2030, which implies an average annual demand growth rate in 2004–2030 of about 2.8 percent, compared to a world growth rate of 1.3 percent and growth in China of 2.9 percent. Obviously, this projection is highly uncertain and sensitive to assumptions for income growth and demand elasticity. For instance, assuming an oil demand elasticity of 0.7 (in line with estimates for non-OECD countries) and annual average GDP growth of 6 percent over 2005–2030 would result in oil demand of 7.4 mbd in 2030, more than 40 percent above the baseline projection (Table I.2).

Table I.2.India: Sensitivity of Oil Demand Projections to Income Growth and Elasticity Assumptions(Millions barrels/day in 2030)
Average Growth of GDP, 2005–2030

(In percent)
5.06.07.0
0.54.95.56.2
0.65.56.47.4
Demand Elasticity0.76.27.48.9
0.87.18.610.5
Source: Staff estimates.
Source: Staff estimates.

7. Despite the rise in oil prices, growth in India has remained strong. Growth was around 7 percent in 2003/04–2004/05 and rose to 8 percent in the first half of 2005/06. The impact on world growth from higher oil prices has also been moderate, because some of the increase has been attributable to strong demand rather than a supply shock, energy intensity has declined since the early 1980s, inflationary expectations have been well anchored, and in some cases pass through to domestic prices has been limited. For India, key factors limiting the impact on growth include:

  • The rise of India as an exporter of refined products has moderated the impact of the terms of trade shock and the transfer of income abroad (Table I.3). Thus, while petroleum imports rose by more than $8 billion (41 percent) in 2004/05, exports of petroleum products increased by more than $3 billion (89 percent). In the event, net petroleum imports only rose by 0.4 percent of GDP (to 3.2 percent of GDP).5
  • The incomplete pass-through of international petroleum prices has also moderated the income effect on domestic consumers. In practice, public oil companies have borne the bulk of these subsidies, which amounted to about 0.7 percent of GDP in 2004/05 and ½ percent of annual GDP in the first half of 2005/06.
  • Large international reserves and strong capital inflows have limited the economy’s need to adjust by reducing non-oil imports (in fact, the rupee appreciated in 2004/05). Similarly, the sectoral reallocation of resources (away from oil-intensive activities) has been able to take place more smoothly as the economy experiences rapid productivity gains that lower non-oil production costs and increase profit margins.
  • Strong global growth has supported export demand, and the maintenance of a supportive monetary policy, made possible by well-anchored inflation expectations has also contributed to domestic growth. By delaying the impact on inflation, the incomplete pass-through of oil prices has also postponed the rise in interest rates to contain potential second round effects.6
Table I.3.India: Basic Petroleum Sector Data(In billions of U.S. dollars)
2000/012001/022002/032003/042004/05
Oil imports (net)1412161722
Imports1614182129
Exports22347
Oil imports (net) (percent of GDP)3.02.53.12.83.2
Imports (percent of GDP)3.42.93.63.44.2
Exports (percent of GDP)0.40.40.50.61.0
Crude oil prices (U.S. dollar)
Indian basket26.621.926.227.838.9
WEO28.123.027.629.141.3
Indian basket (percent change)21.8-17.419.36.139.9
WEO (percent change)36.5-18.019.65.641.8
Crude oil production (million tons)3232333334
Percent change1.5-1.23.21.01.1
Crude oil consumption (million tons) 1/103107113122127
Percent change20.33.74.98.24.3
Consumption of oil products (million tons)100100104108112
Percent change3.10.43.73.53.5
Sources: Reserve Bank of India; Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha.

Includes oil used as an input for refined products that are exported.

Sources: Reserve Bank of India; Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha.

Includes oil used as an input for refined products that are exported.

8. The benign impact of high oil prices may not continue into 2006. High oil prices are increasingly viewed as permanent, leading to adjustments in government subsidies in India and around the world. The realization that high oil prices may remain at current levels over the medium term could eventually have a greater impact on inflationary expectations, necessitating a stronger monetary policy response. Lastly, consumer and investor confidence may wane. In India, net petroleum imports are projected to rise by 1 percent of GDP in 2005/06, more than double the increase in the previous year. Growth is expected to moderate from 7.6 percent in 2005/06 to 6¾ percent next year, and to the estimated potential growth rate of about 6½ percent in 2007/08, reflecting further pass-through of higher oil prices and rising global and domestic interest rates.7

C. The Government’s Response: Pass-Through and Taxes

9. As mentioned above, the pass through of international prices to domestic petroleum prices so far has been partial. Prices of gasoline, diesel, kerosene, and LPG—which together account for about three quarter of petroleum consumption—are under government control. After the dismantling of the administered price mechanism in March 2002, oil-marketing companies (OMC) were allowed to adjust prices based on import parity after consulting with the Ministry of Petroleum. (Kerosene and LPG remained subsidized by the central government through the budget but it was envisaged that these subsidies would be phased out gradually.) The system of quasi-automatic price adjustments, however, was suspended at the end of 2003 as oil prices started to climb.8 Since then, pricing decisions have been made on an ad hoc basis. Kerosene prices have not changed, and the prices of LPG, gasoline, and diesel have only increased by about 20, 30, and 40 percent respectively. Given high taxes, prices of gasoline and diesel are relatively high compared to other countries, but kerosene prices remain among the lowest in the world. Staff estimates that petroleum prices would have to be adjusted by an additional 40–45 percent on average to be fully in line with international prices, with kerosene and LPG requiring the largest adjustments (Table I.4).9

Table I.4.India: Pricing of Regulated Petroleum Products(New Delhi)
Weighted
GasolineDieselKeroseneLPGAverage 1/
Price changes Dec. 2003-Sep. 2005 (in percent)
In rupees10905323
In percent294002227
Further adjustment required (in percent) 2/
In rupees721413750
In percent1581544641

Weights from the wholesale price index (gasoline, 0.163; diesel, 0.372; kerosene, 0.127; and LPG, 0.338)

Staff estimates.

Weights from the wholesale price index (gasoline, 0.163; diesel, 0.372; kerosene, 0.127; and LPG, 0.338)

Staff estimates.

10. With rising oil prices, the cost of subsidies has increased. Staff estimates that the cost of subsidies increased from ½ percent of GDP in 2003/04 to 0.7 percent of GDP in 2004/05. In the first half of 2005/06, subsidies amounted to ½ percent of projected annual GDP (Table I.5). If oil prices remain at current levels ($60/bbl) and petroleum prices are not adjusted further, subsidies for the year as a whole would reach 1–1¼ percent of GDP. Subsidies for kerosene and LPG account for more than 80 percent of all subsidies. While these subsidies have shielded some poor households from the impact of higher oil prices, there is evidence of substantial leakage of benefits to higher income households (see discussion below).

Table I.5.India: The Burden-Sharing of Subsidies to Petroleum Products(In billions of rupees)
2003/042004/052005/06
Apr.–Sep.
Total subsidies134220178
In percent of GDP0.50.70.5
Budget subsidies, Government of India 1/632915
Refining/distribution companies 2/40133102
Kerosene and LPG40116
Gasoline and Diesel018
Upstream companies 3/315861
Sources: Published financial results by petroleum companies; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha; and staff estimates.

Budget subsidies are for kerosene and LPG.

Indian Oil; Bharat Petroleum; and Hindustan Petroleum Corporations, excludes IBP.

Discounts provided to downstream companies by Oil and Natural Gas Corporation; OIL; and GAIL.

Sources: Published financial results by petroleum companies; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha; and staff estimates.

Budget subsidies are for kerosene and LPG.

Indian Oil; Bharat Petroleum; and Hindustan Petroleum Corporations, excludes IBP.

Discounts provided to downstream companies by Oil and Natural Gas Corporation; OIL; and GAIL.

11. State petroleum companies have borne the bulk of the subsidy costs. The 2004/05 budget cut in half explicit kerosene and LPG subsidies, which, in combination with price controls, resulted in revenue shortfalls of about 0.6 percent of GDP for marketing companies.10 About one third of these shortfalls were compensated with transfers from exploration companies mandated by the government.11 Higher refining margins in their export business and domestic sales of unregulated products also provided some cushion to absorb the shortfalls. Explicit budget subsidies fell from ¼ percent of GDP in 2003/04 to 0.1 percent of GDP in 2004/05. While explicit subsidies were frozen in the 2005/06 budget, the quasi-fiscal cost of price controls amounted to about ½ percent of GDP in the first half of the year. Part of this burden will certainly be passed back to the government and raise the fiscal deficit via lower dividends and taxes and via the issuance of government bonds to the oil companies.

12. The pass-through of international oil prices also remains incomplete in a number of other countries in Asia and around the world (Figures I.3I.6). About half of all countries in Asia have freely determined prices and have experienced full pass-through, but Bangladesh, China, Indonesia, Malaysia, Sri Lanka, Taiwan POC and Vietnam have price controls on petroleum products. Fiscal costs of price subsidies in 2004 ranged from ½ percent of GDP in Cambodia to 3 percent of GDP in Indonesia. In many countries, these costs are expected to rise in 2005 (IMF, 2005).12 The pass-through of oil prices has also been incomplete in many other countries around the world (Thornton and Amati, 2005).

Figure I.3.Economies with Administered Prices: Petroleum Product Price Increase, December 2003—Latest

(Percent change)

Sources: Country authorities; and IMF staff estimates.

Figure I.4.Gasoline Prices in Selected Asian Countries, December 2003 and latest

(U.S. dollar/liter)

Figure I.5.Kerosene Prices in Selected Asian Countries, December 2003 and Latest

(U.S. dollar/liter)

Figure I.6.Diesel Prices in Selected Asian Countries, December 2003 and Latest

(U.S. dollar/liter)

13. To limit price increases, the Government of India has lowered oil taxes and partly replaced ad valorem excises with specific rates (Table I.6). In June 2004, when the first price revision of the year took place, excise duties for diesel, gasoline, and LPG were lowered. Two months later, excises for kerosene were cut—which increased producer prices although retail prices remained unchanged—and ad valorem excises for gasoline and diesel were reduced and partly offset with specific taxes on a roughly revenue neutral basis. The 2005/06 budget introduced further changes, notably removing the excises on kerosene and LPG. State governments, which tax petroleum mostly at an ad valorem basis, have kept tax rates broadly unchanged.13 Despite the tax changes, petroleum tax revenues remained broadly unchanged at about 4 percent of GDP during 2003/04–2004/05 and continue to constitute a large source (25 percent) of general government tax revenue (Table I.7).

Table I.6.India: Taxation of Oil Products(In percent)
March 04June 04August 04March 05
Import duties
Crude oil1010105
Diesel20201510
Gasoline20201510
Kerosene101050
LPG101050
Excises
Diesel14+Rs. 1.5/Ltr.11+Rs. 1.5/Ltr.8+Rs. 1.5/Ltr.8+Rs. 3.25/Ltr.
Gasoline30+Rs. 7.5/Ltr.26+Rs. 7.5/Ltr.23+Rs. 7.5/Ltr.8+Rs. 13/Ltr.
Kerosene1616120
LPG16880
State sales taxes (Delhi) 1/
Diesel1213
Gasoline2020
Kerosene44
LPG812.5
Sources: Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (various reports), Lok Sabha Secretariat.

State sales taxes as of April 2004 and July 2005 respectively.

Sources: Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (various reports), Lok Sabha Secretariat.

State sales taxes as of April 2004 and July 2005 respectively.

Table I.7.India: Government Revenues from Oil Sector(In percent of GDP)
2002/032003/042004/05
Central government2.62.52.5
Excises1.51.51.4
Import duties0.40.40.4
Other (CIT, royalties, dividends, etc.)0.80.70.7
State government (sales tax, etc.)1.31.31.4
Total (central+states)3.93.83.9
Memorandum items:
General government total revenues and grants18.318.819.7
Of which : state taxes5.85.96.0
Sources: Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha Secretariat.
Sources: Basic Petroleum Statistics, Ministry of Petroleum and Natural Gas; Standing Committee on Petroleum and Natural Gas (several reports), Lok Sabha Secretariat.

D. Considerations for Reforms

Pricing

14. Efficiency considerations suggest that higher international petroleum prices should be fully passed on to users. The Indian authorities recognize this, especially as high oil prices are increasingly viewed as permanent. Higher user prices would provide the right incentives to reduce the consumption of petroleum products, not only in the short run but also in the long run through the adoption of more energy efficient technologies. Unduly delaying this adjustment process may harm competitiveness over time. Indeed, the dramatic improvement in international measures of energy intensity since the 1970s stems to a large degree from the adoption of new technologies in the wake of oil price shocks. Recent consumption data, showing that the secular decrease in kerosene consumption came to a halt in April–September 2005 while diesel consumption declined, suggest that high subsidies to kerosene may also be leading to its overuse, including to adulterate other fuels.

15. Petroleum prices should also be increased on fiscal grounds. As mentioned above, the cost of price subsidies could exceed 1 percent of GDP in 2005/06. With oil prices expected to remain high, this level of subsidies would seriously undermine efforts at fiscal consolidation and reduce the fiscal space to raise spending on infrastructure and other priorities.

16. In general, automatic adjustments to administered prices are preferable to ad hoc adjustments. International experience indicates that countries with a system of ad hoc changes take longer to adjust prices upward and the size of the adjustment is smaller (IMF, 2005). The experience in India is consistent with this evidence.

17. The formulas used to determine price changes should be transparent and based on the international prices of petroleum products. To be transparent, the adjustment formula should be clearly specified and fully documented. International prices are an appropriate benchmark because they provide a measure of the opportunity cost of fuel consumption. To reduce the volatility of prices, a moving average for the reference price could be used. It is generally recommended that prices be adjusted at least monthly (even more frequent adjustments would be preferable to avoid sharp increases).

18. Having said this, the existing substantial gaps with world oil prices may have to be closed gradually for socio-political considerations. In particular, this is likely to be the case for kerosene (used by 87 percent of all households) and LPG (used by close to 45 percent of urban households and a minority of rural households). A gradual adjustment would give time for the government to identify means to cushion the impact of higher petroleum prices on the most vulnerable groups—preferably through direct income transfers intermediated through an appropriate social safety net. A phased adjustment would also avoid a sharp spike in inflation, which could reduce the risk of second round effects. In practice, a phased adjustment could be achieved in the context of a formula by placing a ceiling on the size of any given price change. For the sake of transparency, however, any subsidies (transitional or permanent) should be explicit and channeled through the budget rather than via oil companies. This would also encourage the entry of private sector oil marketing companies, promoting competition, and would set the stage for a full liberalization of petroleum prices over the medium term.

Protecting the Vulnerable

19. The elimination of kerosene subsidies would have a substantial adverse impact on the real consumption of poor households. For rural households in the first quartile of consumption expenditure, the full removal of kerosene subsidies would result on average in a decrease of real consumption of about 3 percent.14 Such a decline would make a material difference to households that are already very poor. Although the lack of data preclude a similar calculation for the removal of LPG subsidies, their impact on the poor would likely be much smaller.15 There are two main alternatives to mitigate the impact of the removal of kerosene subsidies on the poor: One option would be to maintain the price subsidy but only for the poor while the second would entail the full removal of subsidies accompanied by a system of cash transfers to the neediest.

20. The current system of kerosene subsidies generates substantial leakage of benefits to non-poor households. Subsidized kerosene is sold through the Public Distribution System (PDS) and consumption quotas depend on household characteristics.16 It is estimated that kerosene consumption of households with below poverty line (BPL) ration cards (which represent 39 percent of all households) accounts for less than 38 percent of all kerosene consumption (Tables I.8I.9). Moreover, it is estimated that almost 40 percent of kerosene distributed through the PDS is diverted for non-household use or for sale in the black market (NCAER, 2005). As a result of this, poor and non-poor households alike are already forced to pay market rates for about 20 percent of their kerosene consumption (but the government pays for the subsidies!). Thus, the elimination of abuse and corruption in the PDS system together with the targeting of kerosene price subsidies exclusively to BPL households at current benefit levels could potentially save the government 70 percent of the current (budget and off-budget) subsidy costs.

Table I.8.India: Frequency Distribution of Households By Type of Ration Card
RuralUrbanTotal
Below poverty line 1/30.09.039.0
Above poverty line30.720.050.7
No card6.04.310.3
Total66.733.3100.0
Sources: NCAER; and IMF staff estimates.

Includes households under special schemes.

Sources: NCAER; and IMF staff estimates.

Includes households under special schemes.

Table I.9.India: Distribution of Kerosene Consumption by Household Type
RuralUrbanTotal
Below poverty line 1/27.210.737.9
Above poverty line30.821.652.4
No ration card5.34.49.7
Total63.336.7100.0
Sources: NCAER; and IMF staff estimates.

Includes households under special schemes.

Sources: NCAER; and IMF staff estimates.

Includes households under special schemes.

21. Cash transfers would be a preferred alternative to protect the most vulnerable. These allow for consumer choice, their cost to the budget is explicit and known with greater certainty than generalized subsidies, and they can be better targeted to the poor. This was the route taken by Indonesia after sharply raising petroleum prices last October (World Bank, 2005). Under Indonesia’s program, which required a massive effort to identify beneficiaries, more than 15 million poor families (accounting for 25 percent of the population) receive Rp 100,000 (about $10) per month. As was the case in Indonesia, there is no obvious well-targeted social program readily available in India to channel such transfers to the neediest and time would be needed to establish one. However, gains from a better-targeted social safety net that replaces the myriad of welfare programs and subsidies (petroleum and other) currently in place are potentially very large and worth pursuing (Government of India, 2004).

Taxation

22. In India, where a large component of excise taxes is still ad valorem, consideration could be given to converting them to a specific rate (at least in part). Any changes, however, should be done on a revenue neutral basis or compensated by other revenue or spending measures. Cross-country comparisons show that excises on petroleum products tend to be at a specific rate and ad valorem taxation is usually limited to VAT at the standard rate (Thornton and Amati, 2005). Thus, the combined level of central and state ad valorem taxes in India (exceeding 40 percent in Andhra Pradesh for gasoline or in Maharashtra for diesel, for instance) is likely to be among the highest in the world. The problem with ad valorem taxes is that they amplify the impact of international price increases and could result in a procyclical fiscal policy, as revenues tend to rise when the economy is hit by an oil price shock, placing an additional burden on the private sector. By amplifying the required price adjustments, they also tend to undermine support for an automatic pricing mechanism. Another general principle to consider when deciding the level of taxes is that close substitutes should normally be taxed similarly, otherwise induced substitutions may lead to revenue losses as well as environmental problems if, as with diesel in India, the more polluting fuel is also taxed more lightly.

23. It is critical, however, that specific excises be adjusted automatically for inflation. While it is in fact a virtue of ad valorem taxes that they generally they keep better pace with inflation, specific excises can also maintain buoyancy as long as they are periodically adjusted for inflation. Once a year may be sufficient in a low inflation environment. The Philippines, which did not adjust specific rates of excise for seven years and saw the fiscal deficit balloon in the process, provides a clear example of the risks involved with specific taxes that are not adjusted automatically. In Turkey, when inflation was at two and three digits levels, specific taxes were adjusted automatically on a monthly basis. Given the relative inelastic demand in the short run for petroleum products, specific taxes can also ensure a fairly steady and predictable revenue stream, which facilitates budget planning. In addition to being subject to excises, domestic petroleum products should also be subject to VAT (as a broader base minimizes distortions).

E. Conclusions

24. This chapter provides some considerations that could help guide petroleum pricing, tax, and subsidy reforms currently under consideration in India. It argues that user prices that fully reflect market international costs would provide the right incentives to reduce the consumption of petroleum products and adopt more energy efficient technologies. As the prices of some products—namely, kerosene and LPG—require large adjustments to bring them in line with international prices, this catch-up may need to take place gradually. In any event, pricing changes would be best guided by an automatic and transparent formula that translates changes in international prices into domestic price changes. The reduction of price subsidies, however, will be difficult for the poor to bear unless appropriate compensation mechanisms are in place. In this regard, targeted support through direct income transfers, would be preferable, underscoring the need to develop a social safety net. This could also be used as part of a broader strategy of subsidy reform that tackles other subsidies (such as food, fertilizer, or electricity) and a myriad of poverty alleviation schemes, most of which are believed to be poorly targeted. As regards taxation, the chapter argues that there is room to convert ad valorem taxes into specific taxes but notes that the latter should be adjusted periodically for inflation.

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1Prepared by Enric Fernandez.
2To this end, a high-level committee was formed in October 2005.
3Fiscal year starts April 1.
4In contrast, Japan, France, Germany, Italy, and some Eastern European countries, actually reduced their demand for oil over this period.
5The trade balance deteriorated by 3 percent of GDP but this was mostly due to an increase in non-oil imports.
6Full pass through would have had an additional direct one-off impact on the wholesale price index of 2½ percentage points.
7IMF staff estimates suggest that a permanent $10/bbl increase is associated with 0.2–0.6 percent reduction in global GDP, depending on whether the shock is demand or supply driven. Adverse impacts on confidence would increase the magnitude of this effect.
8In August 2004, the government approved a system whereby OMCs could adjust gasoline and diesel prices within a ±10 percent price band of a 3-month rolling average of import parity prices but the system never became operational.
9Full pass-through prices are estimated by adding international petroleum prices, freight and insurance costs, import duties, excise taxes, distribution and marketing costs, and state sales taxes with information provided by the Ministry of Petroleum.
10Mainly Indian Oil, Bharat Petroleum, and Hindustan Petroleum Corporations, which are refining and marketing companies.
11Oil and Natural Gas Corporation, Oil India, and Gas India. Revenue shortfalls are estimated by staff based on the difference between actual prices and import parity prices.
12In response to ballooning subsidy costs, Indonesia raised petroleum prices in October by more than 100 percent (kerosene by 186 percent).
13State sales tax rates on petroleum products vary widely by state and product: 20–34 percent for gasoline; 9–31 percent on diesel; 0–12½ percent on kerosene; and 1–14 percent on LPG.
14Staff estimates based on an increase in kerosene prices of Rs. 14; average consumption of rural households of Rs. 1,720 per month (based on NSS, 2005); and average consumption of kerosene of 46 liters per year (NCAER, 2005).
15LPG is mostly used by relatively higher expenditure groups in urban areas for cooking. Only 5 percent of rural households use LPG. In urban areas, about 40 percent of households still use firewood or kerosene for cooking and likely to be poorer than LPG using households (NSS, 2005).
16Rules vary by state but quotas usually depend on the type of ration card of the household (which is a proxy for income), and on whether the household uses LPG or not. Households get more than 80 percent of their kerosene demand from the PDS and this share varies little across household characteristics.

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