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Economy: Crude realities!

Sep 8, 2006

International crude oil prices have more than doubled in the past two years. In India, however, non-consensus amongst political parties, upcoming elections and public disapproval have indefinitely deferred the 'pass-through'. All this at the cost of the economy's economic health and burgeoning fiscal burden. The rise in inflation was contained at 4.1% at the end of March 2006 within the indicative trajectory of 5.0% to 5.5% (the RBI's comfort zone). The cause for the actual inflation being considerably lower than the indicative trajectory could be mainly attributed to the deferred pass-through of even the cognisable permanent component of international crude oil prices. In view of the fact that a large component of this increase is viewed as permanent, keeping domestic prices unchanged not only leads to inefficiency in the use of petroleum products but also poses increasing risks to the health of public finances and overall macroeconomic stability.

In most industrial economies, end-user prices, which are market-determined, have increased in consonance with higher crude oil costs. Developing countries, where fuel prices are typically administered, have also been passing on the impact to domestic petroleum products prices, although the pass-through remains incomplete. The increase in end-user prices of petroleum products varies across countries depending upon the share of taxes in retail prices as well as the extent of pass-through.

As per the latest Reserve Bank of India (RBI) Annual Report, the increase in retail prices of petrol (including tax) ranges from 24% (Japan) to 67% (US) between March 2004 and June 2006. As regards diesel, the increase in prices (including tax) ranged between 27% (Japan) and 78% (US). In comparison, India's domestic retail prices of petrol and diesel increased by about 40% and 50% respectively, over the same period.

However, cross-country analysis of end-user prices does not present a proper picture of the pass-through in view of the wedge created by the tax component. The tax component varies across countries and is as high as 40% to 60% of retail price of petrol and diesel in European countries such as the UK, France, Italy and Germany. On the other hand, taxes are at fairly low structures of 14% to 16% for the US.

Share of tax in total price
June 2006 (%) Petrol Diesel
UK 64.3 56.7
Germany 63.0 48.8
France 62.1 45.3
Italy 58.9 41.4
India 55.0 34.4
Spain 50.6 35.1
Japan 44.3 33.2
Canada 30.3 23.9
USA 13.8 15.9
Source: IEA and RBI Annual Report

For countries with high tax components (the European nations), the price increase (excluding tax component) is much higher than that obtained from variation in end-user prices (inclusive of taxes). On the other hand, for countries with low tax component such as the US, the increase in prices (excluding the tax component) is much closer to the actual price rise. To put things in perspective, petrol prices excluding tax in the UK have increased by about 88% between FY04 to FY06 in contrast to an increase of about 28% including tax component. On the other hand, in the US, the increase in petrol prices excluding tax at 86% (during the same time frame) was much more comparable to that of 67% rise in prices inclusive of the tax component (source: ADB, 2006).

This clearly suggests that although an economy may resist passing through the entire rise in the cost of crude oil prices, it will ultimately have to sacrifice its tax revenue. This is certainly not acceptable for an economy like India, where the tax to GDP ratio is already sagging.

Thus, given the rising international crude oil prices and stagnant domestic production (70% of the country's requirement is imported), an integrated approach to efficient use of energy - both oil and non-oil energy resources - assumes paramount importance. While experts may continue to debate on the evidence of a permanent component in the oil price increase, and hence the headline inflation may continue to remain understated, it is time that the concerned authorities stop getting judgmental and the broad magnitudes of the problem are well perceived and articulated. Is the FM listening?

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