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Specific duties on petro products -- A distortionary approach

Asha Ram Sihag

If the basic duty structure is tampered with for the petroleum sector, there could be demands from other sectors and before long, the entire tax structure would be riddled with holes. A specific duty structure for one sector alone when others are on ad valorem also introduces distortions in relative consumption as the prices vary in the market.

TO KEEP the March 31 deadline for dismantling the administered price mechanism (APM) for the petroleum sector. Several issues would need to be resolved.

Some of these, such as the question of continuing subsidy on LPG and kerosene and for freight equalisaton for remote areas and providing protection against price volatility in the international market, are expected to be addressed by the Finance Minister, Mr Yashwant Sinha in the coming Budget.

It has been reported that for achieving the objective of greater price stability than that prevailing in the international markets, specific duties of excise for petroleum are being considered.

This is not the right approach for several reasons.

The question itself is premised on a certain lack of faith in the ability of competitive markets to deliver what the consumer desires, including a modicum of price stability.

It must be noted that, internationally, the competitive retail markets for petroleum products offer greater price stability than what is seen in the international wholesale trade.

There is a sound theoretical basis for it. Because of large costs of entry, petroleum products retailing, even in the markets where competition is legally permitted, is characterised by a oligopolistic market structure.

Behaviour of firms in oligopolistic markets corresponds closely to the kinked demand curve model, because starting from the current price, if any firm raises the price, it stands to lose market share if its competitors do not follow suit.

It is a standard result of this model that prices for the consumers would remain stable over a wide range of variation in the costs of the firm, including that of sourcing in the international markets.

Such behaviour has been observed in the industry around the world. Firms are not known to raise prices unless there is a prolonged and stable rise in the international market in the medium term.

While proposing specific duties, it has been argued that ad valorem imposts tend to exacerbate international price fluctuations. This is wrong.

By their very nature, ad valorem duties would impose the same burden of taxation on each rupee, comprising the price including any increment in it from any pre-specified level.

Against this, specific duties would create an asymmetry of tax treatment above and below a pre-specified price level. However, such an approach would dilute the achievements of indirect tax reforms over the last decade, which have been aimed at achieving a simple and progressive tax structure.

If the basic scheme of this structure is tampered with for the petroleum sector, there could be demands from other sectors and before long the structure would be riddled with holes.

A specific duty structure for one sector alone when others are on ad valorem also introduces distortions in relative consumption as the prices vary in the market.

One of the underlying principles of market-oriented reforms is that free market prices reflect the relative scarcity values of ordinary consumption goods and, therefore, the market is able to allocate resources most efficiently.

Favouring a price level around which the specific duty is set in the face of change in global prices introduces a dis-connect with the global resource allocation signals and may affect competitiveness of the petroleum-intensive exporting industries at lower international crude prices.

While these are valid arguments, they could be brushed aside as mere niceties. The most compelling argument against such sectoral price stabilisation comes from its inconsistency with the stabilisation of the external sector of the economy.

India imports 70 per cent of the crude requirement for the petroleum products it consumes. The petroleum sector accounts for about one-fourth of the value of imports and exports. In such a situation, any significant rise in the international price of crude (and therefore, petroleum products) would amount to a trade shock.

Apart from running down forex reserves in the short run,the policy options available to the government in the medium term to deal with such a shock are to discourage imports and to encourage exports and the instruments available are tax rates, interest rates and exchange rates.

In the absence of a drastic export response (unlikely in the context of oil price shocks which are globally recessionary), to be effective, the policy must reduce demand for imports as well as the aggregate domestic demand.

A specific excise duty on petroleum sector would be contrary to this goal and put the burden of adjustment disproportionately on the rest of the economy.

(The author is a senior fellow at TERI, New Delhi. The views are personal.)

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