Petroleum tax structure: Impetus needed for the sunrise sector

Higher revenue from increased fuel taxes will yield outcome if invested in high fiscal multipliers.

In India, taxation on petroleum products like petrol and diesel are an important source of revenue for the central and state governments. After introducing the Goods and Services Tax (GST) in 2017, taxes on petroleum became key sources or revenue, and allowed governments to quickly change tax rates and plug revenue gaps. Energy prices, therefore, can exert an outsized effect on the Gross Domestic Product (GDP) growth and consumer price inflation.

From the beginning of FY21, the COVID-19 crisis exerted a sizeable setback on the energy sector and the economy. First, the lockdowns imposed by the governments led to a sharp decrease in the consumption of petrol and diesel, as depicted in Figure-1^[1] below.  For example, consumption in April 2021 was lower than the consumption in April 2020. In the first quarter of FY22, the fall in petrol and diesel consumption was so sharp as to be almost 50% of the consumption levels in FY19 and FY20. The government responded by increasing tax rates to compensate for the fall in revenues due to reduced consumption.

Second, due to the global nature of the pandemic, global crude oil prices crashed by almost 70% at the end of FY20 and beginning of FY21 (See Figure 2), anticipating a sharp fall in crude oil demand because of the coming lockdowns and the subsequent fall in global GDP. The major oil cartel Oil Producing Exchange Countries (OPEC) responded by cutting crude oil production to provide support to falling prices. They further extended the cuts in oil supply to recover from the previous losses despite global demand bouncing back sharply on the back of global fiscal and monetary support provided by developed economies. This has led to a rapid rise in oil prices.

Thirdly, the GDP growth rate for FY21 turned negative (-6.3%) resulting in further reduction in the demand for petroleum products. It further exacerbated the revenue impact for the government.  The negative revenue impact came at a time when the government had to increase its expenditure on COVID-19 relief to vulnerable sections and support the hard-hit sectors. The increase in fiscal deficit and debt by the government was possible only up to a certain level, given that India’s credit rating has been just one level above the junk rating and any further increase in debt could have worsened the perception of rating agencies. 

Given the fall in consumption levels of petroleum products and overall decrease in the revenues of the government to negative GDP growth, both the central and state governments have revised the petroleum tax structure and increased the petroleum excise duties (Figure 3) and sales taxes (Figure 4a & 4b)^[2].

Figure 5 below shows how, despite the reduction in the consumption of petroleum products and increase in petroleum prices, central government revenues jumped by 66.8 percent in FY21 consequent to the excise duty hikes. State governments, too, have been able to maintain their revenues from petroleum products despite the reduction in consumption.

Macroeconomics of oil prices

As discussed earlier, oil is one of the key factors of production in an economy. At the same time given the high fiscal deficit and need for government expenditure it is also a key source of revenue for governments. While on one side, it supported government revenues during the COVID-19 year, increase in the crude oil prices also contributed to an increase in inflation, increase in import bill, puts pressure on the exchange rate and lead  to the contraction in GDP growth. As per the RBI annual report^[3] published in April 21 RBI estimates suggest the following:

Therefore, the high taxes on domestic oil prices only make sense if the government uses the money collected on capital expenditures where the fiscal multiplier is very high. If the oil tax revenues are only used to fill in the hole created by the shortfall in revenues, then the overall gains may be miniscule as the revenue gains come at the expense of shortfall in GDP and deterioration of macroeconomic situation. To the government’s credit, capital expenditure has been maintained in the Union Budget. In the Union Budget 2021-22, capital expenditure as a ratio of GDP is the highest in recent years. Spending has been focused on the infrastructure sector.

Future prognosis

OPEC recently decided to increase the production of crude oil, after weighing the trade-offs of higher oil prices in terms of revenues generated vs. the negative effect on demand for petroleum products.

Although the revenue pressure on the government may stay in the near future, the recent fall in crude oil prices may provide respite to consumers and the economy.

An important factor currently at play is the long term decarbonization strategy of the government and promotion of renewable energy, natural gas and electric vehicles. In this sense, the taxes on petrol and diesel form a kind of green tax on vehicles in India. Also, sustained higher oil prices may push consumers towards buying electric or natural gas vehicles. The government may want to continue to provide that impetus to sunrise sectors of the economy.

(This article is authored by Navneeraj Sharma and Chinmaya Goyal, Senior Managers, EY India).