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Why petro products subsidies should be done away with

columns Updated: Jul 10, 2014 15:16 IST

When India gained independence in 1947, it started following socialist policies under Jawaharlal Nehru. India was a newly-born economy and the per capita income was low and that's the reason the government provided essential fuels at less than market price to protect consumer interests. India has come a long way from being an under developed economy to a developing one and things are very different today and hence a change is needed.

Selling fuel at less than market prices result in under-recoveries for oil marketing companies (OMCs) like Indian Oil Corporation Ltd (IOCL), Bharat Petroleum Corporation Ltd (BPCL) and Hindustan Petroleum Corporation Ltd (HPCL).

Government of India (GoI) compensates these OMCs by directing upstream oil companies like Oil and Natural Gas Corporation Ltd (ONGC), Oil India Ltd (OIL), GAIL India Ltd to provide discount on crude oil purchases by these companies and issuing oil bonds. Oil bonds have been replaced by cash compensation from fiscal year 2011 onwards and are part of the budget. The government has over the years ensured that OMCs remain profitable and honour their financial obligations.

Total under-recoveries of the OMCs have increased from $6.7 billion in FY06 to $23.3 billion in FY14 due to increase in crude oil prices and depreciation of the rupee versus the dollar. Aggregate under recoveries have been to the tune of $138.9 billion during this period. This has been compensated for by the upstream companies through cash discount (USD 53.2 bn) and GoI through oil bonds/cash subsidy (USD 85.7 bn).

Subsidies on kerosene have increased from Rs. 12.92/litre to Rs. 34.80/litre and LPG cylinders from Rs. 175.04/cylinder to Rs. 522.10/cylinder during the same period. Diesel accounts for 45%, LPG 33% and kerosene 22% of the total under-recoveries.

To rein in subsidies, petrol prices were de-controlled in June 2012. However, it did not have a significant impact on under recoveries because petrol accounts for only 10% of total petroleum product consumption in the country.

In January 2013, the government decided to increase diesel prices by 50 paise per month and limiting the number of subsidised cylinders to 12 per family per year. This has helped to contain subsidies to some extent.

There are no free lunches...

If you feel you are getting a discount on diesel, kerosene and LPG (three products which are currently regulated), then you are wrong. The discount provided on them is compensated through taxes on your income. Individual income tax collections and the total subsidy bill of the government (food, petroleum, and fertiliser) are at similar levels of $40 billion in FY14. Petroleum subsidy is approximately one third of total subsidy bill.

This effectively means that the income tax paid by individuals could reduce by 33% if subsidies are done away with (as the government no longer needs to spend this money), without impacting our budgetary position in any way.

Thus any increase in inflation due to price decontrol will be compensated by leaving more cash in the hands of an individual. This will also help get rid of the circuitous way of giving money from one hand and then taking if back from the other.

Why are subsidies bad?

It is just eyewash as explained above. Further it makes one use products he doesn't really need only because it is cheaper. Many households in villages have been using cow dung cakes as fuel to cook and now some of them have started using LPG cylinders. Whenever prices are decontrolled can villagers afford it? The answer is a big NO as market prices are double the subsidised prices.

It leads to an artificial differentiation as seen in the demand for diesel and petrol cars. Diesel cars, though expensive, sell more because diesel is cheaper than petrol and is regulated. The increased capital costs is easily recovered in lower variable costs if your daily running is higher in case you buy a diesel car. So in a way even automobile companies have an interest in regulated prices.

Increase in prices of fuels would also encourage some people to use public transport thus reducing traffic congestion on the road. This will also force people to increasingly use car pools. Thus fewer cars on the road mean less pollution.

Health of companies like ONGC, GAIL and OIL which provide discounts will improve substantially. Their profits would improve and they can use the surplus cash balance to invest in exploration and production activities. India needs significant investment in E&P to reduce dependence on crude oil imports. If this money was available to ONGC they could have been able to develop 6 gas blocks like KG-D6 of RIL (notwithstanding problems currently faced by KG-D6).

Even the health of OMCs would improve. These companies borrow short term loans from banks to fund under-recoveries as cash compensation is usually provided at the end of financial year. If prices are decontrolled, OMCs would sell fuel at market linked rates and realise cash upfront from consumers. This would reduce dependence on such short term loans and interest cost of OMCs will reduce. This in turn would increase their profits. (Total short term borrowings of OMCs were USD 12.3b in FY14, implying an interest savings of ~USD 120mn). For the period under discussion this savings could easily be to the tune of USD 1bn. Of course this would be bad news for MNC banks that have buyer’s credit limits running into billions of dollars to these OMCs.

If prices are decontrolled, private players would also participate in marketing of fuels which would encourage competition in the sector. Competition in any sector is good for end users as evidenced by the tariff war in the telecom sector which forced operators to cut down call rates.

There are four players in this story - GoI, OMCs, upstream companies and individuals. Both OMCs and upstream companies would benefit if subsidies are removed. The government's expenditure will also reduce if subsidies are removed. However, this would increase inflation. To negate this impact, the government needs to reduce income tax rates or provide higher exemption limits. This will keep the budget in balance.

Kerosene is used for lighting mainly in villages and also as a fuel to run generators in small towns. The government's inability to provide electricity to each and every household is compensated by giving huge subsidy to villagers on kerosene. If this subsidy is removed, it will put onus on the government to electrify all villages on an urgent basis.

Diesel is used as a fuel to run vehicles. Prices of food items and everything which is transported by diesel-run trucks will increase if its price is decontrolled. LPG is used as cooking fuel and any increase will impact the budget of a household.

So removal of all subsidies won't ignite inflation. Only diesel hike will do so. And all this can be compensated by lowering income taxes as detailed above without creating any strain on the government's budget.

Increase in kerosene prices will hurt the budget of villagers. However, this would be compensated by higher food subsidies of USD 3.8 bn through the Food Security Bill as proposed by Chidambaram in interim budget and which Jaitley is unlikely to tinker with. For the record, kerosene subsidies were approx. USD 5bn in FY14. Anyways there's a lot of black marketing in kerosene and de-regulation will curb all of this.

Views expressed by the author are personal.