Why a Windfall Oil Tax Isn't the Solution to High Fuel Prices

It is unfortunate that both the NDA and UPA governments treat PSU oil companies as their convenient ATMs. The narrative around high petrol and diesel prices needs to change.

In 2008, as crude oil prices skyrocketed to $147 per barrel, there was intense debate on how to share the burden of increasing oil import costs. Though petrol and diesel prices were significantly higher in the international market, they were based on freezing oil prices at $70/b by the UPA.

Currently, with crude oil at $80/b and petrol prices slightly above the highs reached in 2013, the NDA government is under intense pressure to cut fuel prices.

In 2008, petrol prices fluctuated between Rs 45 and Rs 50 per litre and in 2018, they have fluctuated between Rs 70 and Rs 78 so far. In the light of this, questions before the government include: Why are prices “high” when international prices have fallen from $147 to $80 per barrel? Why have consumers not benefited because of lower oil prices?

Graph-1: International Oil Price versus Indian Petrol Price.

Under the UPA administration, when crude oil prices averaged $132 per barrel in July 2008 (it was during that month Brent reached a historic high of $147/b) petrol price was just Rs 50.62 per litre.

Now, when oil price is around $80/b, petrol price on May 28 has reached a high of Rs 78.27 per litre in Delhi. On the surface, it looks like Narendra Modi has been citizen-unfriendly.

Petrol prices reaching historical highs in May 2018 must have prompted former finance minister P. Chidambaram to say that Modi could easily cut petrol prices by Rs 25. However, when we analyse the factors behind the petrol price movement, and the decisions that the UPA took and what the NDA may do now, it becomes clear that it isn’t as simple.

An explainer

The NDA government was lucky in that oil prices fell soon after it came to power in 2014. It wisely decided not to pass on all the benefits to consumers. It increased excise taxes on petrol in small doses from Rs 9.48 per litre to current rate of Rs 19.48 per litre and for diesel it was from Rs 3.56 per litre to Rs 15.33 per litre.

Currently, taxes levied by the Centre and states account for around 47% in the case of petrol and 37% in the case of diesel.

Under the UPA’s pricing policy, public sector oil companies (Indian Oil, Bharat Petroleum and Hindustan Petroleum) bled. It also forced oil producing companies ONGC and OIL India to sell crude oil below international market prices to help marketing companies.

IndianOil service station. Credit: Wikimedia Commons

IndianOil service station. Credit: Wikimedia Commons

What the UPA did was to impose windfall taxes selectively only on them and in a non-transparent way. Unfortunately now, as we will discuss below, the NDA is also planning to adapt such a wrong policy, depriving ONGC and OIL of much needed capital and affecting future oil exploration.

The UPA’s irrational pricing policies also forced private sector oil companies like Reliance, Essar, and Shell to close down their thousands of stations. Their stations were far more efficient than the ones operated by the public sector giants. In addition, the so-called “under recoveries” (in simple term losses) by the public sector companies were hitting stratospheric levels. In 2012-13, under recoveries of public sector oil companies were at a mind boggling Rs 1.6 trillion.

One more comparison should convince how NDA’s policy was far more progressive than the populist policy of the UPA. While the NDA succeeded in collecting additional revenues of Rs 4.4 trillions during its four year rule, UPA incurred a loss of Rs 4.3 trillion by selling petrol and diesel below cost between 2005-06 and 2014-15.

Chidambaram is clearly aware of these facts. As per his suggestion, the NDA can reduce excise taxes by Rs 10 and revert to UPA-era levels. Where should Modi find the additional Rs 15 to cut?

The NDA’s finance ministry is unwilling to reduce excise taxes for obvious reasons of keeping fiscal deficit under control. It may ask PSU oil companies to absorb losses by reducing prices. It also expects state governments to reduce VAT, although it’s unclear if any state government is willing to forego revenues.

However, what it does seem to be getting closer to doing is adapting a flawed policy of the UPA. It has floated a trial balloon to impose so-called windfall profit taxes on oil producing companies – public and private. Any profit over $70/b will be considered as windfall profits and it will be taxed. It is not clear how the ministry has computed that at $70/b, oil companies are able to generate adequate cash-flow to support needed capital expenditure. No oil expert is likely to agree with such an assumption.

Besides, such a windfall tax will be in contravention of production or revenue sharing contracts signed with the oil companies. In fact, the underlying philosophy of PSA or RSA was to share profit/revenue above certain level with the government. When such is the case, it does not make sense to impose a separate windfall tax.

In 2011, the UK government imposed a ‘fair fuel stabiliser’ which actually was windfall profit tax on oil industry when oil prices were above $120/b. As in India, it was to reduce petrol and diesel prices to the consumer by diverting revenues from oil producers to oil consumers. Earlier, a supplementary charge on the oil industry was fixed at 20% and it has now been increased to 32%. The oil industry was given the assurance that when oil prices fall below $75 it would revert to 20%. To be expected, such a windfall tax imposed by Conservative party was not welcomed by all. The government came under attack even from some members of the cabinet. The oil industry warned that investment would suffer. Since the UK did not have contracts like PSAs to share profits when oil prices went above, the government could justify the windfall profit.

The US has also experimented with a profit tax in 1980. After two oil shocks in 1973 and 1978, US had controlled the oil prices for domestic production. In order to decontrol the prices, the government was forced to accept profit tax. There was fear that oil prices would rocket and oil companies would earn excessive profits. In order to claw back the excess profit, windfall taxes were imposed. As a result, oil production fell in the US and oil dependency increased. Later, under the Regan presidency windfall tax was eliminated. The recent US shale revolution which has benefited India and the world by bringing down the oil price was mostly due to liberalised pricing regime.

Pump jacks drill for oil in the Monterey Shale, California, U.S. on April 29, 2013. Credit: Reuters/Lucy Nicholson/File Photo

Pump jacks drill for oil in the Monterey Shale, California, U.S. on April 29, 2013. Credit: Reuters/Lucy Nicholson/File Photo

Instead of India learning from the US experience, NDA is giving the example of UK to consider windfall profit tax. If India does not want foreign investment to come to India, imposing this tax is a perfect formula.

Given the poor prospectives of India’s sedimentary basins, any imposition of a windfall tax would go against the government efforts to attract badly needed foreign investment. In recently held auction blocks under new Hydrocarbon Exploration Licensing Policy, not one foreign oil company had participated. Now, with the dagger of such a tax hanging over the oil industry, the chances of any foreign investment in India’s exploration would be even lesser.

Who do high fuel prices hurt?

It is unfortunate that the media and even some experts are claiming that “high” fuel prices are hurting India’s vulnerable and poor. This is a perfect example of fake news: Who is this common man? Who consumes petrol? It is mostly the owners of cars, SUVs and two wheelers. When 30% of Indians are below the poverty line and roughly 20% are just about the poverty line who cannot afford cars and two wheelers, is it really the common man suffering because of high petrol price?

It is true that diesel prices will hurt farmers who use diesel pumps (only 12% of total diesel consumption in agriculture sector) and those that use public transportation. However, any such impact can be mitigated by Direct Benefit Transfer to poor farmers rather than lowering prices artificially. Since India wants to contribute to the effort of reducing global warming, there is an urgent need to reduce petroleum consumption. Higher prices are one strategy to achieve it.

There is also the misconception that once petrol and diesel prices are brought under GST, fuel prices will fall. No government can afford to forego the revenues from petrol and diesel. World over, these two products are taxed heavily to support government budget. In about fifty countries in the world, petrol prices are above Rs 100 per litre and in Hong Kong it is Rs 145 per litre. Even in countries where they have GST-type of tax system, and petrol and diesel are brought under GST, an additional cess is levied to collect more taxes from them. Even in India when petrol and diesel are brought under GST, a similar policy will be adopted. Thus, to assume that GST will bring down fuel prices is an illusion.

The UPA’s munificence (selling fuels below cost) mostly helped the middle class and the rich. It also increased fiscal deficit resulting in higher inflation, which harmed the poor. NDA’s policy of not passing the benefits of lower crude oil price (by imposing additional excise taxes) may have helped them finance various welfare measures.

It is not that NDA is free from adapting populist policies: during the Gujarat and Karnataka assembly elections, petrol and diesel prices did not change to reflect increasing international crude oil prices. Public Sector Undertaking (PSU) oil companies stated that they were not influenced by any government mandate. But it is hard to believe the Centre did not intervene.

In the case of natural gas, NDA has also been less liberal than UPA. The UPA’s pricing formula which gave a higher price (even though it wasn’t ideal) was rejected by NDA and replaced by something totally irrational. This populist and totally irrational pricing policy has in large prevented the development of gas sector in India. However when NDA has adapted the right fuel price which helps the consumers in long term, there is a need to support it even at the risk of being termed a supporter of NDA.

No one likes paying taxes if they can avoid it. We know how a small percentage of India’s population pay income taxes. How can any government provide essential services (defence, police, health, education, water supply, power etc) and take up welfare projects if it does not have access to adequate funds? As discussed, petrol and diesel are taxed heavily in most parts of the world with exceptions of oil producing countries where they are often sold below cost to ‘buy’ support for the ruling class.

However, in a poor country like India where a large percentage of population live below poverty line, and 83% of our petroleum consumption is imported, it is great injustice to tax petrol and diesel at low rates or sell below cost. This fact is appreciated by all political parties when they are in power. We all know that there is no free lunch.

However, when parties are in opposition they feel it is their “opposition dharma” to protest higher prices. It is unfortunate that both NDA and UPA treat PSU oil companies as their convenient “ATMs”. It is high time that we as a nation should resolve the question of should fuel pricing be influenced to win victory for a political party or to develop the country?

Bhamy V. Shenoy has over 50 years of experience in international oil industry having worked for Conoco in US, and Europe. He was on the board of Georgian National Oil company and in India he served as a member of the advisory committee to chairman of ONGC.