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Why fuel holds key to high inflation and why that’s bad news

Oil prices have been going up because the global economy is expected to do better than it did last year, as more people get vaccinated and economic activity recovers.  (Photo: Mint)Premium
Oil prices have been going up because the global economy is expected to do better than it did last year, as more people get vaccinated and economic activity recovers. (Photo: Mint)

The high excise duty on petroleum products is likely to stay through 2021-22, given that the low collections on the corporate tax front will continue and the government needs to compensate for that from somewhere. This will add to inflation as measured by WPI.

In May 2021, inflation as measured by the wholesale price index (WPI) stood at 12.94%. This is the highest in the current series, which starts in April 2012. Inflation is the rate of price rise.

Source: Centre for Monitoring Indian Economy.
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Source: Centre for Monitoring Indian Economy.

One reason for this rise is the base effect. Prices in May 2020, as measured by WPI, had fallen by 3.37%.

The other reason is the rise in oil prices between May 2020 and May 2021. Data from the Petroleum Planning and Analysis Cell tells us that the average price of the Indian basket of crude oil had stood at $30.6 per barrel in May 2020. It more than doubled to $66.95 per barrel on an average in May 2021. This has pushed up fuel prices over the last one year.

Under WPI, there is an entry titled 'mineral oils', which includes petrol, diesel, domestic cooking gas, kerosene, aviation turbine fuel, etc.

Mineral oils have a weightage of 7.95% in the WPI. Their prices have risen by 81.16% in the last one year, and are hence, responsible for a bulk of the inflation. Of the overall inflation of 12.94%, nearly half, which is 6.45% (7.95% of 81.16%) came from the rise in fuel prices. Basically, to restate the point, nearly half of the inflation is because of the rise in fuel prices.

But all this is with the benefit of hindsight. The question is what the future holds for us. Let’s take a look at this point-wise.

1) Oil prices have been going up because the global economy is expected to do better than it did last year, as more people get vaccinated and economic activity recovers. In fact, as of 11 June, the price of the Indian basket of crude oil had jumped to $72.98 per barrel. As long as the global economic recovery story stays intact, oil price will continue to remain higher than it was last year. In fact, between June 2020 and November 2020, the monthly average of the Indian basket of crude oil moved between $40-44 per barrel. What this means is that unless oil price falls in the months to come, inflation as measured by WPI will remain high.

2) Besides the high oil price, there is something else at play as well. Ever since winning the 2014 Lok Sabha elections, one strategy followed by the current government to earn revenues, has been a higher tax on petroleum products. The initial justification for the strategy came from the fact that oil prices are falling, and hence, we are raising taxes. By that logic, when oil prices go up, the taxes on petroleum products, should come down. But that hasn’t happened. The major reason for this lies in the fact that tax collections have slowed down in the last few years. Gross tax collections in 2017-18 had stood at 11.23% of GDP. This fell to 10.25% of the GDP in 2020-21.

Corporate tax collections slowed down from 3.34% of the GDP to 2.32%. This was primarily on account of a massive cut in the corporate tax rates in September 2019. The goods and services tax (GST) never turned out to be the money-spinner that it was expected to be. Central GST collections in 2018-19 (the first full year of GST) had stood at 2.42% of the GDP. They fell to 2.31% in 2020-21. The central government has tried to compensate for the lower taxes by increasing excise duty on petrol and diesel. Also, much of this excise duty is in the form of a cess and a surcharge, which the government doesn’t have to share with the states.

Take a look at the following table which plots the excise duty earned by the central government over the last few years.

Source: Petroleum Planning and Analysis Cell. Between April and December 2020.
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Source: Petroleum Planning and Analysis Cell. Between April and December 2020.

As can be seen from the above table, the excise duty earned on petroleum products during April to December 2020 stood at 2.36 trillion. The excise duty earned just during nine months of the last financial year (2020-21) was more than the amount earned during previous years. It is safe to say that the central government would have earned more than 3 trillion through this route in the last financial year. This was when the overall economy contracted and there were lockdowns in place across large parts of the country through the year, inhibiting movement.

Hence, central government tax collections on petroleum products went up despite sales of petroleum products falling by 9.1% during the course of the year. This happened primarily because the government increased the excise duty on petrol and diesel massively during the course of the last financial year.

3) The high excise duty on petroleum products is likely to stay through 2021-22, given that the low collections on the corporate tax front will continue and the government needs to compensate for that from somewhere. This will add to inflation as measured by WPI. It will also impact private consumption in its own way. With the incomes either stagnating or not rising at all, the extra money that people end up spending on petroleum products, will have to come from somewhere. And this will mean a cut in expenditure in other areas.

Vivek Kaul is the author of Bad Money.

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