When Prime Minister Narendra Modi advised mostly Opposition-administered State Chief Ministers to cut Value Added Tax (VAT) rates on petrol and diesel in “national interest”, it predictably set off a political and social media slugfest.
Union Ministers took to social media to helpfully point out how BJP-administered state governments had reduced VAT rates after the Centre cut its taxes on petrol by Rs 5 and diesel by Rs 10.
In November 2021, while Opposition-administered states didn’t do so, they were countered vehemently by Chief Ministers and their Finance Ministers in non-BJP run states, who talked about VAT remaining constant even while the Union government had increased taxes multiple times; they also talked about money owed to them by the Union government.
Earlier, various Union Ministers, when queried about why they didn’t cut taxes further, have often said that it was because of the UPA-era oil bonds that they needed to repay.
Who'd Want to Let Go of Money?
Oil economics is complex and wars on social media and television debates typically cherry-pick facts to make political points. The big picture is that the economy is not doing too well, and neither the Union government nor state governments are willing to forgo any revenue in such a situation.
To understand the big picture, one needs to talk about the Goods and Services Tax (GST), oil bonds, overall tax revenue trends, non-tax revenue shortfalls, global disruptions, and many other issues.
Both the Union government and states are aware that if retail fuel prices remain high, it will be impossible to tame inflation. And that will have a host of rub-off effects, including reduced consumption, higher interest rates and lower growth. But neither side is willing to forgo any revenue given the dire economic fiscal condition they are in, and each would like the other to take the responsibility of reducing taxes.
To understand the genesis of the current political spat, you need to go back a little into history.
Petrol prices were ostensibly decontrolled by the UPA II government in 2010, while the Modi government decontrolled diesel prices in 2014. What it meant was that oil marketing companies were free to set the prices of petrol and diesel depending on their costs – which were primarily benchmarked to import parity – which, in turn, would depend on global crude price movements.
In theory, the government gave up its powers of fixing retail fuel prices. In practice, they use a number of strategies to reduce or increase the price that the consumer was actually paying. The basic instruments were tax rates and oil bonds.
Modi Just Got Lucky In His First Term
Shortly after the UPA II took the decision, global crude prices started hardening, which, in turn, raised the import parity prices. In 2010, crude was around $70 a barrel; by the next year, it had crossed $100.
A beleaguered Union government realised that passing on high prices to the consumers would make them suffer, and make the government even more unpopular than it already was. So, they took the help of an instrument first used by the National Democratic Alliance (NDA) government of Atal Behari Vajpayee – oil bonds.
They asked oil marketing companies to keep prices from going too high. In return, their revenue and profit shortfalls would be made up by the Union government, which issued oil bonds to raise the money for that. At any rate, keeping a lid on the retail fuel prices did not help the UPA II very much – they still resoundingly lost the general election in 2014.
Prime Minister Modi’s first term saw an unexpected piece of luck for the government. Global crude prices started dropping sharply, a fact that the Prime Minister even acknowledged in a speech. In 2014, when Modi had taken over as PM, the crude oil price was around $105 a barrel; by 2015, it had halved.
The then-Finance Minister, the late Arun Jaitley, realised that if the government’s good fortune – the drop in crude prices – was not passed on to consumers in full, the government would be able to get far more revenue than it had calculated. So, he increased excise on fuel multiple times as global crude prices kept falling.
Truths and Half-Truths
So, while oil marketing companies reduced prices at which they sold petrol and diesel in line with the drop in global crude prices, and, by extension, import parity of fuel, the Union government increased rates to mop up extra revenues. The consumer got meagre relief.
(PS: In 2018, hardening crude prices forced the Union government to reduce excise on fuel once more by Rs 1.50 per litre, while state-run oil marketing companies also took a Re 1 hit per litre).
The logic of the government was that it needed the extra revenue to reduce the fiscal deficit, pay for oil bond interest that came due, and to spend on infrastructure that was needed to spur economic growth. Like any other statement, this was only partially true. The logic for extra taxes held good in perhaps the first couple of years of the new government. But after that, it was used as a broad excuse.
Meanwhile, the GST came into being in 2017 after multiple rounds of hard negotiations between the Union government and state governments, and after a number of compromises. States gave up much of their rights of taxation under GST, but a few things were kept outside its purview, including alcohol and fuel. The Union government would collect the GST but would give a fixed proportion to states.
The theory was that after a year or so of initial hiccups, the GST system would improve tax revenues while also making it easier for companies to do business without worrying about different tax rates in different states. That the economy would do better after some glitches were ironed out was the hope.
How the UPA-Era Oil Bonds Became a Broad Excuse
Those expectations were belied. The economy did not pick up as Modi and Jaitley had hoped, despite opting for a revised GDP measurement methodology that would paint a rosier picture than the old methodology. Because the economy did not get going as expected, the general tax revenues – both direct and indirect – never kept pace with the government’s expectations.
The government realised that retail fuel demand was largely inelastic. It kept using the UPA-era oil bonds and other perceived mistakes of its predecessor as excuses to justify collecting excessive amounts via fuel taxes. It was a different matter that the amount collected via fuel taxes was more than enough to repay the oil bonds raised, multiple times over.
Meanwhile, Jaitley came up with one more idea that was brilliant as far as the Union government was concerned, but not particularly fair to states: excise duties collected by the Union government on fuel would be shared in a fixed proportion with states as they form part of the divisible pool of taxes, but any money collected as cess can be retained by the Union government without sharing.
So, Jaitley ensured that most of the Union government's taxes on fuel came in the form of cess, and not excise duty, which needed to be shared with states. In 2020-21 for example, while the Union government collected Rs 3.72 lakh crore from its taxes on petrol and diesel, the amount it gave to states as their share was merely Rs 19,900 crore or so. This was because the bulk of the money was collected via cesses.
Double Trouble: Economic Slump Meets Crude Oil Price Rise
Let us come to the state equation now. They levy their own VAT on fuel. The VAT is ad valorem, ie, it goes up when the price of fuel goes up and comes down when the price comes down. It is not a fixed amount that will be collected per litre sold irrespective of whether the fuel price goes up or down. This amplifies the pain for consumers when fuel prices rise.
Now, the problems for the governments got worse for two reasons. One, the economy started slowing in 2018. Second, global crude prices started hardening again. Tax revenue collections of the Union government did not keep pace with expectations, while a slowing economy meant it needed to spend more to prop up growth.
The GDP growth for FY219-20 had fallen to 4 per cent even before the full brunt of the COVID-19 pandemic roiled the global as well as Indian economy. A prolonged lockdown only added to the economy’s already existing problems in FY20-21, when the economy contracted by 6.6 per cent (first revised estimates).
With both tax and non-tax revenues shrinking further, the Union government was forced to increase taxes on fuel once more during the pandemic. The government raised excise duty twice, to Rs 32.98 per litre on petrol and to Rs 31.83 on diesel between 2019 and 2021.
Many state governments, too, increased VAT rates to shore up their resources. For state governments, things got worse when the Union government was slow in giving them their GST share and instead asked them to take debt guaranteed by the Central government.
How the Russia-Ukraine War Was Another Spoiler
The pandemic has left both the Union and state governments with a massive fiscal problem. The deficit is out of control and non-fuel tax revenues have not been enough.
Even though crude prices had started rising before the Russia-Ukraine war, they shot up immediately afterwards. Russia is a big producer of both oil and gas, and sanctions and other restrictions meant that global oil and gas supplies got affected.
Before the assembly elections in various states at the beginning of the year, the Union government had reduced its levies on petrol by Rs 5 and by Rs 10 on diesel. Various BJP-led state governments also reduced their VAT rates, while non-BJP states largely retained existing rates. Oil marketing companies, which are supposed to revise prices in accordance with market conditions, did their bit by making no change to fuel prices for over 100 days, even though the crude price and import parity prices spiked sharply. But after the election results were over, they hiked prices almost daily.
The Key Issue Is Dependence on Fuel Taxes
The Prime Minister’s comments thus lit a political fire. It was true that the Centre had cut some tax on petrol and diesel and also that BJP-run states had reduced VAT, while others hadn’t.
Non-BJP states say that if the Union government gave them the GST dues on time, and if it shared the fuel levies fairly (that is, if the Union government only levies excise, which is shared, and not cess), they can reduce their own taxes on fuel. This, too, is a valid argument.
However, the big picture that is missed in all the bitter exchange is that the economy needs to grow much faster, and so do other tax revenues. Unless that happens, neither the Union government nor states can reduce their dependency on fuel taxes.
BJP-administered state governments, or those in which the party is a partner in the government, rarely go against the Centre's suggestions. Opposition-ruled states, however, are unlikely to be persuaded by the Prime Minister's 'advice'.
(Prosenjit Datta is a former editor of Businessworld and Business Today magazines. He tweets @ProsaicView. This is an opinion piece and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)