Tuesday, June 29, 2010

Finally, A Big Bang Reform

On 25th of this month (june 2010) the Indian Govt. took a major step forward in reforming the Indian Economy. It freed petroleum prices from all regulation and indicated its intention to do so for diesel as well. That's not all, it increased diesel prices by Rs. 2 a litre, LPG by Rs. 25 a cylinder and even increased the kerosene prices, long untouched from price hike. Read the details here.

Now opposition parties have a real issue to thrash the Government on. This statement sounds derisive of the opposition parties and yet there are real short term implications which are worrisome. Inflation, which has stressed the lives of common person on the street in the last several months, will flare up further. in fact this decision would result in price rise of a fairly universal nature affecting everyone including the middle class voter of this Govt. who had been benefited the most in the recent decade of reforms and Globalisation. If so, why did the Govt. take this step and risk facing ire of its vote bank? Why this shift (by no means a sudden one) from a long held policy of managed fuel prices? further, why am I happy about this decision?

First a quick reminder of the situation. According to CRISIL the oil PSUs were projected to lose Rs 74,300 crore on selling petrol, diesel, domestic LPG and kerosene below cost in FY10-11. The current hike in prices would recover Rs. 25,000 crores and would still leave a gaping hole of close to Rs. 50,000 crores to be subsidised by the Govt. Just for the sake of argument if the Central Govt. were to subsidise this fully - this adds three fourth of percentage point to its fiscal deficit. So here is one compelling reason for the Government to seal a leakage which was showing signs of going out of hand.

But wasn't this always the case, and the Govt. has been dealing with it in this way, unique only to us, Srilanka and Bangladesh, in this entire world. So why take the risk now?

Lets check another side of the picture - it is interesting to note that fuel prices are high in India because of its federal structure as well. Read this informative piece to get the complete picture - but in nut shell what it says is that state Governments levy a VAT of between 20% to as much as 35% on petrol. (In MP this happens to be one of the highest at 35%). On an average the central plus state taxes are equivalent to 40% of the price you pay for every litre of petrol, with the lion's share going to the state Govt. Further, what this means is that a price hike in fuel prices gets amplified at the state level, filling the coffers of the state govt., and creating a villain out of the central of Govt.
This is not all. Sales tax or VAT accounts for over 60% of the aggregate taxes of states, a good percentage of this comes from the levy on fuels. What this means is that states are heavily dependent for their revenues on taxes from fuels as they are unable to generate resources from where they should - levy of fee on services provided to citizens (but then that would be unpopular - isn't it?). In other words then - the Central Govt. when subsiding the fuel prices in part subsides the state Govts as well for their mismanaged administration.
What the central Govt. has done is that they have become a one time big villain now and then have left the states to defend themselves in future. Soon the media will start training its guns on state governments like Andhra Pradesh, MP and Tamil Nadu asking why are citizens paying such high taxes on petroleum. Better still Mr. Murli Deora has already asked the state Govts. to reduce taxes so as to mitigate the problems of people on the prices front. So the heat will soon turn towards the state Govt. Can you see why the opposition parties aren't creating half the "hulla" - of what they would on much more trivial matters. Well if you did not guess it already, most state Govts. belong to parties in the opposition at  the centre.

And then there is the ubiquitous connection between policy making in India and the Ambanis. Half a decade back the Big bro entered Petroleum retail trying to create a presence in the entire value chain of its flagship petroleum businesses. Many of us would remember the fate of the Reliance petrol pumps across the country which had to close shop (temporarily, it now turns out). I wrote this piece way back in May 2006. Little was I aware that I was so bloody insightful. I of course do not know this for sure - but why does my gut tell me that the connection is far too easy not to make out? So here is the story of why the government might have bitten the the proverbial bullet.

However, I am happy with he decision. Yes, I know what I am talking about. After lots of deliberation I bought a mid-sized car three years back - a delight to drive and a monster at the petrol pumps (I pay almost 5+ Rs. a KM to drive it on old prices of petrol). Little did I knew that Dr. Manmohan singh's govt. will stop sharing the cost. :)

What makes me happy is that on a macro front this is a step in the right direction. The monstrous and pointless subsidy on automobile fuels is a structural anomaly in the economy. Let me explain. When Central Govt. subsidises fuels - who pays the cost? The taxpayers (I am tempted to write - honest taxpayers). While most profligate consumers of petrol are not these honest taxpayers. So indirectly the Govt. is making you and me pay for these consumers (including the Govt. which is the single most profligate consumer of petrol). My very modest parents purchased their first car and ran it just over 60,000 KM in ten years. I am sure that if you are reading this you can relate many of their ilk. They have been paying for these subsidies for years now.

What decontrol has done is that it will make people pay for their usage. Simple. This can pave the way to reduced deficits for the Govt. (as they will not pay the subsidy at least not to this extent) which will result in two welcome developments for the honest tax payers - further rationalisation of taxes (read reduced tax rates) and a stronger rupee, both of which will help the "Aam Aadmi" in the long run. This Govt. is only two years into this tenure - they might be expected to reap some of the benefits by the end of this tenure, by which time the new Direct Tax Code might also become a reality. Cool. :) So while inflation would happen - I get a feeling that the step will also make the middle class more able to pay the higher costs.

What about the pain during the transition? Well, one of my profs at the IIML said way back in 1996 - that is a cost of past sins. But my take is that the decision is positive to the Indian economy in the long run.