Cut reliance on petro tax revenues

Sachchidanand Shukla | Updated on September 16, 2021

The shift to cleaner fuels will entail huge risks of long-term fiscal sustainability

Expectations are ripe of the inclusion of petroleum in the ambit of GST in the upcoming 45th meeting of the GST Council. Much of the recent focus and ire have been trained on the near-term impact of high taxes on petrol and diesel on consumer wallets besides some commentary on the impact on oil refiners and explorers. However, there is a much larger problem — the overwhelming fiscal dependence on a single source of revenue.

The energy sector is undergoing a massive overhaul as the world is trying to shed its fetish for fossil fuels and transition towards a low carbon economy. This transition is being driven by several push factors. The most important amongst these is in the form of incentives by governments, fresh regulations from regulators including central banks and shareholder activism-led push from the financing side.

Note how the government has completely pivoted its ₹26,000-crore PLI scheme towards laying a strong foundation for rapid adoption of electric vehicles (EVs) in India.

For India, the accelerating shift to clean power and to electrifying mobility will strengthen national security and potentially promote development of a robust domestic manufacturing industry. Yet, the writing is clearly on the wall, the move away from fossil fuels would entail huge risks of long-term fiscal sustainability.

Decarbonisation and the move towards an electric or renewable energy future will directly impact Central and State government revenues in a significant manner — some States more than the others. The sector contributed as much as ₹6.7 trillion to the exchequer in FY21, equivalent to 5 per cent of GDP, with 86 per cent of this amount coming in by the way of excise duties and sales tax.

This is estimated to have accounted for one-sixth of the total combined revenues of the Centre and the States and financed around 35 per cent of the aggregate government fiscal deficit in FY21. The Centre and the States have treated petrol and diesel as a cash cow over the years. They have hiked taxes on fuel products to garner additional revenues and support their fiscal positions, given the largely inelastic nature of demand owing to the lack of substitutes for these products.

Even in FY21, when petrol and diesel consumption declined by 6-12 per cent, aggregate collections by the way of excise duty and VAT on fuels surged by 35.7 per cent due to the sharp increase in taxes.

While it will be a few years before the impact is substantial, it is imperative that the key stakeholders start working on a roadmap or risk a dramatic shortfall in public services as this revenue source dwindles.

Also, the transition to a low-carbon economy could leave a wide range of carbon-intensive assets — that is, large quantity of fossil-fuel reserves and infrastructure — “stranded” or unusable. This could expose the financial system to risks.

Moreover, oil and gas companies and electricity utilities are significantly debt financed which can exacerbate the potential financial stability impact of a sudden revaluation of stranded assets.

This initial ‘revaluation’ shock could in turn trigger systemically relevant second-round effects. The contagion could reverberate across the corporate bond markets and the financial system.

There is no option but to look at some tough imperatives down this road to low carbonising of this economy:

First, the government will have to persuade States to agree to bringing petroleum products under the GST regime — this has been hanging fire for a few years now. Note that the fiscal bargain of States getting guaranteed 14 per cent annual GST revenue increase is set to expire and will be up for renegotiation.

Second, creating just and equitable transition policies will become important to balance social and economic goals but will require collecting data on the current distribution of the pros and cons of the current system, and mapping out how this will change as fossil fuels become a less-important in the energy mix.

Third, the energy sector policy has to be reviewed holistically. Electricity is outside the ambit of the GST Council as it is a Concurrent subject in the Constitution and will require a constitutional amendment. Cross-subsidisation for users (low-income groups, important industries, farm sector, etc) will have to be tackled. State governments impose taxes on electricity, but the Central Government’s loss of revenue from fossil taxes would have to be compensated in some other way.

Broaden the tax base

And, lastly, ways will have to be found to broaden and diversify the tax base away from an emissions-intensive economy. Identifying new streams of revenue, such as the taxation of environmental externalities — example, tax on electricity or carbon tax — where there is significant space for broadening the tax base and increasing rates to help bridge the gap in revenues.

New business models and diversifying economic activity will be crucial for expanding the government revenue base to ensure fiscal and economic sustainability. There are multiple examples — Norway, Scotland, the state of California and the UAE have all shown openness towards new ideas.

The government ideally should have crafted a medium-term framework for this transition and looked at ways to lower its over-dependence on the petroleum sector and identified alternative revenue sources over the next few years. But better late than never as this would be critical to fortify India’s public finances and public services in the medium to long term.

The writer is Group Chief Economist, M&M. Views are personal. With inputs from Rahul Agrawal, Economist, M&M

Published on September 16, 2021

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