Economy Ram Bharose: Taxing fuel will hit consumption, savings and growth

In the good old days, Governments raised revenue for administration by taxing salt, because it was used by everybody; its production was easy to centralize; it cost almost nothing to produce; and the 90% of the selling price was literally revenue. Gandhi ji used salt to launch his independence movement against British rule by defiantly producing salt from the sea, to show the British how fragile their hold over India could be, if people took to defying their Salt Laws. Defying the Salt and Excise Act, was an act of sheer political and economic genius.

Governments are always on the lookout for commodities like salt in order to tax every person in the realm. Crude, or the products derived from it, is one such commodity in the Indian context. Its use in all economic activity is essential; it is price inelastic; and the tax on it is easy to collect at petrol pumps, or a port of entry. So it is one of the ideal commodities to tax for revenue generation. Furthermore, the commodity is largely imported. A higher price would encourage more local exploration and production.

Given all these advantages of using petroleum as a tax mule, one cannot fault Modi for reversing the policy of previous Governments for subsidizing petroleum consumption, when prices of crude peaked circa 2010, in the hope that, crude prices would moderate in future. Such policies pushed up fiscal deficits, and constituted a large non-merit subsidy to the middle class, peaking at nearly 1% of GDP under UPAII.

So how do we parse the hue and cry about high taxes on petroleum prices to understand the policy issues involved?

Firstly, there is no doubt that almost two-thirds of the price of petrol or diesel at the retail level is tax. But this tax is deliberate taxation of a price inelastic commodity that is largely imported. The high taxation is design not accident; feature, not bug. If petroleum were not so taxed, something else like food would have to bear higher taxes. The question then is if it’s better to tax food or petrol, and the answer would undoubtedly be petrol.

Next you may question the need for Govt. to raise so much in taxes. Are such high taxes justified by the Govt.’s need for revenue?

Every year, Govt. raises about 16% of GDP as taxes, 12% at the central level, and the rest in the states. Is this reasonable? If we compare this level taxation to those in countries like China, or USA, the total taxes raised by Govt. are very reasonable. In fact ignoring borrowings, tax revenues raised by Central Govt. vary between 10 to 12% of GDP, a level slightly lower than in China, or the US. So Indians are by no means overtaxed.

However, if Indians are not overtaxed, neither are the corporate tax payers in India. But the Modi Government slashed corporate taxes in 2019 by almost 10 percentage points, giving them a cash bonanza of 1.45 trillion INR per annum, without identifying, how the resulting shortfall in revenue would be made up. Nevertheless, people foolishly welcomed the tax cuts, under the naive presumption that lower taxes would in some magical way produce higher tax revenue.

Nothing of the sort ever happens except at extremely high rates of taxation, when they are moderated. Sure enough, tax receipts were falling, and hence, to make up the shortfall in tax revenue, Modi was forced to steeply hike taxes on petroleum products, in order to contain budget deficits. In short, tax cuts for corporates are being funded by increasing indirect taxes on petroleum products.

What are implications of such a strategy?

Firstly the tax cuts to corporates were predicated on two assumptions: (a) that the tax cuts would spur corporates to invest more in existing or new businesses, thus enhancing future growth of the economy, and (b) lower direct taxes on corporates would help attract “value-chain” investors, fleeing Chinas’s higher costs, to come to India via the FDI route. Neither has happened so far.

Value-chain investing is far more sensitive to relative movements in exchange rates between trading partners, than to tax rates, by an order of magnitude. Unless India implicitly undertakes to pursue sensible exchange rate policies to protect wafer thin profit margins of value chain contract manufacturing, no amount of corporate tax cuts would induce them to come to India, except to serve the local market. FDI data shows no pick up in FDI has happened nor is it expected to. So this was just ruse for justifying tax cuts. [See IMF note to Govt. under Article IV consultations.]

Neither has investing in new capacities picked up, as shown by the GFCF data series, which continue to drift downwards in line with past trends.

Instead the tax cuts have spurred a boom in corporate profits; even with crashing sales, due to lack of demand caused by the pandemic. The well off are therefore thrilled by their new wealth; but as far the real economy is concerned, we are still at the level that obtained in 2019-20. How long can this unreal party can continue is unclear.

Secondly, we have to assess the deflationary impact of higher taxes on a price inelastic commodity like petroleum products on consumption and aggregate demand, keeping in mind its imported, & so constitutes a double whammy to the economy. We have to see, if it helps the economy in any way for Govt. to balance it books, in the manner it has chosen, following corporate tax cuts.

Firstly, in simple terms, what you spend on petroleum out of necessity, has to come from your future savings, if you are lucky to have any, or out of consumption elsewhere, in your total consumption basket. This means either consumption or future savings will fall. There is evidence that consumption, which is 60% of GDP is falling. So higher taxes have moderated growth in consumption already. Furthermore, we can expect a 0.5% to 1% percentage fall in gross savings in the economy in the coming years due to the tax cuts. The fall in household savings may get offset by higher corporate saving, but not to a like extent.

In short, the taxes on petroleum products are reducing consumption, savings, and future growth, while the tax-cuts are producing no incremental investment to offset the reduction in aggregate demand. Future years will thus produce lower longterm growth, than would be the case without higher taxes on petroleum.

As crude prices rise, the tax burden on the economy will rise as well, exceeding the increase in basic price of crude by a large margin. So we have to be sensitive to the equities of Modi’s tax policies as well. Besides, crude being imported means that every Dollar you spend on its import, is a Dollar of lost consumption in India. That impact is highly deflationary, unless offset in some manner by fiscal policy.

Basically, indirect taxes like those on petroleum, extract more from the lower half of the income pyramid, than the rich. True the very poor don’t use petrol so much, but they are impacted by diesel price hikes, and general increase in other costs like public transportation.

Direct taxes are payable only if you have income. They are inherently fair and progressive. The net effect of Modi’s tax policies, has been to pass on the entire burden of the 1.45 trillion in tax cuts to corporates, to the lower half of the income pyramid, in a disproportionate and invidious manner.

When you tax the lower half of the income pyramid thus, you take away from consumption; and from the upper half in savings. The result is slower growth, and higher real interest rates, while inflation moderates, and the poor get poorer.

This squeeze on the poor will not be noticeable for a while. And they can always be pleased with cheap give aways like a free gas refill close to elections.

India’s elites will be quite smug about both lower growth in future, and higher effective taxes for the poor. But what happens when crude goes to $200 per barrel, as it probably will, in a couple of years? From what we have seen about Modi, he appears singularly unconcerned about the longterm.

The next election is all that matters; the economy runs Ram-bharose.

( The writer is an independent commentator. Views are personal)