Time to rationalise fuel taxes: Oil is a major input in production & hence a tax on it is highly inflationary

By Abhishek Kumar

The seeming disconnect between retail and wholesale inflation is not new. In the months between April 2020 and November 2020, retail inflation remained above 6%, while average wholesale inflation was -0.20%. A similar disconnect was seen during the financial crisis (2008-2009) when wholesale inflation came down significantly as commodity prices crashed after a boom, but retail inflation kept rising. This disconnect is reflected in the contemporaneous correlation between these two measures of inflation, which we find to be very low (0.04), and not significant. Therefore, it would seem that the two measures are driven by distinct and unrelated shocks.

However, we cannot rule out feedback from wholesale inflation to retail inflation. The delayed feedback from wholesale inflation to retail inflation is also reflected in the household inflation expectations survey of the RBI.

To better explore this, it helps to understand the driving forces behind retail and wholesale inflation. We use the data from the new series of CPI and WPI. Retail inflation and its components are available from Jan 2014 whereas wholesale inflation and its components are available from April 2013. Retail inflation is closely linked to food and beverage prices, partly because of their higher weightage in the consumer price index (CPI). The correlation between retail inflation and food and beverages inflation is 0.93 and statistically significant.

High retail inflation in 2020 was primarily due to the rising prices of food and beverages. But it is very difficult to argue that this surge in food and beverages inflation was demand-pull, as Covid-19-induced lockdowns led to a broad-based decline in income and demand. The surge was likely led by the usual supply shocks—rainfall, agricultural productivity, or Covid-19-induced supply shocks. While Covid-19-induced lockdowns did not affect farm activity directly, they may have contributed to inflation by disrupting supply chains. In later months of 2021, as food and beverages inflation came down, retail inflation too declined, but to a lower extent as the prices of its other components, such as fuel and light and transport and communication rose. This suggests two important features of Indian retail inflation: it is predominantly led by supply shocks (food inflation shock) and it is transitory in nature. The latter can be deduced by the fact that even though retail inflation was over the upper bound (6%) of RBI target for several months, it came down on its own, without any increase in the interest rate.

This brings us to wholesale inflation, which has been rising. High wholesale inflation in recent months was mainly due to rising prices in fuel and power and manufacturing, which together comprise around 77% of the wholesale price index (WPI). A single component of the WPI, fuel and power, recorded 39.81% inflation in November 2021. What caused these prices to rise? The fuel and power component of India’s wholesale inflation is highly correlated with world energy prices (0.89). Rising fuel and energy prices in India were a result of the recent increase in global oil prices. And the higher inflation in transport and communication is partly due to the pass-through of higher fuel and energy prices.

High wholesale inflation should not warrant any immediate policy responses as the two inflation measures seem to reflect different things. Overall, the high correlation between world energy inflation and India’s wholesale inflation (0.88) indicates that India’s wholesale inflation is predominantly driven by world commodity prices. On the other hand, the low correlation between India’s retail inflation and world energy inflation (-0.13, and not significant), suggests that India’s retail inflation is primarily driven by domestic food prices.

It is worth mentioning that India registered phenomenal growth rates during from 2003 to 2008, while commodity prices rose rapidly, more than doubling over the period. Higher wholesale inflation implies a higher profit margin for producers, which acts as an incentive for investment. There are, in fact, some early signs of a revival in investment in recent quarters, and policy must be careful not to derail this. Of the three important components of domestic demand—private consumption, government consumption and investment—only investment has been higher in Q2 FY22 compared to Q2 FY20. This brings us to important questions about our policy options. Given the pass-through of wholesale inflation into retail inflation, if the ongoing commodity boom persists, then the fuel and power component of the WPI is likely to raise retail inflation directly. At that point, there would be some urgency to increase the interest rate, which may be premature and could dampen the revival of growth prospects.

Usually, demand-led inflation implies that output is above the potential level and tighter monetary policy would bring it to potential. In the case of cost-push inflation, tighter monetary policy would bring output below the potential to reduce inflation, leading to significantly higher output and employment costs. Clearly, to avoid the interest rate response, the best option going forward would be to rationalise fuel taxes, to reduce the pass-through of global commodity prices into wholesale prices and ultimately into retail inflation. These taxes now account for almost 50% of retail prices (of diesel and petrol), when one aggregates the excise duties levied by the Centre and the sales tax/VAT levied by state governments. Oil is a major input in production and hence a tax on it is highly inflationary. The correct fiscal-monetary coordination requires fiscal policy not to be inflationary, so that the RBI can support growth by keeping interest rates low.

The author is Associate fellow, Centre for Social and Economic Progress (CSEP)