The government faces a new internal trade-off between fiscal stability and sticky inflation.
The government has a difficult decision on whether to keep gasoline and diesel prices high or low, since in either case, retail fuel prices will hurt the economy in their own way. While high fuel prices can generate more revenue for the government, they can also lead to higher headline inflation. Similarly, low fuel prices can keep inflation in check, but can affect the Center’s revenue.
Faced with falling revenues in the first weeks of the coronavirus pandemic, the central government had used the collapse in global crude oil prices to increase excise duties on fuel. However, rising oil prices are now being fueled by already high inflation. Consequently, the government faces a new internal trade-off between fiscal stability and sticky inflation, according to a Barclays report.
It is estimated that an increase of $ 10 per barrel in the price of crude oil implies an increase of 5.8 rupees per liter in the retail prices of gasoline or diesel. This would add almost 34 basis points to headline inflation for three to six months if the government does not reduce taxes on petroleum products. However, a cut of Rs 5.8 per liter in gasoline and diesel taxes to offset the rise in crude oil prices would result in a loss of revenue of Rs 87,200 crore, which is almost 0.39 percent of GDP. The Barclays report suggested that this would raise inflation by about 56 basis points, given the current level of inflation and the size of the fiscal deficit.
The government could cut fuel taxes by an amount equal to the impact of the oil price change, but that could widen the tax gap while limiting prices, Barclays added. Furthermore, the government’s priorities are believed to be firmly in favor of supporting the post-COVID recovery and therefore it would be more likely to opt for lower inflation and a higher fiscal deficit in the short term.
Furthermore, while the government can offset the short-term inflationary impact of rising oil prices by reducing excise duties, the medium-term impact is likely to be negligible. So the decision is not how to stop inflation, but when to tackle it.
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