A while ago, in 2012, while the UPA ruled India, the Gujarat Chief Minister joined the chorus against rising petrol prices with this tweet:

We now have a Prime Minister with a passing resemblance to the former Gujarat CM, and petrol prices are high again, leading to incessant chatter on social media about why they’re too high. Comparisons are being drawn with prices in the UPA era when crude prices were much higher, but prices at the pump were similar. Karma, one might say.

Once the NDA took over in 2014, belying some expectations of a drop in petrol prices, taxes were increased to absorb much of the crude oil price drop. As a result, the fiscal deficit is at a much more managable level, thanks to not having to deal with losses (euphemistically called under-recoveries) of oil companies due to administered pricing.

Are petrol prices too high?

Should petrol (and diesel) prices be reduced?

No! Petrol prices are too low in India — they do not account for negative externalities. A “negative externality” is a cost that someone bears when someone else consumes a product. When someone consumes fuel by driving their car, they increase congestion and pollution on the streets, which affects other people. Negative externalities of pollution and congestion have only increased since 2012.

By NOMAD — http://www.flickr.com/photos/lingaraj/2415084235/sizes/l/, CC BY 2.0, https://commons.wikimedia.org/w/index.php?curid=4783150

This makes the case for a Pigouvian tax increase on petrol. A Pigouvian (or Pigovian) tax is intended to correct precisely such a situation, where a negative externality results in over-consumption of a product, as viewed from society’s perspective. Such a tax should be set at a level (ideally) equal to the social cost of consumption of the product.

Gross indicators of negative externalities

Estimating negative externalities are hard. However, it’s often quite easy to see whether prices are too high or low at a gross level. A look at most Indian roads would see larger than optimal levels of private transport usage, and sub-optimal public transport usage. There is a prisoner’s dilemma at play there, where everyone would be better off if everyone would take public transport, but at that point, each individual would be better off if they took private transport instead. Also, rising pollution levels are a matter of concern in most Indian cities including Delhi and Bengaluru. At a gross level, it seems clear that negative externalities are underpriced, given that pollution and congestion are bad and getting increasingly so.

The right thing to do then, is to resist the calls to reduce petrol prices, and impose an increased Pigouvian tax on petrol and diesel, increasing by a substantial amount yearly to drive up the costs of using private vehicles, until a drop is seen in private vehicle usage, or a substantial shift to electric vehicles (which are increasingly a viable option) is seen.

The Common Man question

Won’t this tax hurt the “common man”? The “common man”, we must note, doesn’t drive a car. Those that do will pay for below-par petrol prices in other ways, through higher income or consumption taxes (unless they’ve been evading them, which makes the point even stronger), or through higher inflation. This is in addition to the costs of pollution and congestion noted earlier.

For example, as Shekhar Gupta points out:

That inflation of 12.3% was driven in good measure by the substantial fiscal deficit, which wasn’t helped by having to compensate oil marketing companies for fuel prices being kept artificially low.

What to do with the increased revenue

To reduce negative consumer perception, this should be explicitly linked to reducing GST and Income Tax rates. GST and tax rates in India are too high, and increased revenue from fuel taxes should be used to explicitly bring them down, which will boost economic activity.

Public transport in many cities in India is underfunded. In Bengaluru, for example, the government owned bus service is mostly unsubsidized, and runs as a commerical operation. Public Transport has positive externalities, and should actually be subsidized. Another good way of using petrol tax revenues is to transfer part of them to a fund earmarked to subsidize public transport local to the region from which the tax was collected.