Reforming fuel taxes

Combination of GST and carbon tax can help

Addressing the chief ministers of the states last week, Prime Minister Narendra Modi said that the Union government had reduced excise duty on fuel last November, but pointed out that some states had not followed this lead. He singled out several non-Bharatiya Janata Party (BJP)-ruled states in particular, and urged them to reduce the value added tax (VAT) that they levy on fuel. The prime minister’s exhortation did not go down well with the states in question, who raised several objections to his statement. They pointed out that the Union government has earned windfall gains on fuel production and taxation in recent years, and that even without a VAT cut fuel taxes were lower in several of the states Mr Modi mentioned than in the neighbouring states ruled by the BJP. Kerala’s finance minister, for example, pointed out that while the Union had raised taxes on fuel multiple times in the past few years, his state had not done so — and thus it was being asked to roll back increases it had never made.

Yet the problem about taxation of fuel goes deeper, and unless structural issues with the tax system are solved, tension between the Union and state governments on this account will continue to grow. The original error was made in the failure to incorporate fuel into the reform of the indirect tax system that led to the introduction of the goods and services tax (GST). Petrol and diesel have been kept out of the GST net, which means that not only are consumers not given the advantage of being able to set off their costs as input credits, but also that there is no uniformity in the tax system. The GST has a pre-determined sharing formula built in, and therefore such skirmishing about relative tax rates will no longer occur. These disagreements encourage the politicisation of fuel taxes, which is not in the interest of either the broader economy or of the smooth functioning of the federal polity. Thus, it is essential that a plan be devised to transition fuel into the GST net.

This will be far from straightforward. For one, there are good reasons to keep fuel taxes high. This incentivises switching away from fossil fuels and speeds up the green transition. The fiscal implications for both Union and states will also have to be thought through. But these issues are not insurmountable. Indeed, the two problems can be solved together. Bringing fuel under the GST will mean that overall taxes on petrol and diesel will have to be reduced to conform to the GST slabs. But in order to maintain revenue neutrality, an additional levy can be charged to the extent that current collections are higher than what they would be under the lower GST rates. This additional levy can be a special excise duty. It can also be defined as a carbon tax in keeping with international norms. This will also allow India to make an even stronger case internationally that it is meeting its commitments on climate change. This may not be the best solution, but it is certainly better than the present situation. Ideally, revenue from the carbon tax should be directed towards decarbonisation or sustainability projects, and shared to this end with the states. A major point of contention between the Centre and states would thus be removed.