What’s the Real Story Behind High Petrol and Diesel Prices?

Vivek Kaul and Chintan Patel

(If the charts and the images are not loading, click here

Between 2014-15 and now, taxes imposed by the central government on petrol and diesel have increased by 217% and 607%, respectively. The central government tax on diesel has gone up from Rs 4.50 per litre in 2014-15 to Rs 31.80 per litre currently. This is the real story. 

Petrol and diesel prices are at an all-time high across the country. When it comes to petrol, prices have crossed the 100-rupee-per-litre mark, in many states. As expected, the central government is being questioned on this price rise.

On July 2, the finance minister Nirmala Sitharaman said that no discussions were underway to arrest the rising price of petrol and diesel. Her response to a question on rising prices of petrol and diesel was: “When the international price of crude oil is higher, we have to increase the prices and when the international price is lower, we have to decrease the prices here too. This is a market mechanism which is followed by oil marketing companies. We have given them the freedom.”

Citing the financial burden of the central government’s efforts on vaccine procurement, health infrastructure, and free food to the poor, she added that “state governments can give relief by reducing taxes or levies on petrol.”

In fact, a couple of months ago, she had referred to the taxation of fuels as a “dharamsankat”.  So, what is this dharamsankat that Sitharaman bemoans?

Also, a lot of WhatsApp forwards have been going around explaining why it is impossible for the Narendra Modi government to cut petrol and diesel prices. One reason being offered is that the government needs to repay oil bonds issued by the previous UPA government. As we had explained on an earlier occasion this isn’t true. It’s just propaganda, albeit excellently run.

In this piece, we take the story forward with the hope that it can tackle some of the WhatsApp propaganda around petrol and diesel prices that is currently on.

Price breakdown

In most situations in business, a product is sold at a price which includes the cost of manufacturing the product, the taxes that the company has paid in the process of manufacturing it and the profit margin that the company hopes to earn. Of course, the taxes aren’t a major portion of the overall price.

That’s not true for petrol and diesel in India. Taxes, as we shall see, form a significant part of the overall retail price. The retail price or the price we pay for petrol and diesel at the pump, is made up of four components – a) The price at which the dealer buys petrol and diesel from the oil marketing companies like Indian Oil, Bharat Petroleum or one of the private companies. This price includes the cost of producing petrol and diesel and getting it to the pump where it is sold. It also includes the profit margin of these companies. b) The central government tax. c) The state government tax. d) Dealer commission.

Of the four components, the price at which the dealer buys petrol and diesel from the oil marketing company, is the biggest variable. It is tied to the price of international crude oil. If the price of oil goes up, as it has since April 2020, the price of petrol and diesel also go up. In April 2020, the average price of the Indian basket of crude oil had fallen to $19.9 per barrel.

In June 2021, it averaged at $71.98 per barrel. As of July 13, it had risen to $74.97 per barrel. This, as Sitharaman said, is the main reason for the increase in petrol and diesel prices in the recent past. We would like to say that this is not the reason, but a reason. We will explain the details as we go along.

India produces very little oil of its own. In fact, the overall import dependency in April and May this year was at 85.4%. We are heavily dependent on oil imports. Hence, if price of oil goes up internationally, the price of petrol and diesel also go up within the country.

Now getting back to the components of the retail price of petrol and diesel. The second component is the central government tax, which is the central excise duty. This is fixed and only changes when the government decides so. (The central excise duty has further components, but we won’t get into that in this piece).

Then comes the state government tax on petrol and diesel. Some states refer to it as sales tax and in some other states it is called the value added tax. This tax is over and above the central excise duty and varies from state to state.

The pumps through which petrol and diesel are retailed also need to make some money. They earn a dealer commission, which is also a part of the per litre retail price . Having said that, the dealer commission is a small fraction of the total price, and mostly inconsequential in affecting the final retail prices of petrol and diesel.

Let’s look at the retail price breakdown of petrol and diesel in Delhi as of  July 1, 2021. The following table shows us that.

 Table 1. Price breakdown of petrol and diesel
(in Rs per litre): July 1, 2021 (Delhi)

Source : https://hindustanpetroleum.com/documents/pdf/pb/petrol.pdf

Let’s consider the price of petrol and try and understand this structure in detail. The price charged to the dealer is Rs 39.33 per litre. On this the central government charges an excise duty of Rs 32.90 per litre. Then there is a dealer commission of Rs 3.82 per litre.

These three entries add up to Rs 76.05 per litre. On this price, the Delhi government charges a value added tax of 30%, which works out to Rs 22.82 per litre. This is added to Rs 76.05 per litre and it adds up to a retail selling price of Rs 98.87 per litre of petrol.

It is interesting to note, the value added tax of the state government is charged on Rs 76.05 per litre, which also includes a central excise duty of Rs 32.90 per litre. This means that when you and I buy petrol we are paying a tax on a tax.  This is true across the length and breadth of India and not just in Delhi.

Also, it is worth mentioning that the value added tax or the sales tax of the state governments is ad valorem, which means it is a certain proportion of the sum of the dealer price, central excise duty and dealer commission.

So, if the dealer price goes up or the central government decides to increase the excise duty, the state governments earn a higher tax per litre of petrol sold. What is true for petrol is also true for diesel, though the numbers change and so does the calculation accordingly.

Now let’s look at what proportion of the retail sales price do each of the four components form. Figure 1 and Figure 2 show that for petrol and diesel, respectively. The data is as of July 1.

Figure 1


Source : https://hindustanpetroleum.com/documents/pdf/pb/petrol.pdf

Figure 2

Source: https://hindustanpetroleum.com/documents/pdf/pb/petrol.pdf

Figure 1 and Figure 2 make for a very interesting reading. In case of petrol, the dealer price forms 39.8% of the retail price of petrol. The rest are largely taxes, imposed both by the central government and the state government. The taxes added up to 56.4% of the retail selling price of per litre of petrol in Delhi as of July 1.

Along similar lines, the dealer price makes for 46.8% of the retail price of diesel. The rest are largely taxes. Taxes amount to 141.7% of the dealer price for petrol and 107.3% of the dealer price for diesel. So, taxes form a significant portion of the price of petrol and diesel.

The interesting thing is that the central excise duty on petrol and diesel has been raised over the years. Up until early May 2020, the excise duty on petrol was Rs 22.98 per litre. It was raised to Rs 32.98 per litre. When it comes to diesel, the excise duty was raised by Rs 13 per litre, from Rs 18.83 per litre to Rs 31.83 per litre.

From February 2, 2021, the total excise duty on petrol and diesel has stood at Rs 32.90 per litre and Rs 31.80 per litre, respectively. Clearly, a significant proportion the increase in price of petrol and diesel over the last one year has been due to an increase in the excise duty charged by the central government. Hence, it’s not just about global oil prices going up, as Sitharaman would like us to believe.

In fact, in May last year, India had the distinction of being the highest taxer of auto fuels in the world, a whopping 69%.  Since then, the portion of petrol and diesel prices that goes towards taxes, to both the central government and the state governments, has come closer to 50%, although the retail price at the pump has increased. Irrespective of whether it is 69% or 50%, taxes on petrol and diesel in India are high. Has it always been like that, or is it a recent development?

Let’s examine. Figure 3 plots the breakdown of the retail price of petrol over the years in Delhi (We are not obsessed with Delhi. But regular data in the public domain is only available for Delhi, hence, limiting our choice). For the sake of avoiding visual clutter, we have considered only the price in the month of May every year. In fact, petrol prices change frequently, sometimes several times a month due to fluctuations in crude oil prices.

Also, the central excise duty has been hiked more than once during some years. Thus, the chart below does not capture every price point over the last eight years but is still a good representative of the overall trend.

Figure 3

Source: Petroleum Planning and Analysis Cell

Now let’s try and understand this in detail. A look at the above chart tells us very clearly, the central government taxes on petrol have gone up over the years, from Rs 10.39 per litre in May 2014 to Rs 32.90 per litre in May 2021. This is a jump of around 217%. The state government value added tax in Delhi has also gone up from Rs 11.90 per litre to Rs 21.81 per litre, a jump of around 83%.

Clearly, taxes on petrol, more at the central government level than the level of state governments, have gone up over the years, and this has pushed up the retail selling price. Take a look at Figure 4 and Figure 5. They plot the proportion of each component in the retail selling price of petrol and diesel in May 2014 and May 2021, respectively.

Figure 4


Source: Petroleum Planning and Analysis Cell

Figure 5


Source: Petroleum Planning and Analysis Cell

As can be seen from Figure 4 and Figure 5, the price charged to the dealer, which was 66% of the retail selling price of Rs 71.41 per litre in May 2014, has since fallen to around 38% of the retail selling price of Rs 94.49 per litre in May 2021.

The central excise duty as a part of the retail selling price of petrol has jumped from 14.5% to 34.8%. This shows again that the increase in central excise duty has been a major reason for the increase in the price of petrol over the years. The increase in state government taxes have also played their role.

In fact, the dealer price of petrol in May 2014 was Rs 47.12 per litre in comparison to Rs 35.99 per litre in May 2021. Despite this, the retail selling price of petrol in May 2014 was at Rs 71.41 per litre, which was significantly lower than Rs 94.49 per litre in May 2021.

All that is true for petrol is also true for diesel. Figure 6 plots the price breakdown for diesel over the years. As can be clearly seen, the central government tax has gone up from Rs 4.50 per litre in May 2014 to Rs 31.80 per litre in May 2021, a jump of around 607%.

Meanwhile, the state government tax has almost doubled from Rs 6.61 per litre to Rs 12.50 per litre. When it comes to the dealer price for diesel, it was at Rs 44.98 per litre in May 2014 and at Rs 38.49 per litre in May 2021. Despite this, the retail selling price of diesel in May 2014 was at Rs 57.28 per litre, which was significantly lower than Rs 85.38 per litre in May 2021.

Figure 6


Source: Petroleum Planning and Analysis Cell

Let’s take a look at some interesting insights that emerge from the data above:

1) The price paid to the dealer was the highest in 2014. Since then, the dealer prices have come down, although not in a linear fashion. This is primarily because the average price of the Indian basket of crude oil in May 2014 stood at $106.85 per barrel. The oil price has seen a largely downward trend since then.

2) There have been some ups and downs when it comes to the dealer price, with the lowest prices for both petrol and diesel recorded in 2020, when they were around half of the price in 2014. This was on account of the price of the Indian basket for crude falling to $30.61 per barrel during May 2020, the lowest in any May since May 2014. Compared to the lows of 2020, dealer prices have risen by over 60% which explains the recent price surge at the pump. As explained earlier, retail prices have also gone up due to a massive increase in the central excise duty on petrol and diesel by Rs 10 per litre and Rs 13 per litre, respectively, in early May 2020.

3) From 2014 to 2021, taxes imposed by the central government have increased by around 217% on petrol and around 607% on diesel. The bulk of these increases were over two periods – from 2014 to 2015, and from 2019 to 2020, either by co-incidence or by design, both these periods were immediately following Narendra Modi’s election victories.

4) The first round of hikes in central excise duty in 2014 was effectively done to capture the gains from the drop in crude oil prices. The average price of the Indian basket of crude oil in May 2014, the month in which Modi was elected the prime minister, had stood at $106.85 per barrel. By January 2016, it was down to $28.08 per barrel. Instead of passing on lower prices to the consumer, the government decided to bolster tax revenues when global oil prices fell. Thus, the end consumer did not see a price decrease from the fall in crude oil prices.

5) After that, from 2015 to 2019, the central government tinkered with the central excise duty with marginal increases or decreases to keep the retail price somewhat bounded. In fact, in October 2017 and October 2018, the excise rate on both petrol and diesel was cut by Rs 2/litre and Rs 1.50/litre, respectively, to counter the increasing oil prices. The 2019 general elections also likely influenced these cuts.

6) The next big hike in central excise was in early May 2020, again around the same time when global oil prices plummeted in the aftermath of the covid pandemic, when the duty on petrol was increased by Rs 10/litre and that on diesel by Rs 13/litre. The price of the Indian basket of crude averaged at $19.9 per barrel in April 2020. It has since risen to more than $70 per barrel. But with a rise in oil prices in 2021, the excise tax has not been reduced. Hence, a higher oil price and a higher excise duty have both contributed to the rise in pump prices of petrol and diesel.

7) The charts above are for Delhi. As explained earlier, each state has a different value added tax or sales tax when it comes to petrol and diesel and a slightly different trend over the last eight years. A detailed analysis of every state is outside the scope of this piece. Nevertheless, the broader point stays the same. A major reason for the increase in the retail selling price of petrol and diesel, and the fact that petrol is selling at more than Rs 100 per litre in many states, is because the central excise duty on petrol and diesel, has been increased majorly over the years. The increase in state government taxes have also had a small role to play.

Officials in both the central government and state governments know that the current petrol and diesel prices are placing a high burden on the end consumer. Both sense discontent brewing on this issue, which can ultimately cost at the ballots. So, both stand to gain, if taxes are cut and prices fall.

Crucially, both have the ability to reduce the retail price, by lowering their portion of the tax. But the way things are currently it seems that the state governments would prefer the central government reducing excise duty, and the central government would prefer the state governments reducing the sales tax or the value added tax.

Given that both sides are standing firm, the consumer has ended up teary-eyed. Also, as we have seen, the central government taxes on petrol and diesel have gone up significantly more than the state taxes. Clearly, the ball is in the central government’s court.

To add more intrigue to the petrol and diesel tax saga, there is one other thing to consider. A part of the central excise duty is shared with the states. This part is referred to as the divisible pool. Much of the increase in central excise since May 2014 has been in the form of surcharge and cess, which are not shared with the states. We have discussed this in detail in an earlier piece.

As of 2021, only Rs 1.40 of Rs 32.90 collected through the central excise duty on per litre of petrol, and only Rs 1.80 of the Rs 31.80 collected through the central excise on per litre of diesel, goes to the divisible pool.

Since the states get 42% of the revenue from the divisible pool, they end up getting 59 paisa per litre which is a mere 1.8% of excise duty collected by the central government on per litre of petrol.  For diesel, the states’ share comes to 76 paisa per litre amounting to 2.4% of the central excise duty per litre of diesel.

Given that the central government has employed such a strategy of actively undercutting states’ revenue from the central excise duty collections on petrol and diesel, it is a tad optimistic to expect the state governments to be enthusiastic about a coordinated approach, where both the central government and the state governments reduce the taxes they collect on sale of petrol and diesel at the same time.

Central government dependence   

In the last couple of years, the central government has become overly dependent on the central excise duty that it earns on the sale of petroleum products (primarily petrol and diesel). In 2014-15, the central government had earned Rs 99,068 crore from this. This jumped to Rs 2.23 lakh crore in 2019-20. It jumped to an all-time high of Rs 3.72 lakh crore in 2020-21.

This compensates for the massive fall in corporate tax or the income tax paid on corporate profit. This had stood at Rs 6.64 lakh crore in 2018-19. In 2020-21, it fell to Rs 4.57 lakh crore, a drop of about a third. This happened because in September 2019, the government reduced the base rate of corporate tax to 22%, from the earlier 30%. Hence, the collections of corporate taxes fell in 2020-21, despite the massive increase in profits of listed corporates during the year.

Over and above this, a badly designed and run Goods and Services Tax has not brought in the amount of taxes it was expected to. As the Fifteenth Finance Commission Report put it: “In terms of government finances, [GST] was expected to improve the overall tax-GDP ratio in the medium term and lead to higher Union [central government] transfers to States.” But that hasn’t happened. This can clearly be seen in Figure 7.

Figure 7


Source: Centre for Monitoring Indian Economy.

There is no free lunch in economics. The costs of a fall in corporate tax collections and weaker than expected GST collections, are being borne by everyone who buys petrol and diesel in a direct way. In an indirect way, we are paying for it in the form of higher inflation.

This is why the central government cannot reduce excise duty on petrol and diesel. Their finances have become too reliant on the revenue generated by the excise duty on petrol and diesel.

The economy was already on weak footing when Covid hit. The pandemic triggered a massive reduction of economic activity – one that is still on going, which has reduced tax inflow from other sources. The fact that corporate income tax was cut hasn’t helped either.

Additionally, there are more financial demands on the government than the past. The government needs money to finance pandemic-induced expenses like vaccine procurement and improving healthcare delivery. All this could have been easily done if corporate income tax rates hadn’t been cut or GST had been launched and run properly.

In such an environment of decreased income, the government is unable to wean itself off  taxes it earns from the sale of petrol and diesel. In many ways this dilemma is self-imposed since this government’s original sin was its economic mismanagement before the pandemic hit. You construct a house poorly and a storm hits. Now you are drenched due to a leaking roof. Is the storm the only one to blame?

Good policy, bad policy

As a thought experiment, say the central government reduces the central excise duty on petrol and diesel by Rs 10/litre. The immediate knock-on effect will be one of the following three scenarios. One, the government will have to scale back spending to make up for the loss in revenue. Two, the government will increase a different tax (as we said earlier there is no free lunch). Three, the government takes on a higher fiscal deficit (the difference between its annual expenditure and revenue).

Given this, the government has decided to continue with the high central excise duty on petrol and diesel. But is that the best option available?

High prices of petrol and diesel cause misgivings in a large section of the electorate, especially the middle class and the poor. That the Modi government is willing to risk this public sentiment speaks to their confidence in assuaging voters through other avenues. While it’s for the government to figure out its politics on this issue, the economics of the decision though, can be debated.

As always, the economic argument on general topic of taxation of petrol and diesel is nuanced.  An increase in taxes on petrol and diesel (such as the central excise) has two negative economic impacts.

One, this leads to a higher inflation. Most goods need to be transported from where they are produced to where they are consumed, and the primary mode of transport of goods in India are trucks that run on diesel. So, when diesel prices go up, due to higher taxes or otherwise, price of most goods also increase. Inflation has its impact on consumption and that in turn slows down economic growth.

Two, a higher tax on petrol and diesel, is the opposite of a consumer stimulus i.e., it takes money out of people’s pockets. Higher fuel costs mean lesser disposable funds for other purchases, which then depresses demand for goods and services.  

One criticism of India’s economic response to the covid pandemic has been that most of the government actions have been directed towards suppliers and firms, instead of the consumers. Most developed nations have put money directly in the hands of citizens  to revive consumer demand.

Whether India’s fiscal situation allows for a meaningful stimulus is debatable, but surely a negative stimulus (which is what the higher central excise duty on petrol and diesel works out to), cannot help with the economic revival.

Given that the government has been addicted to taxes it earns from petrol and diesel, for more than a few years now, it has gone slow on disinvestment of its stakes in public sector companies as well as the land owned by them. The revenue that could potentially come in from here, could reduce the dependence on taxes coming in from the retail sale of petrol and diesel. But that hasn’t happened.

On the flip side, there is an argument in favour of higher taxes on petrol and diesel, related to environmental impact. Given the negative impact of fossil fuels on carbon emissions and global warming, higher taxes on petrol and diesel could/should in theory dampen their demand. However, in India, this line of reasoning is not very convincing.

Figure 8 shows the annual consumption of demand of petrol and diesel.

Figure 8

Source: Petroleum Planning and Analysis Cell

Other than 2020-21 which was affected by lockdowns and curfews, the demand for petrol and diesel has increased each year, despite changing prices. Moreover, diesel makes up for most of the fuel consumption, and it is particularly insensitive to price fluctuations since it is used for commercial transport and so the cost is passed on to the end consumer.

As RS Sharma, former chairman of ONGC said in 2018: “Demand for diesel is typically inelastic as most of the rise in price is borne by the end consumer and can be seen to directly impact inflation.”

Of course, one can’t rule out the possibility that if petrol and diesel prices had not increased due to a higher central excise duty, the demand would have grown even more. One cannot even quantify how the increased prices may incentivise adoption of alternative sources of energy, electric vehicles and such.

The trade-off between economic development and environmental stewardship is the ultimate dharamsankat of our times and taxes on petrol and diesel do lie in that realm. But we doubt that is on Sitharaman’s mind.

PS: This article can become the WhatsApp forward to beat all WhatsApp forwards. So, what are you waiting for? Press the share button.

India’s International Black Money Can’t Be Brought Back Though It Can Keep Coming Back

Black money has been a hot topic among us Indians over the past few years, especially Indian black money that has been stashed abroad, over the years. Possibilities of getting this money back to India have been raised and extensively discussed and can lead to flaring up of tempers on the University of WhatsApp.

In this scenario, any news item on the Indian black money stashed abroad tends to fly off the charts. The University of WhatsApp has been buzzing over the last few days on the news of Indian black money in Swiss Banks having gone up in 2020. This has led to surprise among the supporters of the present dispensation and happiness among those against it.

As the Press Trust of India reported: “Funds parked by Indian individuals and firms in Swiss banks, including through India-based branches and other financial institutions, jumped to 2.55 billion Swiss francs (over Rs 20,700 crore) in 2020.” This is a jump from 899 million Swiss francs (Rs 6,625 crore) at the end of 2019.

The Press Trust of India rightly doesn’t use the term ‘black money’ in reporting the funds that Indian firms and individuals have parked with Swiss Banks. Some amount of money can be taken out of the country legally every year and be deposited in Swiss banks (or other foreign banks for that matter).

This is not to say that all the funds that Indians have placed with Swiss banks will be kosher. But the fact of the matter is there is no way of specifically knowing that how much of it is black money. Black money is basically money on which taxes have not been paid.

Of course, after the Press Trust of India reported on it, other news media latched on to this story. In their reports, the phrase funds parked in Swiss banks was replaced with the term black money.

And soon headlines which said that Indian black money in Swiss bank jumps, were all over the place. Politicians from other parties also reacted to this piece of news and said that this was because of increased corruption under the Bhartiya Janata Party. This shows us clearly why nuance is neither a strength in politics or on the University of WhatsApp, for that matter.

The government immediately issued a press release, in which it said: “Media reports allude to the fact that the figures reported are official figures reported by banks to Swiss National Bank (SNB) and do not indicate the quantum of much debated alleged black money held by Indians in Switzerland.”

In all this noise, the more important points on Indian black money which goes abroad or doesn’t come back in the first place, were never made.

Let’s look at them here.

1) The money that Indians had parked in Swiss banks in 2020 has been estimated to be at Rs 20,700 crore. One dollar was worth around Rs 74 on an average in 2020. This works out to $2.96 billion. For the ease of discussion, let’s round this to $3 billion.

Even if all this was black money (which it isn’t), no media house bothered to ask a very basic question. How come the Indian black money in Swiss banks was just $3 billion? $3 billion on its own is a large number. But in the context of a nation which has had a history of a huge black money, this isn’t even small change.

2) A lot of black money is generated through trade misinvoicing. As Global Financial Integrity (GFI), an organisation which specialises in this area, defines this as “a method for moving money illicitly across borders which involves the deliberate falsification of the value, volume, and/or type of commodity in an international commercial transaction of goods or services by at least one party to the transaction.”

Imports coming into the country can be over invoiced. In that process, money can go out of the country without the required taxes being paid on it. Further, imports can be under invoiced to not pay customs duty.

In a similar way, exports going out of the country can be under invoiced and money that should have come back to the country, and taxes should have been paid on it, continues to stay outside its borders.

A number is put to this misinvoicing through the value gap analysis. As GFI explains in a report: “For example, if Ecuador reported exporting US$20 million in bananas to the United States in 2016, but the US reported having imported only US$15 million in bananas from Ecuador that year, this would reflect a mismatch, or value gap, of US$5 million in the reported trade of this product between the two partners for that year.”

While data on imports and exports is never perfect, a significant portion of any value gap is a result of misinvoicing, in order to not pay tax on money earned and ensure that it continues to stay abroad, or to simply move money out of a country. This is the largest component of illicit financial flows globally. In India, we call this international black money.

3) As per GFI, the average value gap of India from 2008 to 2017, a period of 10 years, stood at $78 billion per year, which in total amounts to $780 billion. This means that a significant portion of $780 billion would have left India during these years or should have come back to India, but never did. Of course, this is just one period of ten years that we are talking about. All this didn’t just start happening in 2008. Now compare this with the $3 billion lying in Swiss banks. That’s not even small change.

Also, it is worth remembering that we are talking about black money through just the misinvoicing route. As GFI points out: “Many illicit transactions occur in cash to prevent an incriminating paper trail. For these many reasons, our estimates are likely very conservative.”

Of course, this problem is not specific to India. China, Russia and Mexico were ahead of India, on this front, with an yearly average of $482.4 billion, $92.6 billion and $82.5 billion, respectively, during the period.

4) Take the case of 2016. The value gap of the misinvoiced imports and exports stood at $74 billion. As GFI points out: “The analysis shows that the estimated potential loss of revenue to the government is $13.0 billion for 2016. To put this figure in context, this amount represents 5.5 percent of the value of India’s total government revenue collections in 2016.” Given this, the government loses out on a significant amount of taxes because of international black money.

5) The question is, if so much money on which adequate amount of tax has not been paid, is going abroad every year or simply staying there, why doesn’t it reflect in the Swiss bank numbers. This is where things get interesting.

As the government press release referred to earlier points out: “These statistics do not include the money that Indians, NRIs or others might have in Swiss banks in the names of third–country entities.” This could be one possible reason.

6) The common perception in India is that all the black money that leaves India (or simply doesn’t come back) is in Swiss banks. This is totally wrong. There are around 70 tax havens all over the world. An estimate made by The Economist in 2013 suggested that: “Nobody really knows how much money is stashed away: estimates vary from way below to way above $20 trillion.”

And this money is spread all across the world and isn’t just held in banks in Switzerland. As Gabriel Zucman writes in The Hidden Wealth of Nations – The Scourge of Tax Havens, points out:

“In the past, Swiss bankers provided all services: carrying out the investment strategy, keeping securities under custody, hiding the true identity of owners by the way of famous numbered accounts. Today, only securities custody really remains in their purview. The rest has been moved offsite to other tax havens—Luxembourg, the Virgin Islands, or Panama—all of which function in symbiosis. This is the great organisation of international wealth management.”

Given this, India’s international black money could possibly be anywhere in the world. Also, a lot of this money is held “through intermediaries of shell companies headquartered in the British Virgin Islands, or foundations domiciled in Liechtenstein.” This ensures that the money is not easily traceable to those who took it out of the country or decided not to bring it back.

7) It is worth remembering here that all the focus on black money in India should have made people who stash their black money abroad, smarter. Clearly, when everyone and their grandmother knows about Swiss banks, the black money wallahs are bound to be cautious and ensure that they spread their money around across the world.

8) So, the question is how good are India’s chances of getting this money back? The money that has left Indian shores or should have come to India but never did, could be anywhere. Tax havens maintain secrecy to ensure that they remain attractive options for those who are looking to hide their black money. Hence, recovery will continue to remain difficult. If even a small part of this money is to be recovered, a massive amount of international cooperation will be needed.

9) While it might be difficult to recover black money from outside India’s shores, some of it does keep coming back to India through the foreign direct investment route. A lot of this money comes in through countries like Mauritius, Singapore, Netherlands and Cyprus. In 2020-21, 44% of the total foreign direct investment coming into India, came from these countries. This was a low figure in comparison each of the five years before that, when the proportion had stood at more than 60%. Of course, not all this money is India’s international black money, but a significant portion might be.

As the finance ministry white paper on black money published in May 2012 had pointed out:

“It is apparent that the investments are routed through these jurisdictions for [the] avoidance of taxes and/or for concealing the identities from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, though a process known as round-tripping.”

India’s international black money is also round-tripped to be invested in stocks. 

To conclude, instead of trying to chase this black money and get it back, it makes more sense for us to create economic conditions where this black money comes back to India and is invested in different projects. We should also try and simplify our tax system to ensure that the incentives to generate black money in the first place, come down. 

But then that hardly makes for great rhetoric and management of narrative, which is what Indian politics seems to be all about these days. As Thomas Sowell writes in Knowledge and Decisions: “Sober analysis seldom has the appeal of a ringing rhetoric.”

And that’s something worth thinking about.

Petrol and Diesel Prices are High Due to Lower Corporate Taxes, Not Because of Oil Bonds

Life is what happens between WhatsApp forwards.

Yesterday evening, a friend from school WhatsApped a doubt he had. He wanted to know if petrol and diesel prices were high because the Narendra Modi government had to repay oil bonds, which had been issued by United Progressive Alliance (UPA) government more than a decade back.

To repay these oil bonds, money is needed. This has led to significantly higher central government taxes on petrol and diesel, which has in turn led to higher pump prices.

However convincing the argument may sound, it’s wrong. 100% wrong. And I have been saying this for a few years now.

Of course, my saying this hardly makes a difference, given that every time petrol and diesel prices rise, WhatsApp starts buzzing all over again with forwards blaming oil bonds issued by the UPA for high petrol and diesel prices. Currently, the price of petrol is more than Rs 100 per litre in several parts of the country.

This high price is on account of a higher excise duty collected by the central government in order to compensate for a fall in corporate tax collections. In that sense, you and I are bearing the cost of lower corporate taxes, in the form of a higher price of petrol and diesel. 

Let’s try and understand the issue of high petrol and diesel prices, and why things are the way they are, in some detail.

1) Crude oil prices have risen between last year and now. In June 2020, the average price of the Indian basket of crude oil was at $40.63 per barrel. As of June 16, 2021, the price was at $73.18 per barrel. Clearly, this is one reason behind the rise in petrol and diesel prices, but this isn’t the only reason, and not even the main one.

2) Before getting into any other detail, let’s understand what oil bonds are. These bonds were issued by the UPA government to the oil marketing companies (Indian Oil, Bharat Petroleum, Hindustan Petroleum), for the under-recoveries (the difference between the administrative price and the cost) they suffered when selling petrol, diesel, kerosene and domestic cooking gas, below their cost. This happened up until 2009-2010. Officially, these bonds are referred to as special securities issued to oil marketing companies in lieu of cash subsidy.

Instead of compensating companies immediately for the subsidy offered by them, by giving them money, the government gave them oil bonds, which would pay annual interest and mature a few years down the line. By doing this, the government expenditure during those years didn’t go up. This helped control the fiscal deficit in those years, when oil bonds were issued. Fiscal deficit is the difference between what a government earns and what it spends.

3) Of course, these bonds would mature over the years and the government of the day would have to repay them. And that would need money.
So what is the value of these bonds which the government still needs to repay?  In a question raised in the Rajya Sabha in December 2018, the government had said: “The current outstanding balance on account of Government of India (GoI) Special Bonds issued to the Public Sector Oil Marketing Companies (OMCs) in lieu of cash subsidy is about Rs 1.30 lakh crore.”

So, two and a half years back, the value of the outstanding oil bonds had stood at around Rs 1.30 lakh crore. What’s the latest number? Take a look at the following table. It has been sourced from the latest government budget. It lists out the different oil bonds that are still to be repaid, with their maturity dates.

Source: https://www.indiabudget.gov.in/doc/rec/allrec.pdf

What does this table tell us? It tells us that as of March 2021, the total outstanding oil bonds issued by the government stood at Rs 1,30,923 crore. Or the same as what the government had told the Rajya Sabha in December 2018.

4) In fact, the amount of outstanding oil bonds has barely changed during Modi government’s tenure. Look at the following tabled sourced from the 2014-15 budget, presented in July 2014, after Narendra Modi became prime minister.

Source: https://www.indiabudget.gov.in/budget2014-2015/ub2014-15/rec/annex6e.pdf

As of March 2014, the total outstanding oil bonds stood at Rs 1,34,423 crore. Two different oil bonds with maturity amounts of Rs 1,750 crore each, matured in 2014-15, on March 7, 2015, and March 23, 2015, respectively. This brought down to the total outstanding oil bonds to Rs 1,30,923 crore, and which is the current outstanding amount as well.  

The point being that the government hasn’t had to repay any outstanding oil bonds since March 2015. Of course, it has had to pay an interest on these oil bonds, like it does on all other bonds.

How much is this interest? As the government told the Rajya Sabha in December 2018: “The annual aggregated amount of Rs 9,989.96 crore was paid every year during 2015-16 to 2017-18 and the similar amount is required to be paid in the current financial year.”

Given that, the outstanding amount of oil bonds didn’t change through 2018-19, 2019-20 and 2020-21, the government would have paid the same amount as interest in each of these years, as it did during 2015-16 to 2017-18.

How does the situation look in 2021-22, the current financial year? As can be seen from both the tables (I know the tables are not very clear. If you really want to verify the data, the source of the tables is available just below them. All you need to do is click), Rs 5,000 crore of bonds are due to be repaid on October 16 and November 28, respectively, later this year. This amounts to Rs 10,000 crore in total.

Over and above this, interest needs to be repaid on the outstanding bonds. Given that Rs 10,000 crore worth of bonds of the total Rs 1,30,923 crore of oil bonds, will be repaid during this financial year, the interest to be paid on the remaining bonds will be less than Rs 9,989.96 crore that the government has been paying year on year. A back of the envelope calculation tells us that the interest to be paid this year should amount to around Rs 9,500 crore.

Hence, in total, the government needs Rs 19,500 crore to repay oil bonds as well as pay interest on them during 2021-22. When it comes to government finances, this is small change.

5) If we look at the excise duty collected on petroleum products over the years, data from Petroleum Planning and Analysis Cell tells us that it stood at Rs 99,068 crore in 2014-15, the financial year in which Narendra Modi was sworn in as prime minister.

The number reached Rs 2,23,057 crore in 2019-20. It touched Rs 2,35,811 crore between April and December 2020, the first nine months of 2020-21. Given this, it would have crossed Rs 3,00,000 crore during 2020-21.

In 2021-22, the central government expects to collect more than Rs 3,00,000 crore through excise duties on petroleum products. A look at this year’s budget tells us that the government hopes to collect Rs 74,350 crore on special additional duty of excise on motor spirit(petrol) and Rs 1,98,000 crore through duty of excise on motor spirit and high-speed diesel oil (road and infrastructure cess). Just this adds to close to Rs 2.75 lakh crore.

Over and above this, one needs to pay a basic excise duty on every litre of petrol and diesel purchased, and there is an agriculture infrastructure and development cess to be paid as well. Clearly, this year, the government will earn more than Rs 3 lakh crore from different kinds of excise duties on petroleum products.

From February 2, 2021, the total excise duty on petrol and diesel has stood at Rs 32.90 per litre and Rs 31.80 per litre, respectively. The total central excise duties on petrol and diesel have been rising since 2014. They had stood at Rs 10.38 per litre and Rs 4.52 per litre in March 2014.

In fact, even in April 2020, they had stood at Rs 22.98 per litre and Rs 18.83 per litre, respectively.

Between April last year and now, the petrol price is higher by close to Rs 10 per litre just because of higher central government taxes on it. When it comes to diesel, it is higher by close to Rs 13 per litre because of this.

6) There is another small reason for higher prices as well. The state government taxes on petrol and diesel are ad valorem, that is they are a certain percentage of the price charged to dealers plus the excise duty of the central government plus the dealer commission on every litre of petrol and diesel sold.

Take a look at the following table, which has the detail for petrol sold in Delhi.

Source: https://www.bharatpetroleum.com/pdf/MS_Webupload_16.06.2021.pdf.

The price of petrol charged to dealers in Delhi by Bharat Petroleum was at Rs 37.68 per litre as on June 16. On this there was an excise duty charged by the central government of Rs 32.90 per litre along with a dealer commission of Rs 3.80 per litre. This adds up to Rs 74.38 per litre.

On this, the Delhi government charges a value added tax of 30%, which amounts to Rs 22.32 per litre. This leads to a retail selling price of Rs 96.70 per litre (Rs 74.38 plus Rs 22.32) in Delhi.

Like, the Delhi government, other state governments also charge a value added tax or a sales tax on petrol and diesel sold in their respective territories. The 30% tax charged by the Delhi government is ad valorem. Hence, if the petrol price charged to dealers goes up as oil price goes up, the tax collected by the Delhi government also goes up.

Over and above this, when the central government increases the excise duty on petrol, the tax collected by the Delhi government (and all other governments) goes up because the state government charges a value added tax on dealer price plus excise duty plus dealer commission.

Hence, every time you and I buy petrol or diesel, we are paying a tax on tax. This is an anomaly that needs to be set right. And state governments need to charge a sales tax just on the dealer price and commission, and not on the central government excise duty as well.

7) A major reason for the central government implementing a high excise duty on petrol and diesel, lies in the fact that the government’s tax revenues as a proportion of the size of the Indian economy, measured by the gross domestic product (GDP), has been falling over the years.

Look at the following chart. It plots the ratio of gross tax revenue earned by the central government as a proportion of the GDP.


Source: Centre for Monitoring Indian Economy and Controller General of Accounts.

What does this chart show? It shows that the gross tax revenue as a percentage of the GDP reached an all-time high of 12.11% in 2007-08. The gross tax revenue was at 11.22% of the GDP in 2017-18 and fell to 10.25% of the GDP in 2020-21.

The recent fall has been more because of a fall in corporate tax collections. In 2017-18, the corporate tax collections amounted to a total of 3.34% of the GDP and fell to 2.32% of the GDP in 2020-21. This was despite the listed companies registering bumper profits during the financial year.

Corporate taxes have come down primarily on account of the base tax rate being cut from 30% to 22% in September 2019 and to 15% from the earlier 25% for new manufacturing companies.

In absolute terms, the total corporate tax collected in 2019-20 had stood at Rs 5.57 lakh crore. It fell to Rs 4.57 lakh crore in 2020-21, thanks to lower tax rates. The collections of the goods and services tax have also not gone along expected lines.

To compensate for this to some extent, the government has had to increase the excise duty on petroleum products. Hence, it is only fair to say that the cost of lower corporate tax rates for the government, is being borne by citizens in the form of higher petrol and diesel prices. There is no free lunch, as I keep reminding.

To conclude, while the revenue earned by the government can vary, its expenditure doesn’t. It usually goes up year on year. In 2017-18, the total expenditure to GDP ratio stood at 12.53%. This jumped to 17.47% in 2020-21. Of course, 2020-21, could very well be an anomaly given that the size of the economy (GDP) contracted.

Nevertheless, the expenditure in 2019-20 had also stood at a higher 13.20% of the GDP, while the gross tax collections fell. And someone had to pay for this. 

Matthew Effect of Covid Pandemic: Rich Got Richer and Poor Got Poorer

In 1968, sociologists Robert K Merton and Harriet Zuckerman, came up with the concept of the Matthew Effect of accumulated advantage. The term takes its name from the Gospel of Matthew, which points out: “For to everyone who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away.”

In simpler terms, the Matthew Effect of accumulated advantage is stated as the rich become richer and the poor get poorer. This is precisely how things have played out over the last one year, as the covid pandemic has spread through India and large parts of the world.

Let’s take a look at the different ways in which this has happened.

1) Central banks in the rich world have printed a massive amount of money post covid. Just the Federal Reserve of the United States has printed more than $3.5 trillion between end February 2020 and now. Other big central banks like the Bank of England, the Bank of Japan and European Central Bank have also done the same.

This has been done in order to drive down interest rates. The hope is that at lower interest rates people will borrow and spend money, and businesses will borrow and expand. This will help the economy revive. Many rich countries have put money directly in the bank accounts of people, encouraging them to spend.

Some of this money has found its way into stock markets all around the world, including India, driving stock prices way beyond what the earnings of companies justify. The foreign institutional investors invested a whopping $37.03 billion in Indian stocks in 2020-21, the highest they have ever invested. The next best being $25.83 billion in 2012-13.

This sent stock prices soaring with the Sensex, India’s most famous stock market index, gaining 68% in 2020-21. In fact, the market capitalisation of all BSE listed stocks (not just the 30 Sensex stocks) went up by Rs 90.82 lakh crore in 2020-21.

The poor don’t buy stocks, the rich do. The rally in the stock market has benefitted them tremendously, making them richer. In 2019-20, investment in shares and debentures (which includes mutual funds), despite all the hype, formed a minuscule 3.39% of the overall Indian household financial savings. In 2020-21, this would have definitely gone up, but given its low base it would have still formed a very small part of the overall financial savings of Indian households.

As per the 10th Edition of Hurun Global Rich List 2021, India added 55 new dollar billionaires in 2020, with the total number of billionaires in the country going up to 177, a 45% jump in the number of billionaires in comparison to 2019. If one looks at the list of the richest Indian billionaires, most of their wealth is in the stock market. And with stock markets rallying big time in 2020-21, their wealth has gone up.

2) Like the central banks of the rich world, the Reserve Bank of India (RBI) also joined the money printing party and printed Rs 3.6 lakh crore between the beginning of March 2020 and the end of March 2021. This has primarily been done in order to drive down interest rates and help the government borrow at lower interest rates. The central government borrowed Rs 12.8 lakh crore last year and is expected to borrow Rs 12.06 lakh crore in 2021-22.

While money printing helps the central government borrow at lower rates, it hurts the middle class and the poor, who invest in fixed deposits and other forms of fixed income investments to save money. It needs to be remembered that most Indians save by investing in fixed deposits, small savings schemes, provident and pension funds and life insurance. In 2019-20, 84.24% of the household financial savings were made in these financial instruments. Low interest rates largely mean lower returns from these investments. 

In the last two years, the average interest rate on bank term deposits (fixed deposits, recurring deposits, etc.) of more than one year has come down dramatically. It was at 7.5% in March-April 2019. In March 2021, it stands at 5.5%. A bulk of this fall has happened from the beginning of 2020. Recently, the government had majorly cut the interest rates on small savings schemes for the period April to June. Nevertheless, it reversed the decision overnight, probably because of the assembly elections that were still on. It is now expected that the government will cut the interest rate on small savings schemes for the period July to September. 

Lower interest rates, hurt the middle class and the poor especially when the rate of inflation is as high as the interest rates on offer.

The money printing by the RBI to drive down interest rates is likely to continue in the months to come. The Indian central bank is expected to print Rs 1 lakh crore during April to June . This means that bank interest rates will continue to remain low, continuing to hurt the poor and the middle class.

3) While the Indian economy is expected to contract during 2020-21, data from Centre for Monitoring Indian Economy (CMIE) shows that the listed corporates (both financial and non-financial) have made their highest profits ever during the period July to September 2020 and October to December 2020.

As Mahesh Vyas of the Centre for Monitoring of Indian Economy pointed out in a recent piece: “In the December 2020 quarter, the net profit of listed companies exceeded…the record profits of September 2020.” The net profit during the quarters stood at Rs 1.51 lakh crore and Rs 1.53 lakh crore, respectively. These were the highest quarterly profits ever made by listed Indian corporates. 

This means that owners of these businesses have grown richer and so has the top management of these companies given that they own employee stock option plans and benefit from the dividends paid by the companies every year.  

But how did listed Indian corporates make their highest profits ever, while the economy was contracting? The net sales of the non-financial companies, which are a bulk of the listed corporates, fell by 10.4% in the quarter ending September and by 0.9% in the quarter ending December, in comparison to a year earlier, but the companies still made record profits. This happened primarily because the companies were able to drive down their operating expenses.

In the quarter ending March 2020, the operating expenses or the cost of running a business, made up 91.1% of their sales. In the quarters ending September 2020 and December 2020, the operating expenses amounted to 81.4% and 82.8% of the sales, respectively.

In simple English, the companies slashed employee expenses and they renegotiated their contracts with their suppliers and contractors, to drive down their costs. The larger businesses benefitted in the process  at the cost of the smaller ones.

Of course, if a small company gets paid a lower amount of money from a large company, it also has to renegotiate the money it is paying to its employees and suppliers. This also leads to job losses as smaller companies then need to fire employees in order to cut costs and continue to stay viable.

This has played out for the last one year and continues to play out now as well, with the second wave of covid spreading. It is not easy to put a number to this phenomenon, but that does not mean that this is not happening or is not important.

4) Data from the Centre of Monitoring Indian Economy shows that the size of the labour force between January 2020 and March 2021, has shrunk by 1.66 crore. This when the size of the working age population or the population greater than 15 years of age has increased by 2.88 crore during the same period.

What this means is that many individuals who can’t find jobs, have stopped looking and simply dropped out of the workforce. To be counted as a part of a labour force, an individual needs to be either employed or unemployed and be looking for a job.

The sheer size of numbers here tells us that it is the poor who are dropping out of the workforce, giving up on job search. Also as I have discussed in the past, women have faced the brunt of India’s unemployment problem.

5) The rise of the internet and the availability of cheap broadband has ensured that the need to have all hands on the deck is no longer there.

Of course, this does not mean that everyone can work from home. The working class has faced the brunt of the crisis. As Scott Galloway writes in Post Corona – From Crisis to Opportunity: “Most working-class people… can’t do their jobs at home, since they are tied to the store, warehouse, factory, or other place of work.”

People working in factories, hotels, bank branches, hospitals, real estate projects, mom and pop shops, emergency services, delivery services, etc., or driving cabs for that matter, need to turn up at their places of work and job sites every day.

Also, extended working from home, will end up having other major economic consequences. Other than permanent employees, every office has office maintenance jobs which are not on the rolls of the company. Most large offices have canteens run by a contractor. Some companies offer pick up and drop facilities to their employees.

This is how services companies create low-skilled and semi-skilled jobs. Around many large office complexes there are tapris (very small shops) selling tea, coffee and food. Further, the app cab drivers and normal taxi drivers, have already seen their business go down.

Working from home has already hit people in these professions hard. Again, while it is not easy to put a number to this phenomenon, that does not mean that this is not happening or is not important.

6) Given these factors, it is hardly surprising that many people have dropped out of the middle class. A Pew Research centre analysis found that “the middle class in India is estimated to have shrunk by 32 million in 2020 as a consequence of the downturn, compared with the number it may have reached absent the pandemic.”

This accounted for three-fifths of the global retreat in the number of people in the global middle class (defined as people with incomes of $10.01-$20 a day).

While the number of people dropping out of the middle class is high, the increase in the number of poor is shocking beyond belief. Their number is “estimated to have increased by 75 million because of the COVID-19 recession.” This also accounts for around three-fifths of the global increase in poverty.  

In fact, this is something that Nobel Prize winning economist Angus Deaton confirms in a recent research paper, where he points out:

“China did better than almost all other countries, while India did worse. China’s 1.4 billion people experienced few deaths and growth in per capita income, which took them closer to the richer countries of the world and decreased (weighted) global inequality. India’s 1.4 billion people experienced many more deaths, as well as a large drop in income, which increased (weighted) global inequality.”

Of course, with the second wave of covid starting, all this is likely to continue. One point that we need to consider here is the ability of individuals to make a living in the years to come. School and college students are being taught digitally since the last one year. It needs to be considered here that not every student has access to a computer. Further, even if there is access to a computer, it might have to be shared among multiple siblings. Then there is the question of internet speed, electricity and so on.

The quality of education being delivered digitally will impact the earning capacity of many middle class and poor students, in the years to come.

In short, like the disease itself, the negative economic effects of covid, especially among the poor and the middle class, will continue to be felt in the years to come. 

Only 1.7% of Central Govt Petrol Taxes Shared with States – Where Has Cooperative Federalism Gone?

Note: Detailed analysis takes time. Like this piece took three weeks to write. Hence, please continue supporting this effort. Every rupee helps. 

Chintan Patel and Vivek Kaul

The devil, as they say, is always in the detail.

Nevertheless, in an era of instant digital journalism, where you, dear reader, are constantly bombarded with information, the real story, or should we say stories, often get buried under numerous headlines, lazy journalism, government press releases and the false news that is the flavour of the day.

But if one is willing to do some basic number-crunching, like we are, some interesting details and narratives can emerge.

This is one such story of the central government taking both the states and the common man, for a ride and that too in broad day light. At the risk of stretching the metaphor a bit too far, the scene of the crime is the petrol pump and the motive, the dire state of the economy.

But to do this story full justice, we need to set up the background with some dry, academic points as well as digress into some adjacent details.

So, kindly bear with us. While sensational things might get you excited and help us get a few more clicks, but as we said at the beginning, the devil is in the detail.

And here’s presenting the detail.

What’s the point?

Over the years, the central government has been sharing less and less of the overall taxes that it collects, with the state governments. This is the main point we make in this piece. 

The annual budget of the central government is presented in February ever year. The budget is analysed by the media in minute detail.

However, amidst all the analyses, one subject that is often ignored is the financial relationship between the central government and the state governments. After all, much of the services that the government provides are in fact delivered by local and state governments.

It is worth remembering that while the central government collects the bulk of the taxes in the country, it’s the states that the taxes ultimately come from. And given that, this money in one way or another needs to go back to the states.

But does it? The short answer is no. And there is a longer answer which explains the reasons, has some nuance and which forms the heart of this piece.

This piece is divided into three sections. The first section provides a background on how tax revenue is transferred from the central government to the state governments and the role of the Finance Commission.

The second section focuses on a special tax category – cess and surcharge, their increased prominence in recent times, and how that raises prices of petrol and diesel.

The third and final section examines the trend of total transfer of funds from the central government to the state governments.

This is an opportune time for such an analysis, since this year’s Union budget was accompanied by the unveiling of the 15th Finance Commission’s report for the period 2021-22 to 2025-26.

So, read on, to find out.  

Who Gets How Much?

The Constitution stipulates how taxes are collected and split between the central government and the state governments. It empowers the central government as well as the state governments to raise revenues from different sources of taxation.

The central government gets to collect more taxes while the state governments end up with the bigger portion of the expenditure, leading to a mismatch. This mismatch of money that is earned through taxes and other routes and money that needs to be spent, is referred to as a “vertical imbalance”.

Take a look at Figure 1. In 2018-19, the Union Government raised 62.7 per cent of the aggregate resources raised by both the Union and states, whereas the states spent 62.4 per cent of the combined aggregate expenditure. While Figure 1 shares data for just one financial year, what’s true for 2018-19 has also been true for other financial years.


Figure 1: Vertical imbalance (2018-19)

           Source: 15th Finance Commission Report. 

To offset this imbalance, the Constitution provides mechanisms for intergovernmental transfers – the transfer of funds from the central government to the state governments. A key player of this setup is the Finance Commission.

The Finance Commission (FC) is an advisory body that is appointed by the President every five years and which evaluates the state of finances of the central as well as the state governments, and determines how taxes collected by the central government are to be distributed between the central government and the state governments, and among the state governments.

Over and above this, the FC also recommends grants to states based on revenue needs, grants for local governments and grants for specific purposes e.g. health sector grants etc. Thus, there are two broad channels of transfer of funds under the FC umbrella – i) devolution of taxes, and ii) grants. 

At the heart of the idea of intergovernmental transfers and tax devolution is the concept of ‘divisible pool’. The divisible pool is the portion of the taxes (technically referred to as the gross tax revenue) collected by the central government, which is distributed between it and the state governments. What this means is that all the taxes collected by the central government aren’t shareable with the state governments.

Till the tenth FC which tabled its report in 1995, only union excise duties and personal income taxes made up the divisible pool. Under this arrangement, 85% of the personal income taxes and 40-45% of excise duties were shared with the state governments.

In 2000, the tenth FC recommended a constitutional amendment to expand the divisible pool to all central taxes. The central government accepted this recommendation and the 80th Amendment was passed making a certain portion of  central government taxes shareable with the state governments, effective retrospectively from April 1, 1996.

Further, the portion of the divisible pool that is shared with the states is referred to as the devolution of taxes and is determined by the FC. Before the14th FC which came into effect from April 2015, 32% of the divisible pool was shared with the states.

The 14th FC increased the share of the state governments in the divisible pool to 42%. At the same time, the sector-specific grants were eliminated. This decision was primarily in response to grievances expressed by the state governments. State governments prefer funding through devolution since such transfers are unconditional.

Other transfers of money, whether they are through FC grants, or through channels outside the FC (like schemes from central government ministries) impose policy priorities set by the central government over the state governments, compromising the latter’s fiscal flexibility or the ability to spend money as the state government deems fit.

To give an example, a FC health-sector grant can only be used for health spending by the states, or funds transferred to the states under Pradhan Mantri Gram Sadak Yojana can only be used to make roads.

When state governments have more flexibility in allocating funds for various initiatives, they can craft policy that is more responsive to the needs on the ground than having to blindly follow policy that is framed in New Delhi.

The 14th FC recognised this and increased the state share of the divisible pool from 32% to 42%. The intent behind this increase was not to increase the amount of transfers but rather change the composition of the transfers – from diverting conditional funds to diverting unconditional funds, to state governments.

The 15th FC tabled in 2021 lowered the divisible pool marginally to 41%, from the earlier 42%. The is because Jammu and Kashmir is no longer a state and the money allocated to it has not been counted as transfer to a state government. Given this, the 15th FC has kept the divisible pool distribution unchanged.  

And now we come to the most important point of this write up. A key detail in this entire discussion is that the only tax revenue that is excluded from the shared divisible pool are different kinds of surcharges and cess.

As we shall see next, this exclusion has proved to be the back door that the central government has been using to divert funds from the states governments’ kitty to its own.

A Tale of Two Taxes

Before we get into the details, let’s first try and understand what surcharge and cess actually are.

A cess is tax on a tax imposed by the central government attached to a specific purpose. For example, an education cess collected should be utilised only for financing education and not for any other purpose. It is worth remembering here that the education cess is imposed on the total income tax and not on the total taxable income.

Hence, as explained earlier, it is a tax on a tax. Examples include infrastructure cess on petrol and diesel, krishi kalyan cess, health and education cess on Income Tax, etc.

In theory, money collected under a cess is to be spent on the specific purpose for which it is collected but that’s not always the case.

A Comptroller and Auditor General (CAG) report for 2018-19 indicates that only Rs 1.64 lakh crore of the Rs 2.74 lakh crore or around 60% of the amount collected from cess and surcharge during 2018-19 had been transferred to their respective funds. Around 40% was still retained in the Consolidated Fund of India, which is the general-purpose fund of the Indian government.

The provision of levying a cess was intended to be used for shorter specific purposes. So, the procedure for introducing a cess is comparatively simpler than introducing new taxes, which usually require change in the law.

Coming to surcharges, a surcharge is also a tax on a tax, but is not tied to a specific purpose like a cess is. Let’s take the example of the surcharge on income tax. It is an added tax on the taxpayers having a higher taxable income during a particular financial year. So, an individual having a taxable income  between Rs 50 Lakhs and Rs 1 crore pays an income tax surcharge of 10%.

Further, an individual with a taxable income between Rs 1 crore and Rs 2 crore, pays an income tax surcharge of 15%, and so on.

Note that this surcharge is only on the base income tax, not on the income itself. So, if an individual earning Rs 1 crore in a year needs to pay an income tax of Rs 20 lakhs, the applicable surcharge would be Rs 2 lakhs (10% of 20 lakhs).

A surcharge can be utilised for any purpose of the government, without having to bend the rules, like they do sometimes for cess collections.

In the last few years, these surcharges and cess, which do not need to be shared with the state governments, have become the central government’s go-to tools to address the tax revenue shortfall.

Take a look at Figure 2a, which basically plots the total amount of surcharges and cess collected by the central government over the years, along with the surcharge and cess it hopes to collect during 2021-22, the current financial year.

Figure 2a: Total cess and surcharge revenue (in Rs crore).

Source: Union budget documents.  

Figure 2a clearly shows that the general trend is upwards, with small blips in 2017-18 and 2018-19. The government expects to collect total surcharges and cess of Rs 4,45,822 crore (revised estimate) in 2020-21.

This is surprising given that overall tax collection during the year is expected to come down. In comparison to the years before 2020-21, the collections for 2021-22 are also expected to be at a very high Rs 4,48,821 crore.

The collections of cess and surcharge surged from Rs 2,53,540 crore in 2019-20 to Rs 4,48,822 crore (RE) in 2020-21, an increase of a whopping 77%. This huge increase is almost entirely due to increased cess and surcharge on petrol and diesel – in particular, the road and infrastructure cess and the additional duty of excise on motor spirit (which is a surcharge), which increased by Rs 1,92,792 crore. Motor spirit is the technical term for petrol.

The increased reliance on cess and surcharge is also seen in Figure 2b below, which plots the total cess and surcharge earned by the central government as a proportion of the Indian gross domestic product (GDP). This is done in order to take the size of the Indian economy into account as well.

Figure 2b: Cess and surcharge revenue expressed
as a proportion of the GDP (in %).

Source: Union budget documents.

The above figure makes for very interesting reading. The total amount of cess and surcharges earned by the central government went up from 1.25% of the GDP in 2019-20 to 2.29% of the GDP in 2020-21, a massive jump of 104 basis points. Some of this jump was obviously because the size of the economy or the GDP is expected to contract in 2020-21. Nevertheless, the fact that cess and surcharges collected by the government went up in a year when the economy contracted, does come as a surprise.

In Figure 3, let us look at the breakdown between cess and surcharges earned by the central government over the years. Looking at the below figure it is evident that cess collections form the bulk of the total revenue.

Figure 3: Cess and surcharge breakdown (in Rs crore).

Source: Union budget documents.

Clearly, cess is bringing in more money for the central government, though the contribution of surcharges has also jumped up since 2019-20.

Now let’s try and understand, why has the central government increasingly become more dependent on earning money through cess and surcharges, and in the process it is sharing lesser proportion of taxes with the state governments.

This increased reliance on cess and surcharges in the last two years can be understood when one looks at what is happening with the total tax revenue. Figure 4 plots the total taxes earned by the central government or gross tax revenue as a proportion of the GDP.

Figure 4: Gross tax revenue as a proportion of GDP (in %).

Source: Union budget documents 

While the negative economic impact of the covid pandemic has been a telling blow, the downward trajectory in tax collections of the central government had started as far as back as 2018-19. The twin economic debacles of PM Modi’s first term – demonetisation and a shaky GST implementation – meant the economy was already tottering before the covid pandemic hit.

An obvious casualty of this slowdown has been a declining tax revenue as a proportion of the GDP. In the normal scheme of things, this would have meant that the central government would have ended up with lesser taxes for itself, after sharing with the state governments.

But this fall has been cushioned with the central government earning a higher amount of taxes through cess and surcharges (as can be seen from Figure 5).

Figure 5: Cess and surcharge as a proportion of total central government taxes. 

Source: Union budget Documents
RE = Revised Estimate
BE = Budget Estimate

 In 2019-20, the total taxes earned by the government or the gross tax revenue had stood at Rs 20.1 lakh crore. In 2020-21, it is expected to fall by 5.5% to Rs 19 lakh crore. The net tax revenue of the central government (what remains after sharing taxes with the state governments) in 2019-20 was at Rs 13.59 lakh core.

This is expected to fall to Rs 13.45 lakh crore in 2020-21, a fall of 0.9%, which is much lower than the 5.5% fall in gross tax revenue. While, the total gross tax revenue is expected to fall by Rs 1.1 lakh crore (Rs 20.1 lakh crore minus Rs 19 lakh crore), the net tax revenue is expected to fall by just Rs 14,000 crore (Rs 13.59 lakh crore minus Rs 13.45 lakh crore). 

In percentage terms, in 2019-20, the central government kept 67.6% of the taxes for itself in 2019-20. This shot up to 70.8% in 2020-21. 

Clearly, the state governments have been short-changed here, with their share of taxes falling from Rs 6.51 lakh crore in 2019-20 to Rs 5.5 lakh crore in 2020-21, a fall of a little over Rs 1 lakh crore or 15.5%, in such economically difficult times.

This is primarily because the share of cess and surcharge in total taxes collected by the central government has jumped from 12.67% in 2019-20 to 23.46% in 2020-21. Do remember that cess and surcharges are outside the divisible pool.

So, when the inflow of these taxes increases, the central government gets to keep all the revenue, as opposed to sharing 41% (15th FC guideline) with the state governments. So, it is far more efficient for the central government to increase cess and surcharge when it needs to increase tax collection. 

This overuse of cess and surcharges by the central government has not gone unnoticed. In fact, the chairman of the 15th FC, NK Singh has talked about introducing a constitutional amendment to include them in the divisible pool.

As he said

“I see no viable solution except a constitutional amendment. If that constitutional amendment is introduced, recognizing some proportion of cess and surcharge to the divisible pool, it will certainly allow greater flexibility to the successive Finance Commissions subsequently to be able to calibrate a framework.”

Ultimately, as we said at the very beginning, whatever might be the term used, a tax, or a cess or a surcharge for that matter, it is being paid by people. And hence, the money thus collected should be shared with the state governments.

How does all this affect you, dear reader?

If you have managed to make it thus far, many of you by now would be like how much gyan are these guys going to give. Why can’t they tell me straightaway how does all this impact me or the world at large or the aam aadmi?

Well, sometimes it is important to take a look at the bigger picture first and then arrive at how it impacts all of us.

The government’s increased reliance primarily on cess actually has had a direct impact on most citizens – in the form of increased prices at the petrol pump.

The biggest contributor to the spike in cess collection over the last two years has been cess collected on the sale of petroleum products. The figure below charts the total cess collected on petroleum products (crude oil, petrol and diesel) over the last five years. While the cess on petrol formed at least 50% of total cess each year, it was as high as 69% of the total cess revenue in financial years 2019-20 and 2020-21. 

Figure 6 clearly shows that the government has resorted to taxing petrol and diesel to make up for revenue shortfalls. This conclusion is hardly a revelation to anyone paying attention to prices at the pump, but the numbers help understand the government’s motivation.

Figure 6: Total cess on petroleum products (in Rs crore).

Source: Union budget documents

There is another way of looking at the cess on petrol and diesel. Table 1 below gives a breakdown of the union taxes on petrol and diesel for 2020-21 and 2021-22. Note that the table below only analyses central excise tax and excludes customs duty. There are technical complications in figuring out the per litre customs duty.  

Table 1: Central government tax breakdown on petrol and diesel.

Source: https://www.ppac.gov.in/content/149_1_PricesPetroleum.aspx

 

The total union excise duty on petrol and diesel, in 2021-22 are Rs 32.90 per litre and Rs 31.80 per litre, respectively, which are marginally lower than the previous year. All taxes other than basic excise duty, including special additional excise duty, which is a surcharge, are exempt from the divisible pool.  

1) For 2021-22, only ~5% of the excise taxes on petrol and diesel will go to the divisible pool. The rest (~95%) will be kept by the central government. In 2020-21, this portion was at around 91% for petrol and 85% for diesel. Clearly, the government is keeping a greater share of petrol and diesel taxes for itself.

2) The above point does not clearly bring out the gravity of the situation. Let’s do a simple calculation to show that. In 2021-22, the total excise duty on petrol stands at Rs 32.90 per litre. Of this, the basic excise duty of Rs 1.4 per litre is the only part which is a part of the divisible pool and hence, will be shared with the states. It is worth remembering only 41% of this or around 57 paisa per litre needs to be shared with the state governments.

What this means is that just 1.7% of the total excise duty earned by the central government per litre of petrol will be shared with the state governments. It was at 3.8% in 2020-21.

3) Now let’s carry out the same exercise for diesel. The total excise duty earned by the central government on the sale of one litre of diesel will be Rs 31.80 during 2021-22. Of this only Rs 1.8 per litre will be shareable with state governments. 41% of this amounts to around 74 paisa per litre.

This amounts to around 2.3% of the total excise duty of Rs 31.8 per litre earned by the central government per litre of diesel. It was at 6.4% in 2020-21.

4) In 2021-22, a new agriculture infra cess has been introduced. It amounts to Rs 2.5 per litre on petrol and Rs 4 per litre on diesel. This has led to the reduction of basic excise duty on petrol from Rs 2.98 per litre to Rs 1.4 per litre and that on diesel from Rs 4.83 per litre to Rs 1.8 litre. As mentioned earlier, only the basic excise duty needs to be shared with the state governments.

Hence, by introducing a new agriculture infra cess, the central government has ensured that state governments get an even lower share of taxes from petrol and diesel in 2021-22.

The general public is quite sensitive to price rise at the petrol pump since it is a highly visible and recurrent cost. That the government has still resorted to this strategy for increasing revenue, speaks to the lack of better options – a fact that is a direct consequence of the tepid economic scenario even before the pandemic began. Of course, the covid pandemic has only made things more difficult for the government on tax front.

Nonetheless, things are even more difficult for state governments, which don’t have many avenues to raise tax. Clearly, this amounts to the centre shortchanging the state governments during difficult economic times.

Oh wait, there is more – Total intergovernmental transfers

Other than the divisible pool of taxes, there are other channels of intergovernmental transfers between the central government and the state governments. So, to get the complete picture on the flow of money from the central government to the state governments, it is instructive to examine the total intergovernmental funds transferred in more detail.

Before diving into those details, a brief overview of intergovernmental transfers would be useful. Figure 7 below is a good graphical representation of all the ways in which the central government can transfer funds to the state governments.

Figure 7:  Vertical fiscal transfer channels. 

Source : Asian Development Bank

Broadly speaking there are two instruments of fund transfers.

1) Finance Commission funds: As discussed earlier, this includes the 41% of the divisible pool revenue, general-purpose grants for states with weak revenue raising capacity and specific purpose grants for funding local governments (panchayats and municipalities) and funding certain specific initiatives (eg. health-sector grants by the 15th FC). Most of the funds provided via the FC channel are not conditional and don’t require state government contributions.

2) Funds from central ministries: In addition to the FC funds, the central government also gives specific purpose grants through the respective ministries. These funds are transferred either through centrally sponsored schemes or central sector schemes. Central sector schemes are entirely funded by the central government. Some examples include the free LPG connections provided to poor households, crop insurance scheme etc.

The centrally sponsored schemes require a matching component from the state governments i.e. they have to fund a portion of the scheme. Examples of this include the Pradhan Mantri Gram Sadak Yojana, the Swachh Bharat Mission etc.

As Figure 7 shows, the mechanism of intergovernmental transfer underwent a major transformation in 2015. Two things led to this. Firstly, the 14th FC gave its recommendations for increasing the devolution share of state governments from 32% to 42% and eliminating a host of specific purpose grants. The underlying rationale was to change the composition of state transfers to increase the “no-strings-attached” outlays and reduce conditional grants to give state governments more financial headroom.

Secondly, the newly elected NDA government disbanded the Planning Commission and replaced it with the NITI Aayog. While the NITI Aayog has some shades of resemblance with the Planning Commission, the five-year plans, which was the responsibility of the Planning Commission, were scrapped.

The five-year plans would have their own grants for states in the annual budget of the central government. The establishment of the NITI Aayog and the approval of the 14th FC recommendations were two initiatives that formed the basis the oft-cited “cooperative federalism” mantra of the NDA government, especially in the early years.

The argument put forth to claim this catchphrase was that the Modi-led administration was reversing the centralising tendencies of earlier governments and ushering in an environment where states had greater fiscal autonomy.

Does the data corroborate these claims? Let us examine. Figure 8 below charts the tax devolution to states as a portion of the gross tax revenue.

Figure 8: Tax Devolution vs Gross Tax Revenue (in %).

Source: Union budget documents

  

Some interesting observations can be made from Figure 8.

1) The first few years after the 14th FC came to effect (April 2015) saw a significant increase in the portion of taxes devolved to the states.

2) This increasing trend of devolution peaked in 2018-19 when the devolution was 36.6%. The last three years have seen this number come down, with the 2020-21 figure (~29%) close to the pre-2015 levels. So, all the talk about cooperative federalism has gone for a toss, in the last few years.

3) Note that these numbers don’t reflect the 32% (pre-2015) or 42% (post-2015) devolution share prescribed by the FC since cess and surcharge revenue is not devolved. This also explains why the devolution percentage has dipped sharply in the last two years, a period when cess revenue has had a corresponding increase (as shown earlier in Figure 5).

While the 14th FC may have been the catalyst, the Modi government can rightfully claim credit for strengthening fiscal federalism, at least in its first term. However, most of these gains have been reversed in their second term. This justifies N.K Singh’s lament

“ It should not be a cat and mouse game that every finance commission raises the devolution number and it then neutralised simultaneously by an increase in cess and surcharge leaving the states where they were, nor the opposite way.”

Next, in Figure 9, let us look at the total transfers made to state governments in recent years, not just tax devolution. The total transfers to states includes tax devolution, finance commission grants, centrally sponsored schemes, central sector schemes and other miscellaneous items listed as state transfers in the union budget.

The figure below charts the total transfers made to states as a percent of the total expenditure of the Union government.

Figure 9: Portion of total expenditure of central government
transferred to state governments (in %).

Source: Union budget documents

 There are two caveats on the chart above.

1) Starting 2014-15 there was a change in how expenditure for central schemes was routed to the states. The figures for 2013-14 have been adjusted to make the comparisons with the subsequent years correctly.

2) We have excluded loans made to states from the total transfer amounts and only included grants and devolution, since loans do need to be repaid.

That said, these figures also lead to similar observations made from Figure 8. The period from 2015-16 to 2018-19 (roughly co-incident with NDA’s first term) had a significant increase in funding to the state governments.

While the increased devolution of taxes could be attributed to the recommendations of the 14th FC, the increase in total transfer of funds was certainly government policy. The last two years (and the projections for the next year) show a steep decline in the intergovernmental transfers.  
The huge spike in cess and surcharge collections which are not shared with states and declining tax revenues during this period contributed to this effect.

There are two other conjectures one can make based on the trends seen above. First, when Narendra Modi won in May 2014, he was a sitting chief minister and his perspective on governance was heavily biased towards the challenges of governing a state.

Hence, financial outlays were perhaps favourable to the states. In the second term, he was well-entrenched as a national leader and the instincts were now honed favouring centralisation.

Second, the Bhartiya Janata Party has adopted an increasingly overt approach favouring homogenisation of the country. Whether it is the abrogation of Article 370, the passage of national farm laws, or flirtations with one-nation-one-language, it is evident that impulse is towards uniformity and centralisation. In this context, the trend of holding back funds from states, seems a natural accompaniment.