States have room to cut VAT on fuel

VAT on fuel acts as an automatic stabiliser. Thus when Centre increases excise duty on fuel, states gain in revenue and when centre cuts excise, states forego revenue from fuel. Estimates indicate that States have gained Rs49,229 crore from VAT revenue on fuel when oil prices were increasing and the States will forego Rs15,021 crore when oil price has been downwardly adjusted through excise cut.

Mumbai: The change in excise duty by the Centre has a direct and automatic implication on the States as most of them levy ad valorem VAT on diesel and petrol.

VAT on diesel and petrol depends on base oil price, transportation charges, dealer commission and excise duty. So when the excise duty is reduced by the Centre, state's VAT revenue gets reduced automatically. Interestingly, after the excise duty cut on fuel by the Centre, the VAT cuts announced by some of the states is only by default.

However, in the cacophony of states VAT revenue getting reduced automatically, two aspects get missed. First, VAT on fuel acts as an automatic stabiliser. Thus when Centre increases excise duty on fuel, states gain in revenue and when centre cuts excise, states forego revenue from fuel. Estimates indicate that states have gained Rs 49,229 crore from VAT revenue on fuel when oil prices rose and the states will forego Rs 15,021 crore when oil price has been downwardly adjusted through excise cut. This implies that gains still outstrip the revenue forgone by Rs 34,208 crore and hence states can further cut the oil prices. Maharashtra has gained the most, followed by Gujarat and Telangana, says a study by SBI's internal economic research.

However, fuel prices in Gujarat are much lower than Telangana and Maharashtra. In fact, the average VAT on petrol in Maharashtra, Telangana and Andhra Pradesh is around 29.6 per cent.

Second, contrary to popular perception, state finances have improved significantly post pandemic indicating states have the necessary wherewithal to adjust taxes if so required. This is also reflected in lower state borrowings. For example, one clearly see that the actual borrowing of the states has been lower than the calendar figures for the past few years (except FY20). Even the spread between the 10-year State Development Loans (SDL) yield from 10 year G-sec yield has now narrowed down significantly since mid-Feb'22 (63.7 bps to 35.9 bps currently).

Third, lower state borrowings is also because of a recent policy change that notifies that off balance sheet borrowings of states needs to be adjusted against borrowings. According to the notification, the net borrowing of states in FY23 will have to be adjusted for the off balance sheet expenditure they had incurred in FY21 and FY22. Some states have huge amount of outstanding guarantees (For instance 11.7 per cent of GSDP in case of Telangana) which in turn will limit their borrowing for this fiscal. For FY23, the finance commission has also notified that besides 3.5 per cent of GSDP borrowing by states and additional 0.5 per cent of GSDP borrowing contingent on power sector reform, states have also been allowed additional borrowing equivalent to the state government's and employee's share of contribution under the NPS. The inclusion of off-budget expenditures in borrowing might put states under pressure to curtail their budgeted expenditure. However, it must be emphasised that many of these states (Telangana, Rajasthan, Chhattisgarh, Andhra Pradesh, among others) have offered freebies like farm loan waiver, restoring old pension system, etc, which are economically unsustainable given the financially bad shape of many states. Clearly, states seem to be currently living beyond their means and it is imperative that states rationalize their spending priorities in accordance with revenue receipts.

Taking all these factors into consideration and if the cushion of Rs 34,208 crore from oil excise is entirely adjusted such that states have no gain or loss from oil revenue over and above the budgetary estimates, we believe that states on an average can still cut diesel price at least by Rs 2 per litre and petrol price by Rs 3 per litre each without impairing their VAT revenue from oil. Bigger states like Maharashtra which have lower debt to GDP ratio have significantly large fiscal space for lowering their tax on diesel and petrol by even upto Rs 5. Also, state's own tax revenue to GDP of many states including Haryana, Kerala, Maharashtra, Rajasthan, Telangana and Arunachal Pradesh is higher than 7 per cent.

"We believe there is compelling reason for these states to adjust taxes on fuel. The ultimate solution to reduce the complexities in oil tax structure and bring down extreme volatility in oil revenues due to volatile crude price would be to bring it under the ambit of GST," says Soumya Kanti Ghosh, SBI Group's chief economic advisor.

However, if the two fuels are put under GST, the Centre will have to let go Rs 20,000 crore input tax credit. Thus, a fair methodology would have to be developed for this. Lastly, the recent measures by the Government would ease inflation by 35-40 bps. CPI inflation for May might come down by 10 bps from our earlier projection to 7.0 per cent and the full impact of these measures will be visible only in the later months, he said.

Under current circumstances, domestic consumer price inflation is expected to average at 6.5-6.7 per cent in FY23. Additionally, these measures are likely to have fiscal implication for the Centre as well. However, considering the conservative budgetary estimates for FY23 the net fiscal implication could be around Rs 66,000 crore to Rs 17.27 lakh crore from Rs 16.61 lakh crore in FY23 BE. But with higher nominal GDP estimates, fiscal deficit as percentage of GDP can still be contained closer to 6.4-6.6 per cent in FY23.