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Over the last many days, a major topic causing a furor among the masses has been "Hike in fuel prices". One can see several posts being shared by people on social media about the price rise, many of them blaming the government and a lot of them, defending it.

Most of these posts include technical terms and terminologies that many of us may not understand completely. Also, these posts have a tendency of being biased due to the sympathies the person writing such posts may have for their favorite political party, leaving the rest of us confused. Given that not all of us understand the financial jargons and nitty-gritty of fuel pricing mechanisms, let's try to understand the issue in more simpler terms, through common man's language and in a way that may help us to draw our own conclusions regardless of the parties we support.

I have decided to discuss this whole issue in a series of articles, written down as simplistically as possible, to be understood by even a layman. This is the first among those articles.

Part 1: How the petrol is priced in India and the various stages involved in it.  

From where does India buy crude oil and How is it priced?

  • Crude oil is traded internationally in US dollars. Which means anybody who wishes to buy it has to make payment to the suppliers in dollars. India imports almost 80% of its oil requirements. So, it has to make huge payments of dollars to the suppliers. It means, if the exchange rate increases, India ends up paying more for crude oil. Similarly, if the exchange rate decreases, India ends up saving.
  • Oil prices are quoted at a 'Per-Barrel' rate. A barrel is a container which holds almost up to 159 liters of crude oil. Currently, the rate of oil is being quoted in the international market at around '$80/Barrel'. Which means, 80 dollars for about 159 liters of crude oil. This is the rate that Govt of India pays to buy the oil currently.

More than two-thirds of India's oil imports currently are from Middle-Eastern countries like Saudi Arabia and Kuwait.  

What happens after crude oil comes to India?

  • The crude oil is taken up for processing by Oil Marketing Companies (OMC's) such as Indian Oil Corporation and Bharat Petroleum. These companies process the crude oil in their refineries and separate the by-products such as petrol, diesel, kerosene, etc. So, the processing charges of these companies are added to the by-products at this stage.
  • Once the petrol and diesel are ready, the Government of India adds Central Excise Duty to it. Which is currently about Rs. 20/ litre. (rounded off). This tax is Central tax and it will mostly go to Central Government.

What after refining?

  • The petrol is then passed on to the dealers of petrol in various states. These dealers are none other than the petrol pumps from where we buy the petrol. These dealers charge their own commission for distribution of petrol to the public, which is added to the cost of petrol.
  • Depending on which state the petrol pump is situated, the state governments charge their share of tax on petrol, which is VAT (Value Added Tax). This tax goes to State Governments as VAT is a state tax. The rate of VAT differs from state to state and therefore, different states charge different amount of VAT on petrol depending on their requirements. That's the reason why the rates of petrol are different in each state of India.

In summary, the price you pay for petrol at the petrol pump includes the following at the least-

  1. Price paid by Govt of India to international suppliers (which depends on exchange rate) +
  2. Processing charges charged by Oil Marketing Companies like Bharat Petroleum. +
  3. Central Excise Duty charged by Central Govt. +
  4. Commission Charged by petrol pumps. +
  5. VAT charged by State governments.

Part 2: Indirect taxation mechanism of commodities in India and the cascading effect.

It's necessary that we understand a bit about India's indirect taxation system, to develop an understanding about how and why petroleum products are taxed.

Short overview of indirect tax mechanism in India.

We can all agree that India is a land of many taxes (like many other countries). And be assured, whenever you buy or consume something, you have already paid tax on it because the MRP includes the tax that will eventually go to the government.

Our Constitution has included the topic of taxation under concurrent list, which means, the tax is something that both the Central Government and the State governments can charge from their citizens. This is how taxes were charged until recently. A product would consist of both the central taxes such as Excise Duty and also State specific tax such as VAT.

So, You were paying to both central and state governments out of your pockets. In short, with central taxes, the central government would earn its income. And with state taxes, the state governments would earn their income. A win-win situation for both of them.

But, there was a problem. Not for the governments, but for us the tax payers.

The Problem of Cascading Effect.

Explained very simply, cascading effect is tax on tax. A product which is taxed once, gets taxed again and again due to different types of taxes and different rates of tax at different stages. The best way to understand this is by an example.

Example

  • Suppose a product is manufactured in Maharashtra for Rs. 100, The Central Govt would charge Excise duty @ 12.5%. Thus, making the cost of product- Rs. 112.50. (100+12.50).
  • The product is then sold to a dealer in Gujarat, on which Central Govt would charge Central Sales Tax @ 2%. Which comes to Rs. 2.25 (112.50 x 2%). Thus, making the cost of product Rs. 114.75.
  • The product is finally sold by that dealer to the customer. On that sale, the Gujarat government would charge VAT, say @ 10%. This takes the final price of the product at Rs. 126. (114.75 + 11.25) (rounded off).

Observations:

Observation 1: The taxes are charged not just on cost, but also on taxes already charged at previous stages. CST of 2% is charged not just on Rs. 100, but on Rs. 112.50, which includes excise of Rs. 12.50. Similarly, VAT of 10% is charged not on Rs. 100, but on Rs. 114.75 which includes both Excise and CST already.

So, when the customer is buying the product at Rs. 126, logically speaking, he is paying tax on tax on tax.

This is like asking you to pay income tax. And then asking you to pay tax on your income tax. Doesn't make sense, right?

Observation 2: The effective tax rate in above example comes to 26% due to the cascading effect, which would otherwise have been 24.50%, had the cascading not been there. Meaning, the customer could have saved Rs. 1.50 had the product not been double taxed. This is, of course, a small example. For products costing thousands and lakhs of rupees, the savings would have been equally large.

Observation 3: The different taxes are charged and collected independently by Central and State governments at different stages. Excise and CST are charged and collected by Centre, whereas VAT is charged and collected by states. They don't interfere with each other.

Observation 4: States get to charge their tax separately and at the rates of their choice. As much the Centre earns, so much do the states too, which keeps the state's revenue flowing in. Also, the states are given authority to decide the rates of VAT on products, depending on the public mood and needs of the state.

In the next post, I'll discuss why petrol is not brought under GST and still taxed in the old way, giving rise to cascading effect. And other important points connected therewith.

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