The government is considering raising the price of diesel by Rs 1 per litre per month for 10 months. This will slash the fiscal deficit without creating the big outcry of a one-shot rise of Rs 10. However, many politicians fear that a higher diesel price will have a cascading effect on the prices of all goods transported by trucks and railways, and on farm produce.

So, it’s timely that Kirit Parikh and his colleagues at Integrated Research and Action for Development have just produced a seminal study, Taming diesel subsidy to curtail inflation and foster economic growth. This shows that inflation will actually be higher and GDP lower if diesel prices are kept static than if they are raised to economic levels. This challenges the conventional wisdom of politicians and TV anchors.

Look at countries without oil subsidies. Annualised inflation is just 1.76% in the US, 1.9% in Germany and -0.2% in Japan. This is not just a rich-country phenomenon: inflation is just 2% in China and 2.8% in the Philippines, which allow prices to rise. Clearly, the supposed cascading effect of higher diesel prices is vastly exaggerated.

India has stringent price controls on diesel and other petroleum products, yet, wholesale price inflation is 7.3% and consumer price inflation is almost 10%. Under-recoveries of oil marketing companies are a whopping Rs 2,00,000 crore a year. This is six times the Rs 33,000 crore being spent on the government’s flagship employment scheme MNREGA. This wrecks all priorities in spending.

Why do price controls on diesel fail to curb inflation? The Parikh study explains that the implicit diesel subsidy is financed by higher government borrowing, and leads directly to a higher fiscal deficit. Research by Jadhav and others shows that a 1% rise in the fiscal deficit raises broad money (M3) by around 0.9% in Indian conditions. And a rise in M3 is inflationary, since more money chases the same goods and services.

The implicit oil subsidy of Rs 2,00,000 crore is around 2% of GDP today. This causes M3 to rise by around 1.8%, raising the price of all non-oil goods. So, the attempt to keep oil prices down leads to a rise in other prices. It is like squeezing one part of a balloon: this merely creates a bigger bulge in the rest of the balloon. When a high fiscal deficit fuels inflation, it makes exports uncompetitive, increases imports, widens the trade deficit and, so, causes depreciation of the rupee. This further raises the prices of imported goods like oil, worsening inflation in a vicious circle.

Some analysts argue that the RBI should not allow M3 to rise with higher fiscal deficits. But under-recoveries of the oil companies have to be financed through borrowing, whether by oil marketing companies or the government. If M3 is not allowed to expand to accommodate this additional borrowing, the result will be a big squeeze on lending to all other business, causing a recession. Hence, a high fiscal deficit will be either inflationary (if M3 expands) or recessionary (if M3 is kept unchanged).

The Parikh study notes that artificially cheap diesel creates perverse incentives. It encourages purchase of diesel cars, which are much more expensive than petrol cars and so represent a distortion of capital use, but are cheaper to run because of the subsidy. Again, furnace oil prices are not controlled, so this inferior fuel has become more expensive that diesel. The result: industries are burning three million litres of diesel instead of furnace oil in boilers, a scandalous waste.

The study runs a complex economic model to estimate the impact of different policies on inflation. It finds that in the short run, a 30% oneshot rise in diesel price raises inflation by 2.3 percentage points, because it affects transport and farming costs. However, within five quarters, raising diesel prices becomes less inflationary than keeping them static.

Over four years, a 30% rise in diesel price will lead to average annual inflation of 5.68%, much lower than the 7.13% if diesel prices are kept static. Four years after a 30% price hike for diesel, the wholesale price index will actually be 5.66% lower than with a static diesel price.

A 10% rise in diesel price will cost only Rs 2 per month more per person in the bottom rural decile, and Rs 4-6 extra for the fifth decile. Farmers using diesel pump sets will have to spend another Rs 2,500 crore on fuel, but this can be offset by a targeted subsidy. Three lakh telecom towers burn 2.75 billion litres of diesel, and this can be substituted by solar power.

The study shows that GDP will be 3.86% higher four years after prices are raised 30%. This means additional production of more than Rs 4,00,000 crore, with attendant jobs and opportunities. Raising diesel prices to rational levels improves the allocation of resources in the economy, wastes less on pointless subsidies and, thus, increases production overall.

Conclusion: the government should go ahead and increase the price of diesel by Rs 1 a month till under-recoveries are eliminated. That will be a blow against populist myopia, and a blow for faster growth with lower inflation.