India’s net-zero commitments have made the energy transition from fossil fuel inevitable. It is going to be a complex task with many interlinked moving parts. As India currently gets a large part of its revenue from fossil fuels, fiscal transition will play an important part.

In a recently published IMF-BU Working Paper, we have studied how governments’ (both Centre and State) revenue from . coal, oil and natural gas, will be affected over the next two decades as India shifts toward renewable energy sources. We use the International Energy Associations (IEA) scenarios for India to represent the future situation.. Under fairly standard assumptions on growth, prices and taxes, there would be continued growth in revenues from fossil fuels till 2040. However, revenues would fall significantly as a share of the gross domestic product (GDP) and overall government budget, which would naturally impose fiscal challenges for both the Central and State governments in the next two decades.

On examining the revenue from fossil fuels, we found that more than a fifth of the Centre’s revenues were from fossil fuels as of 2019 which included both tax (both direct and indirect) and non-tax revenues (including royalties, dividends etc.) paid by public sector undertakings.

For the State governments, total revenues from fossil fuels were lower at about 8 per cent of total revenues. The combined revenue for both the Centre and States was 13 per cent of the total revenue collected, which translates to 3.2 per cent of India’s GDP. To understand the enormity of the revenue from fossil fuels, this is much higher than India’s Defence expenditure, and comparable to the combined education, culture and sports expenditures of both the Centre and States.

As we start pursuing our net-zero commitments, the first step would be to reduce the use of fossil fuels and consequently this major source of revenues will disappear. As India undergoes this energy transition, it would be forced to undergo a fiscal transition.

Fiscal transition

So, how will India cope with fiscal transition? The government may impose additional taxes on coal or something like a carbon tax. Similarly, if current events are any indication, when the government experiences revenue stress, it finds energy to be the easiest source of revenues.

In our analysis, we calculated revenue from fossil fuels for 2019 and use the same for projections as well. However, if the events post 2019 are any indication, it only reinforces our analysis. During the Covid period, governments’ reliance on fossil fuel for revenues — mainly petroleum increased.

Despite decrease in the international crude oil prices, taxes on petrol/diesel in India were increased leading to decoupling of international and domestic oil prices. According to latest data, the revenue from petroleum was 2.7 per cent of GDP in 2019-20 which increased to 3.4 per cent of GDP in 2020-21 on account of higher excise and VAT.

Such indirect measures can lead to higher revenues from fossil fuel, but only for a limited period. Over time the revenues from fossil fuel will steadily fall as India shifts to renewable energy sources, ramps down the use of fossil fuels, and as electric vehicles (EVs) increase.

According to our estimates, if current economic trends persist, revenues are estimated to fall from 3.2 per cent in 2019 of GDP to 1.8 per cent and 1 per cent in 2030 and 2040 respectively.

Fiscal pressures on the Centre and States will make investing in energy infrastructure difficult. On the top of that, a large part of the energy transition may need to be supported through direct or indirect subsidies by concession of excise duty on EVs, concessional GST on electric cars, concessions given under Green Hydrogen Policy etc like the Small wind energy and Hybrid systems programme. The subsidies will add to the Centre and States’ fiscal stress. But without these subsidies the energy transition itself may slow down.

The declining revenue can have political economy ramifications as well. This is the last year of GST compensation given to State governments, which may put stress on certain States’ revenue. Furthermore, under the GST structure, States have limited autonomy to raise taxes, which may exacerbate the issue.

The Centre n the last few years have started collecting more revenues via cess which is not shared with States, running the risk of straining the center-State relationship.

The question that arises, is how can India deal with this challenge? The tax-to-GDP ratio in India has been very sticky in the last decade but fortunately, GST revenues are buoyant now.

Over a period of time, this buoyancy may compensate for the fall in fossil fuel revenues. Also, it is crucial for the government to continue with the formalisation drive to increasing the tax base. However, these are long-term processes. In the short run, India would need to increase revenues from some other source like increasing tax on demerit goods like alcohol, tobacco etc. to compensate for the reduction in energy sourced from fossil fuels.

Bhandari is Senior Fellow and Dwivedi is consultant at CSEP, New Delhi