The Welfare Effects of Fuel Conservation Policies in the Indian Car Market

Abstract

The Indian car market is the fastest growing in the world. With increased mobility has come increased foreign oil dependence, fuel consumption, and associated externalities. In response to this, the Indian government is contemplating fuel economy standards, but at the same time continues to subsidize diesel fuel. The result is a diesel discount of 30%, relative to petrol, and an increasing market share of diesel cars. We use a model of vehicle choice and kilometers driven to compare the welfare impacts of two possible fuel conservation policies: a tax on diesel fuel that would equalize diesel and petrol prices, and a diesel car tax. The latter is an alternative to taxing diesel fuel recently proposed by the Indian government. We find in 2006 that a diesel fuel tax that equalizes petrol and diesel prices reduces total fuel consumption by about 9 percent, at a deadweight loss of about 8 Rs. per liter of fuel saved. The tax reduces the market share of new diesel vehicles by 4.6 percentage points. A diesel car tax of 25% would achieve the same reduction in market share; however, it would reduce total fuel consumption by only 1.5 percent, at a deadweight loss of about 30 Rs. per liter saved. A smaller diesel fuel tax, sufficient to yield the same total fuel conservation as the diesel car tax, actually results in a net welfare gain: The increase in petrol fuel revenues as buyers switch from diesel to petrol cars exceeds the deadweight loss of the diesel tax.