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The government is getting a lot of flak for its decision to adopt the dirty float mechanism in determining petrol and diesel prices. Pakatan Rakyat, Rafizi Ramli especially, is attacking the government by highlighting the fact that the government is not passing the full saving from the falling crude oil prices to the consumers and pointing out that consumers are effectively being taxed for consuming petrol and diesel.

Politically, I am enjoying the show because Barisan Nasional politicians and their supporters are so fond of asking others to be thankful to the BN-led government for providing subsidies. Now that the government is actually taxing fuel consumption, the politicians and their supporters are trapped by their own rhetoric and suffocating logic. There are people like Tan Keng Liang who is trying to defend the government but his messages are incoherent and uninformed. So, he is not doing the government much favor and I dare say he is hurting the government instead.

But beyond the politics, I prefer that we tax both petrol and diesel and then completely float it. That would leave retailers to set the prices, and hopefully compete with one another rather than having the government sets the prices from above. So, in some ways, I do approve of Rafizi’s action because I see his campaign ending up pressuring the government towards a better floating system, regardless whether that is his intention.

But I think it must be said that the current dirty float system is better than the old one. It is still inefficient, but it is more efficient than before. There has been significant policy progress in the past year or two and I think we have to be fair to the government for having the political will to do so.

On to the dirty float system itself, while the current mechanism has its weaknesses, it also has its strengths. In fact, its weaknesses are its strengths depending on the direction of the price change, from consumer perspective. Its lagged nature does provides some kind of stability to consumers.

I will not describe the current system in full, but in summary, it uses the average market prices from the last period as the reference retail price for the current month. The information that the system uses is lagged by a month.

I have drawn a chart to illustrate this:

From the consumer perspective, in time of falling crude oil prices (I label as actual market prices), the dirty float is not ideal. This is because saving from the current difference between market and retail prices goes to the government. The government would pass some saving to the consumers eventually but as you can see, the saving passed is only a fraction of total saving the consumers would have gained under a pure floating mechanism. The area colored red is actually the taxes paid by consumers.

But in time of rising prices, consumers would prefer to have this lagged pricing exactly because the situation is reversed. Consumers will also pay less, essentially enjoying a subsidy, as represented by the blue area. Of course, right now, this scenario is a hypothetical. When prices rise, you can bet the rhetoric will be different and wanting this kind of system instead.

But this also highlights that the dirty float mechanism does not really do away with the subsidy regime despite all the hoo-ha that Malaysia has finally abolished petrol and diesel subsidies. The truth is that the government has changed its system from that which always subsidizes consumption to that which would subsidize it only when prices are rising (and taxing it when prices are falling).

I would like to see the abolition of subsidy. That means a complete floating system where retail prices correlate almost completely with market prices, with a slight tax on it. That imposition of tax should be considered alongside the cash transfer policy.

  p/s — I have additional thoughts on the matter.

Apart from free-floating the prices to keep retail prices closely following the market prices with the view of passing the saving to the consumers, another way of improving the dirty float mechanism is to shorten the lag period.

Right now, the retail prices are dependent on the average prices of the previous month. What we could do is that make it dependent on average prices of the last two weeks, or the last week. The shorter lag would ensure the effective tax and subsidy be smaller than what it is right now. Here is another chart to show what I mean:

Here, I have added a new dirty float retail price with a shorter lag, superimposed on the first chart. You can see the amount taxed or subsidized is smaller compared to the original case. For clarity, area A+B is the total tax enjoyed by the government with the original month-long lag. With shorter lag, the total tax is just the area B.

It is also worth noting that if market prices are completely random, the total tax and subsidy would cancel out each other.

I also want to take this chance to clarify my ideal policy, i.e. free float with a slight tax on it. I figure the next chart will deliver my message crystal clear:

I am showing a fixed tax version. There are other ways to do this, like through ad valorem, which is how the GST would do.