Monday, August 3, 2009

Airline industry woes - searching for wrong solutions?

The latest airline industry debate in India confuses me. In a virtual plea for a bailout, eight of the major private airline operators in India have joined together to suspend air services on August 18, 2009 in protest at the irrational sales tax levied on Aviation Turbine Fuel (ATF) and high operating charges caused by rising airport charges. Both ATF, which forms about 40-45% of the operating costs, and airport charges (navigation, landing and other ground support charges at the airport) are priced 60-80% higher in India. Airlines want ATF to be classified as a 'declared good', so as to attract a uniform sales tax of 4%.

Now, here are six reasons why this plea for help (or blackmail tactic) may not pass the test of closer scrutiny.

1. I am surprised that no one is speaking of the obvious way out of such situations - higher ticket prices! Econ 101 teaches us that market pricing should be done at the marginal cost of production. It therefore follows that when cost of production and delivery increases, the prices too should follow suit.

In the instant case, the private airlines should pass on a part of their higher operating cost to their consumers by raising the ticket prices, if need be, or else cut other expenditures to bring costs in line with their revenues. If the oil prices go up, as it appears inevitable, then will the airlines demand cutting taxes and other subsidies to keep prices unchanged?

It appears that after having cut their costs and captured their market shares, none of the airlines are willing to forego any advantage by increasing prices, especially in a price sensitive market like India. And if they cut their prices then the no-frills carriers are waiting in the wings to capture market share!

2. All the private airlines are subject to the same levels of taxation and suffer the same adverse impact of the higher ATF prices and airport charges. Further, there are no foreign private airlines as competitors. Thanks to its inefficiency, Air India will never be able to match the private carriers even if it is flooded with bailout sops.

There is therefore a very clear level-playing field among all private airline operators. All of them, including the low-frills carriers, are subjected to the same set of pricing pressures due to these two factors. In relative terms, nobody is disadvantaged and the pricing can start at level zero after discounting for the same set of ATF prices and airport charges. In economic terms, in a closed economy, when taxes are equally administered among everyone, there are minimal incentive and efficiency distortions.

3. Without going into merits of the arguement against oppressive taxes, it needs to be borne in mind that taxation is the prerogative of any government. In any democracy, those affected by taxes have the right to lobby with the government to reduce them, but then should abide by the government's final decision. In any case, tax on a particular product or service is part of the larger set of government policies on various issues, and it would be inappropriate to tinker with them in isolation.

However, it would set a very bad precedent if businesses start resorting to virtual blackmail to get governments to lower taxes. Other businesses would be encouraged to follow suit, leaving only the small tax payers without recourse to any such option.

4. Sales tax is a state subject and therefore it may not be appropriate nor desirable to expect the Union Government to put pressure on states to lower their respective local taxes. Imagine private businesses lobbying with the WTO to get its members to lower tariffs on their imports!

Only Andhra Pradesh and Rajasthan among the major states have lowered sales tax on ATF to 4%. The sales tax, generally 28% in most states, is a major source of indirect tax revenues for them.

5. Interestingly, the brunt of the losses have been taken by the regular carriers like Kingfisher and Jet Airways, while the low-cost carriers like Spice Jet appear to have fared far better. In fact, the low cost carrier Indigo broke ranks with the rest and withdrew from the protest strike. I am inclined to believe that in their effort to retain and expand their market shares in the face of intense competition from the no-frills carriers, the regular airlines too have tried to keep their prices below commercially viable levels.

In other words, the regular private airlines too have tried to follow the pricing model of the low-cost carriers while retaining their other features, a clearly unsustainable model. One only needs to visit MakeMyTrip and compare the prices to know that there is little difference between regular from low-cost airlines especially in the major routes.

6. It does not require any great insight to realize that the mounting losses (airline industry is facing losses of about Rs 10,000 Cr in 2008-09), accumulating dues to government oil companies (Kingfisher is the major culprit), and difficulty in raising resources (as creditors have grown wary of the sector), have driven many of the private airlines to a desperate financial situation. They sense the proposed bailout of Air India as an opportunity to squeeze out some concessions for themselves from the Government.

Inefficiency and wasteful expenditures have contributed substantially to the present plight of these airlines. When the going was good, the major airlines indulged in irresponsible competitive price cuts, massive fleet expansions (many of those planes are now being returned and deliveries are being postponed), opened many commercially unviable new domestic routes, and initiated unsustainable promotional offers. The net result is that the Indian airline operators, with only a 2% share in global air passenger traffic, are estimated to account for a quarter of the global airline industry losses of $9 bn for the year 2009.

Interestingly, by cutting down on several loss-making routes the British low-cost carriers, Ryanair and easyJet, may have set the stge for the Indian private airlines to emulate to atleast partially address their financial woes. Either, price these routes at the marginal cost or exit them. Part of the problems of public carrier, Indian Airlines, can be traced to it having to service such commercially unviable routes.

The present travails of airline industry in India is yet another timely reminder of the fact that privatization and de-regulation do not offer automatic routes to efficiency, greater profitability and lower government support. In the larger canvas, the state of affairs at Air India and the private carriers appear no different. The higher airport charges are the direct impact of privatization (or PPP) in air transport sector, as the these higher charges are being levied by the private airport operators.

Different global experiences at de-regulation and privatization - ranging from the tightly controlled duo-poly arrangement in Brazil, to the fragmmented market populated by many state and private carriers as in China and India, to the mergers and consolidations driven US airline market - appear to have left the industry none the wiser. Price wars and irresponsible route expansions driven by pressures to capture market shares, which characterize all these markets have left everyone badly hurt and may even have compromised on passenger safety. In an ironical twist, there have even been calls for a retun to the era of regulation.

About Indian airline industry, given the price-sensitive nature of the Indian air flier, I am inclined to the opinion that a lower cost model may be a more practical approach. The regular service airlines will have to confine themselves to certain high-volume routes and instead of competing with the low-cost carrier market, will have to charge higher, cost-recovery ticket prices.

Consolidation and outsourcing of all ground support services can be another area of cutting costs. This is all the more important in smaller markets like India where separate ground support logistics for each airline cannot be sustained by the traffic volumes.

In the final analysis, air fliers will have to get used to higher prices for better, safer and more reliable quality of airline and airport services, and airlines will have to price their services at atleast the marginal cost of delivery. Instead of relying on the government and tax payer to subsidize (after all lower taxes is aform of subsidy, albeit one which does not arouse the indignation of the intelligentsia) both, such problems can be solved in a sustainable manner only through the most fundamental of economic decisions - raise ticket prices!


Anonymous said...

Good one. High on readability.

Naveen Mandava said...

This may not be relevant directly to the current political context. But if there are taxes being levied, how do you ensure that they are competitive and market feedback based rather than plain prerogatives? Given the structure of the market, how can we have airports competing to let true "prices" emerge?