How justified are non-merit subsidies?

The Hindu Business Line, March 25, 2008

Much of the justification for support pricing of foodgrains would weaken if the government brought the farmer closer to the ultimate consumer through better communication and transport facilities, says Pradeep S. Mehta and VV Singh

The loan waiver for farmers was indeed a welcome announcement in the Budget by the Finance Minister. But the banking industry is asking a different question: Who will bear the burden? The question remains unanswered as it is an off-Budget item.

This is not an exception; subsidies, in general, remain off-Budget as only a small portion of them are explicitly shown in the Budget document. The total subsidy burden in 2007-08 is expected to be Rs 1 lakh crore, of which almost half is going to be off-Budget. But how justifiable are these subsidies for which government is afraid of making provision in the Budget?

In India, we find subsidy support for various goods and services, such as like food, fertiliser, petroleum, energy, irrigation, education, drinking water, and so on. The simple justification for such support is that the cost of providing these goods and services is so high that the common man cannot afford them.

Politicians who oppose a reduction in subsidies always argue that in a welfare state, maximisation of aggregate consumer welfare is facilitated through the subsidisation of goods and services that benefit the poor. But unfortunately, much of the subsidy benefits go to the rich and undeserving in place of the poor.

What is worrying is that, instead of reducing the share of government expenditure, it has been increasing over time. Even when the original reason for putting a subsidy in place no longer exists, the Government simply does not have the courage to remove/reduce it for fear of losing votes.

Sensitive issue

Food subsidy has been a highly sensitive issue and, therefore, reducing or removing it constitutes a tough challenge for any government. At present, the food subsidy policy uses MSP-PDS operations to serve the conflicting objectives of ensuring remunerative prices to farmers and providing foodgrains to the poor at affordable prices.

This entails a huge gap between the purchase price and the issue price and, consequently, a large subsidy burden. In the future, this burden might rise as a rising MSP is not going to be accompanied by an increase in the issue price in the same proportion. Given that the burden of these subsidies on the exchequer has been increasing, it is advisable to try and achieve the welfare objectives of these subsidies by an alternative route — that provided by the introduction of competition in agricultural markets.

The PDS is also almost out of reach of the poor as it suffers from considerable leakage and management inefficiencies. Thus, benefits derived by the poor are negligible. Moreover, efficiency is so poor that the administrative costs amount to almost 85 per cent of the total expenditure.

Alternatives to PDS

To improve on the inefficient system of delivery of foodgrains to the poor and, thereby, reduce the government’s budgetary burden, food vouchers/stamps can be employed. Such vouchers/stamps can be issued to BPL families through the panchayati raj system/local government bodies for use in the open market. This would also improve consumer choice.

Support pricing, as it exists today, is of no use to the nation as it goes to the medium and large farmers, who produce for the market, and distorts the income distribution against small and marginal farmers, who produce only to meet part of their subsistence needs.

Much of the justification for support pricing of foodgrains would weaken if the government brought the farmer closer to the ultimate consumer through better communication and transport facilities. This would enable the farmer to get a higher price for his produce.

The fertiliser subsidy is indirect and much of the benefits accrue to the industry and large farmers rather than small and marginal farmers.

The share of fertiliser cost in the total cost of inputs in agriculture being high, only large farmers get significant benefits from subsidies as they are the ones who incur a large expenditure on agricultural inputs. Fertilisers are not used in large quantities by poor farmers as their purchasing power is low. The budgeted subsidy is continuously rising and has doubled between 2002-03 and 2006-07. The budgeted subsidy, at Rs 30,985 crore for 2008-09, is grossly underestimated and the actual amount is estimated to be around Rs 75,000 crore. The Fertiliser Association of India is already demanding this amount. The difference between estimated and actuals is, again, expected to be off-Budget.

Providing direct subsidy only to small and marginal farmers can lead to a reduction in the budgetary burden caused by such subsidy as well as greater social equity.

Petroleum subsidy

Petroleum subsidy has become a political issue. LPG and kerosene continue to be heavily subsidised. This subsidy benefits largely the higher income groups and proves to be regressive. Diesel subsidy can be considered to be an exception because of its use in agriculture and public transport but, increasingly, many from the higher income groups in urban areas are switching to diesel cars.

Strong political reasons prevent the Oil Marketing Companies from changing the price according to shifts in international prices. The government, to compensate these losses, issues oil bonds to the OMCs, which is a further off-Budget liability for the government.

The paradox of tax and subsidy on petroleum products is beyond understanding. If the government wishes to reduce the prices of these products, why are they taxed so heavily?

Collecting revenue from taxes and transferring it in the form of subsidy has little economic relevance, only political. The only way to get out of this paradox is to take the tough decision of allowing OMCs to increase prices in phases and reduce the tax burden on them.

One way of reducing the overall subsidy burden is to abolish, or at least reduce the magnitude of, subsidies across the board and let the market do the rest. In the long run, efficiency and equity also require proper targeting of subsidies.

Proper targeting is easier to achieve if we move away from indirect subsidies to direct income support. Thus, providing vouchers/stamps would be a better option that will empower the consumer and increase consumer welfare.

(Mr Mehta is Secretary General, CUTS International, and Mr Singh is Fellow, CUTS Centre for Competition, Investment and Economic Regulation)

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