Subsidy Reduction - Printable Version

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Subsidy Reduction - FDArchitects - 12-08-2016

Subsidy Reduction

A subsidy is a benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy is usually given to remove some type of burden and is often considered to be in the interest of the public.

Subsidy is a form of intervention which lowers the cost of production of a producer, or raises the price received by the producer, compared to the cost and price that would prevail in an undistorted market.

One initial purpose of subsidies is to protect the poor. Thus, distributional fairness is the first case in which subsidies might be justified. However, even this case needs to be treated with some considerable caution. In the context of water supply, for example, where the “protect the poor” argument is voiced very often, Briscoe (1997) points to the “hydraulic law of subsidies” In many cases, water tariffs were set below costs of production, often below short-run operating costs. Operating revenues were thus far below the level necessary to sustain an investment program. This meant that when government subsidies dried up, it was impossible to extend services to cover all.
Politics play an important part in subsidization. In general, the left is more in favor of having subsidized industries, while the right feels that industry should stand on its own without public funds


Environmental Concerns


Harmful effects of subsidies tend to come about because:

• the subsidy causes too much production or harvesting of the subsidised product, and hence too much associated effects such as pollution or resource depletion;

• governments have to find the money to pay for subsidies and this will come from taxation or  borrowing, causing macroeconomic problems, or, at the very least, diverting money from socially valuable uses such as health and education;

• overproduction caused by subsidies in the developed countries has to be disposed of, and this may result in “dumping” the excess production somewhere else, perhaps in developing countries, undermining their economies;

• subsidies also divert resources away from higher value uses to low value uses

• subsidies mean that true costs of supply are not recovered, which implies that the utilities supplying energy, water and so on, may not have enough revenues to secure surpluses that they can invest in new supplies. This is why public utilities in many developing countries are often locked into a vicious circle of poor supply and have little or no money for new investments

• subsidies create “economic rents” – money for doing nothing – and hence attract “rent-seekers”.

One of the side effects of subsidies is the encouragement of corruption. This is because the process of rent-seeking is likely to lead the beneficiaries of subsidies to exaggerate the basis on which they receive subsidies.

India majorly offers subsidy on food, fertilizer and petroleum.


Food subsidy: Over the past decade, the government spending over food subsidy has drastically increased. This is especially so after the Food Security Bill, which promises essential food grains at cheaper rates for people in the low-income category. This is to ensure access to food for those who cannot afford a basic meal.

Fertilizer subsidy: Fertilizer subsidy is given to the farming section of the population. Government provides subsidies to farmers in terms of reduced urea and other fertilizer costs. It also provides separate subsidies for irrigation-related activities.

Petroleum subsidy: The government also sells fuel at subsidized rates. This included petrol, diesel, kerosene as well as LPG. However, the government has de-controlled petrol and diesel prices. This means the end of subsidies for these two fuel variants. Only kerosene and LPG – gas cylinders are sold at cheaper rates. The subsidies on the petroleum and diesel prices have varied over the past years. This is mainly because of the fluctuations in the crude oil prices worldwide. In the financial year 2015-16, this subsidy is expected to decrease because of the diesel price decontrol. The government could now utilize this money constructively for infrastructure development projects.

SUBSIDY REFORMS / REDUCTION
The study brings to the fore the massive magnitude of subsidies in the provision of economic and social services by the government. Even if merit subsidies are set aside, the remaining subsidies alone amount to 10.7% of GDP, comprising 3.8% and 6.9% of GDP, pertaining to Centre and State subsidies respectively. The average all-India recovery rate for these non-merit goods/services is just 10.3%, implying a subsidy rate of almost 90%.

The macroeconomic costs of unjustified subsidies are mirrored in persistent large fiscal deficits and consequently higher interest rates. In addition, unduly high levels of subsidisation reflected in corresponding low user charges produce serious micro-economic distortions as well. Its prime manifestations include excessive demand for subsidised services, distortions in relative prices and misallocation of resources. These are discernible in the case of certain input based subsidies. These problems are further compounded where the subsidy regime is plagued by leakages which ensure neither equity nor efficiency.

The Direct Benefit Transfer (DBT) system, on the other hand, entails consumers paying the full market price for the commodity upfront. The admissible subsidy is, then, transferred separately to their bank account. The experience of DBT in LPG cylinder distribution under the Centre’s PAHAL scheme points to its success in not only delivering the subsidy efficiently, but also resulting in substantial savings for the exchequer. The challenge lies now in extending the DBT model to other subsidies, including those on agricultural inputs. That is where the recent example of Uttar Pradesh, which has successfully implemented DBT for seed subsidy, may be relevant.

The agenda for reform should therefore focus on:
·         Reducing the overall scale of subsidies
·         Making subsidies as transparent as possible
·         Using subsidies for well defined economic objectives
·         Focusing subsidies to final goods and services with a view to maximising their impact on the target population at minimum cost
·         Instituting systems for periodic review of subsidies
·         Setting clear limits on duration of any new subsidy schemes

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