Ways to reduce the subsidy burden

Rather than direct action, the government chose moral persuasion to make people give up subsidies. The focus then shifted to relying on technological solutions. We need to take a few more steps forward

When the new government assumed office there were great expectations of bold measures to reduce subsidies and redirecting expenditure to public investment. As global crude prices plummeted, progress was made on diesel and petrol. The pace slowed down in the context of liquefied petroleum gas (LPG). Rather than direct action, the government chose moral persuasion. Now the discourse seems to have changed to relying on technological solutions for reducing subsidies.

Let's start with the magnitude of the problem. In 2014-15, subsidies accounted for Rs 2.7 lakh crore or 2.1 per cent of gross domestic product (GDP). Subsidies pre-empted 23.7 per cent of the entire revenue receipts of the central government. In terms of opportunity cost (read lost), subsidies were 2.64 times the entire Capital Plan Expenditure for 2014-15. Food, fertilisers and oil-based subsidies account for 95 per cent of all subsidies. Will technological solutions suffice, especially after the mandatory use of Aadhaar has effectively been proscribed?

Food subsidies are the political hot potato. The grounds for a cutback are all well-known. First, apart from the intended beneficiaries, that is, below poverty line (BPL) families, the subsidies reach many others. Second, there are large leakages in the public distribution system, for example, grains finding their way to roller flour mills and thence to the market (bread, biscuit and savoury makers). The subsidy then shows up as a profit of some traders and producers at the cost of the government exchequer! Third, the subsidy pays for the carrying cost of stocks built up with the Food Corporation of India (FCI) and all inefficiency in the management of such stocks (rotted grains). Fourth, there are losses ascribable to graft when procuring grains of less than Fair Average Quality.

The food subsidy is on staples, wheat and rice. It seems naïve to believe that the poor live on grains alone. And, on other food items, the last decade has seen an inflation of 10 per cent or more per annum. Surely, a modest increase in price would have been tolerable. Nevertheless, central issue prices have not been changed in 15 years.

Fertiliser subsidies are facing worse outcomes. First, the greatest beneficiaries are farmers with large holdings (kulak). Such subsidies cannot accrue to the poor, landless labourers or in any significant measure to small holders. Second, there are long-term economic losses. Excessive fertiliser usage has led to serious deterioration in soil quality. Under-pricing is responsible for ecological damage. Third, there is the widely accepted position that subsidies support inefficient domestic fertiliser production, that is, they do not actually reach the farmers. Even if fertilisers have to be subsidised, why not import them and then provide a subsidy? The budgetary outgo would be less in that case. Economists call this a "make-or-buy choice". Why make when it is cheaper to buy? However, the reality is that "make" is the revealed preference, a throwback to the self-reliant (import substitution) era.

The case for reducing kerosene subsidies is much the same. There are unintended beneficiaries, not only (or mainly) the intended beneficiaries - the poor. There are big leakages. And, the use of kerosene as an adulterant entails other economic costs.

Technological solutions can only take us so far. We need to look beyond. And, there is simply no escaping from at least moving towards getting the prices right.

Take food subsidies. Technological solutions will reduce some losses due to unintended beneficiaries. But unless price distortions are addressed, no headway can be made to plug leakages in the system. Further, technological solutions cannot address losses on the FCI's carrying costs, rotting stocks, or graft in procurement; price adjustment can. Technological solutions offer virtually no relief on fertiliser subsidies. They cannot address the unintended beneficiary problem. And, fertiliser overuse can only be tackled by reducing the price distortion. Further, import price discipline is the easiest way to induce efficiency improvements in domestic fertiliser production. On kerosene, the argument is the same: no significant impact can result unless the price differential (distortion) is reduced.

Economists use the criterion of Pareto superiority to assess outcomes. Simply put, if a change results in an outcome in which gainers can compensate losers, and still be better off, the changed outcome is deemed Pareto superior. The gainer from subsidy reduction is the government. Surely it can redirect expenditure savings back to intended beneficiaries, for example, a 20 per cent reduction yields Rs 53,000 crore. If Rs 34,000 crore of this is used for MGNREGA, it would double the outlay on a programme where self-selection ensures better targeting. An amount of Rs 14,000 crore extra would double the outlay on 'Housing for All'; Rs 4,500 crore would double the outlay on Rashtriya Krishi Vikas Yojana; and Rs 5,300 crore would double the outlay on the Krishi Sinchai Yojana.

To address the issue of the FCI's losses requires price and non-price adjustments. We need an enduring reduction in stocks and a review of the minimum support price regime where relative prices distort productive incentives. An overhaul of the FCI system can no longer be delayed. On fertilisers, the 'make' decision needs review. If the concern is the vagaries of international markets, can't we replicate the Indian Farmers Fertiliser Cooperative/Krishak Bharati Cooperative Limited-Oman Oil type of joint venture?

Any serious action on subsidies ought to be taken in the early years of a new government, when political goodwill is still alive and election fever some time away. Mr Prime Minister, the first majority government in India in the last 30 years is expected to take action. If you won't, who will?