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Understanding Subsidies in India

                                                      Subsidies in India

Table of contents

  1. Introduction
  2. Subsidies: are they solution to a problem or are they themselves a problem?
  3. Subsidies and its opportunity costs
  4. Some subsidies led distortion in India
  5. Direct Benefit Transfers as solution
  6. JAM Trinity – Jan Dhan Yojna, Adhaar and Mobile base
  7. Conclusion

Subsidies are one of the quintessential attributes of any welfare state. India, at the eve of independence was left with uphill task of socio-economic development. Markets were almost nonexistence, masses lived in abject poverty and illiteracy, we were not producing enough food to satiate hunger of masses, life expectancy was just 32 years; in short, there was crisis in every sphere; be it agriculture, industry, health or education; partly due to colonial legacy. Given such circumstances, founding fathers of democratic India rightly envisaged Indian state to be a welfare state. However, 70 years down the line only few problems have abated, while new ones cropped up and poverty still stubbornly remains a pressing problem.

In this context, latest economic survey rightly points out that despite spending as high as 3.77 lakh crore rupees annually on subsidies there is no ‘transformational impact’ on standard of living of masses. While subsidies have helped some poor people to do firefighting in life, main allegation on a subsidy economy is that, through subsidies, money meant for poorest is appropriated by richer sections of the society due to mistargeting and leakages.

Subsidies: are they solution to a problem or are they themselves a problem?

As already said, a welfare state without subsidies cannot be imagined. Governments have to extend subsidies to achieve objectives of socio- economic policy. By this, they aim at-

  1. Making basic necessities affordable to poor people through extension of consumer services.
  2. To prepare a foundation of various economic sectors in which private sector can participate later. When economy is at lower stages of development, it is often unviable and unaffordable for private sector to step in production. This is mainly because there are limited resources with private investors and there are informational externalities/uncertainties. In such case government do handholding by supporting private sector by extending subsidies and withdrawing them when private sector becomes competitive.        

Subsidies should be aimed at specific development objectives. On achievement of these objectives subsidies should be phased out. It is only then that subsidies can go well with an undistorted market economy.

However, in a democracy, subsidy once extended becomes a politically sensitive issue and governments suffer huge political risk if they phase out such subsidies. Overtime, new subsidies are extended which pile up on older ones and they soon consume scarce revenue resources of government. This takes a heavy toll on other expenditure of the government. They are forced to cut allocation to developmental and infrastructure avenues. Further, higher subsidy expenditure pushes up fiscal and revenue deficits as government starts spending more than it earns. This fiscal deficit can be closed preferably by raising more revenue through new taxes (proactively) or by borrowing money.

Most significant consequence of either of this alternative is that money is squeezed out of economy and which results in lower consumption/demand. This, in turn hits the growth in economy. Less growth results in lower collection of taxes. On other hand subsidy burden remains same or even increases. Further, higher borrowing results in higher amount of interest to be paid. So in short, careless or politically motivated subsidy results in lower revenues for government and higher unproductive expenditure.  

Further, if government is unable to borrow money or to raise taxes, it will have to print new currency to finance deficits, which increases money supply in the economy. This creates inflationary trends in economy. Incoherent subsidy regime unintendedly does more harm than good for the cause it stands – socio- economic development.     

Subsidies and its opportunity costs

Subsidies are that part of government expenditure that is ‘consumed’ by beneficiaries. In economics, debate between two alternative uses of money: Consumption and Investment is quite old.

Consider a family of four with limited means which earns Rs 10000 a month. If this family consumes food for all this money, month after month then it is likely that its earning will remain same in perpetuity. However, if family manages to save Rs 3000 a month or Rs. 36000 an year, and invest this money in some return yielding avenue, in education of children or developing skills of working members, then its income will gradually increase and poverty, someday, will certainly will be thing of the past. While doing so family will have to take care that all its basic needs like housing and food, gets fulfilled in Rs 7000 a month. It may be quite hard, but if done, will certainly bring family out of poverty.

Same concept goes for economy as a whole. We have Tax to GDP ratio of around 17.7%. (Center plus states) With this amount government has to provide for interest payments of its debt, expenses for its humongous administration, defence of the country, devolution to states and panchayats, developmental work, infrastructure and for subsidies.

In 2013, total expenditure by government was 13.8% of GDP. Out of this revenue expenditure (consumption) was 12.1% of GDP, leaving just 1.7% of GDP for Capital expenditure (investments). Out of this revenue expenditure, non-plan expenditure was 9.5% of GDP. Further, non-plan expenditure had following breakup –

  1. Interest payments – 36.9%
  2. Defense Services – 12.1%
  3. Subsidies – 24.2%
  4. Grants to states and U.T.s – 6.3%
  5. Pensions – 7.3%
  6. Others – 13.2%

It goes without saying that it is in interest of nation to minimize this consumption part of expenditure and increase allocation to capital expenditure which stood at just 1.7% of GDP. However, most of the components of above list are inflexible. Interest payments cannot be reduces unless there is higher growth in the economy. Pensions are ballooning as there is consistent increase in life expectancy across demographic spectrum of India. Grants to states are also expected to go up given government’s commitment towards federalism. In all this, there is significant scope of reduction in subsidies as they are infested rampantly with problem of mis-targeting and leakage. This can be easily grasped from the fact that just shifting to cash transfers in distribution of subsidized LPG is expected to save annually Rs 15000 crore for the exchequer.

Some subsidies led distortion in India:

  1. Energy- Groundwater nexus – Agriculture sector is perhaps having most justifiable claim on subsidized inputs given the dismal situation of the farmers in the country. On these lines, water and electricity for agricultural use are heavily subsidized by state governments. Again, politics seeped into this economic cause and most governments have failed to ensure rational and sustainable use of subsidized water and electricity. Owing to this, in large parts of India, groundwater is being extracted indiscriminately as electric pump consume electricity that is almost free of cost. This has led to dramatic fall in groundwater levels. Wells have gone dry at numerous places. Water extracted from deep earth often gets contaminated by arsenic mineral. This, together with erratic monsoon due to climate change, has pushed rural India in deep distress.

To remedy this problem, government has plans to separate agriculture feeder network from rest, under Deen Dayal Upadhayay Gram Jyoti Yojna. This separate agriculture feeder will supply electricity only for a few hours a day. This was first tried by Gujrat and results were encouraging as it had role in making Gujrat a power surplus state, along with arresting continuous decline in groundwater levels.  

  1. Subsidized fertilizers – Nutrient Based Subsidy or NBS was introduced in 2010 with objective to promote balanced use of fertilizers and to limit fertilizer subsidy of the government. Idea was to fix subsidy as per nutrients (in per Kg ) in the fertilizer and leave the determination of price to suppliers. Presently Urea is not covered under the scheme due to political compulsions. Consequently subsidized price of Urea remained stagnant even when real costs of production have risen significantly. On the other hand Potassium and Phosphorous are covered under the scheme and a fixed subsidy as per content of nutrients is given to suppliers and they change Maximum Retail Price as per market signals. Secondary and Micronutrients are also covered under the scheme. (In short urea is still controlled and P,K, are decontrolled)

As a result, actual use of NPK is in ratio of around 8:3:1 while recommended use is 4:2:1. This additional use of urea doesn’t give any additional benefit to the farmer. Instead this can degrade soil and harm crop. Productivity and quality of a crop depends upon use of diversified mix of macro and micronutrients, which vary from soil to soil. While urea consumption has increased from 59 per cent to 66 per cent of total consumption in 2012-13 over 2010-11, per hectare consumption of fertilizer has declined from 140 kg to 128 kg over the same period. 

Fertilizer subsidy was `67,971 crore in 2013-14, an increase of 11 per cent over 2009-10. Large part of this went to production and consumption of urea that was not needed at all.

Also, due to excessive use of fertilizers groundwater is also getting polluted and chemical bioaccumulation problem is impacting health of people.

Apart from Urea, farmer is not even getting benefit due from NBS in case of subsidized potassium and phosphorus. Subsidy is provided to manufacturers, who in turn are responsible to pass this subsidy to farmers in form of reduced retail prices. Rather, manufacturers have increased their prices forming a cartel and have usurped subsidy meant for farmers. It’s only now that Ministry of Chemicals and Fertilizers has undertaken review of prices charged by registered manufacturers. It has plans to penalize and cancel registration wrongdoers.

Another mistargeting of fertilizer is that most of this is consumed by rich farmers of Punjab, Haryana and North West Uttar Pradesh. Uptake of fertilizers depends a lot on sufficient supply of water to the crop. As about 60% of total cultivated area of India is rain fed, subsidy is cornered overwhelmingly by well irrigated states.    

  1. Cultivation of wheat, Rice and sugarcane at cost of pulses, horticulture crops and coarse but nutritious grains

Consumption patterns in India are shifting rapidly from calorie rich diet to protein and vitamin rich one. Despite this, protein based diet in India is abnormally expensive. Main source of protein for Indian masses is pulses. Last whole year there was clamour on the issue of skyrocketing prices of pulses. India’s subsidy regime had its hand behind this problem.

Pulses are most suitable to be grown in areas of Maharashtra and Madhya Pradesh, yet large parts of these areas are under cultivation of sugarcane. Sugarcane due to high ‘fair and remunerative price’ is being sown in these areas. This create two problems – one, it deprives Indians of their source of protein; two, these areas are water deficit and sugarcane is water guzzling crop. This crop is sucking scarce water rapidly and when monsoon failed again this time, mainly in Marathwada; farmer had no way to escape.

Ironically, pulses are water efficient crops with capacity to rejuvenate soil by process of nitrogen fixing and farmer chooses crop like sugarcane which later proves to be a gross liability for him. Sugarcane is suitable to be grown in areas of Bihar and Bengal given abundant water, but it is not due to lack of electricity and irrigation.

Similar is the case for cultivation of Wheat and Rice. These two crops yield much larger quantity (about 5 times) per acre/hectare than crops like pulses. Higher MSP for pulses is not so high to make whole value of produce more remunerative for farmer. So he prefers conventional grains. This has led to huge stockpile of wheat and rice (40-50 million tons) in government inventory which decays and is carried forward at cost of Rs 5/ year. On the other hand, India has to import more than 25% of its consumption of pulses.

  1. Railways: Subsidization and Cross- subsidization – Between 1993 and 2011, the wholesale price index rose by 295% and the fares of sleeper class and second class travel rose just by 144% and 106% respectively. Consequently, railway runs at heavy loss, which can be construed as subsidy to passengers of the railways. It’s only natural that railway has failed to expand capacity and improve quality to serve needs of booming Indian economy. When British left India had network of 52000 Kms, which now increased to measly 64000 Km.

Apart from this, freight carriers of railways are even more uncompetitive, because railway subsidizes passenger fare further by charging higher freight charges. Accordingly, in 1970’s freight used to contribute 65% of railway revenues and now it does only 33%. This is due to shifting of freight carriage from rail to road transport, which much costlier, more polluting and more time consuming. This has made our economy a lot more uncompetitive.

  1. Agricultural Finance: Farmers are entitled to pre- harvest loan at 7% interest rate. They are allowed further 3% subvention in case of timely payment. Farmers can also take loan for post-harvest time against negotiable warehouse receipt.

Economic survey notes three discrepancies in this subsidy. One, trend indicates that amount for a single loan is increasing for most of these subsidized loans. This means that more subsidies is going in favor of rich farmers. Two, extension of subsidized credit is concentrated in last three months of the financial year, which indicates that reluctant banks otherwise unable to meet priority sector lending targets, desperately disburse loans to reach target at the end only. It is unlikely that this way credit will reach to desirable party. Third, agriculture credit is getting concentrated on peripheries of urban areas, which means that money is being diverted to nonagricultural use.    

  1. Food inflation: Fact that India produces surplus foodgrains doesn’t mean that these are available to consumers at cheaper prices. Rather, India till couple of years back witnessed spiraling double digit inflation driven by expensive food, even when world was reeling under deflation. This distortion is mainly due to increasing input costs to farmer coupled with persistent increase in Minimum Selling Price declared by government. This forces government’s agency FCI to procure foodgrains in open ended manner. As a result, government ends up procuring 25-33% of total foodgrains production in the country. Apart from this, about 33% of foodgrains are captively consumed by farmers. All this leaves just 33%-45% of total foodgrains for open market. This. At times, culminates in an absurd situation, where there is shortage of grains in open market which push prices upward and millions of tons of grains stored in FCI godowns.

Few experts believe that entitlements under Food Security Act are sufficient only to fulfill 50% of requirement of foodgrains for a household. For this 50%, there is massive but inefficient storage and PDS system. This in many ways significantly increases price of remaining 50% food grain need of households. So, a well-intended system may be actually working counter to its stated goals.      

Direct Benefit Transfers as solution

Given above are only few examples of subsidy support gone wrong. In such scenario, direct benefit transfers comes to rescue government from this problem. It is likely to have multiple benefits –

  1. Fiscal savings – Assuming explicit subsidies being extended by state in current form to remain between 3 to 4 lakh crores, DBT will curb this expenditure by around 15%, which is a conservative estimate of current leakages. This can save government around 50,000 crore, which can be used more efficiently for developmental purposes. Given that government is capable of sailing through implementation of DBT in comparative smooth manner, as there is huge support from beneficiaries and opposition is weak (unlike other issues such as disinvestment, land acquisition), this will prove to be a low hanging fruit.
  2. It hits at roots of corruption – It is common knowledge that subsidized fertilizer is diverted to industrial use from agricultural sector, kerosene is mixed in diesel and PDS food is leaked in black markets. In short, subsidy regime has nurtured a mammoth corrupt ecosystem and black economy in India. When DBT is implemented everything will be sold on market prices by the government. For E.g. Fair Price Shop owner will get PDS food in full central issue price plus margin kept by state government. Then question of giving away PDS commodities illegitimately doesn’t arise.

Further, Direct transfers will eliminate intermediaries which will end system of rent seeking from beneficiaries. Otherwise there is rampant system of illegitimate commission which is collected by government officials where they have power to stop, deny or delay the benefit to be passed.

  1. It is likely to control inflation – Distortions created by subsidy regimes discourage investment in relevant sectors. This creates supply side constraints in economy. It is expected that recent deregulation of diesel will increase production and private firms will reopen their retail outlets. This will create competition which often results in cheaper prices.

Further, trading and purchase at market prices keeps demand in check. For e.g. subsidy on urea encourages farmers to use it more even when there is no due benefit. This created huge demand of urea and in turn high prices of unsubsidized urea. This scenario has increased government’s subsidy on urea manifold, which is not only waste but a disaster in itself. Similar case is with the food grains. DBT will leave more food grain in market and hence lower prices.

  1. Better nutrition – When there is cash transfer poor will be able to diversify their diet by including more items like pulses, eggs etc. This will increase their protein intake.

However, there is risk that some households will misuse this cash in social evils like alcohol, tobacco or gambling. For this government has made eldest women in a household target beneficiary for cash transfers. This step is likely to empower women.

Government launched PAHAL scheme – pan India initiative for transfer of direct benefits for Liquefied Petroleum gas. Its huge success and about 3 crore fake beneficiaries have been eliminated, which will contribute to annual saving of Rs. 15000 crore.

Direct Cash Transfer is also being implemented for transfer of wages in MGNREGS scheme. It has resulted in reduction in delayed and fake payments in relevant areas.

Further, Direct Benefit Transfer for fertilizers and kerosene is on the cards. In case of fertilizers government is facing problems in determination of beneficiaries because there is lack of clear land titles.

JAM Trinity – Jan Dhan Yojna, Adhaar and Mobile base

Direct benefits transfers intend to transfer subsidies directly to account of beneficiaries. For this to happen efficiently there are two separate but related issues which need to resolve as prerequisite. One is medium of transfer and second is identification of beneficiaries.

For first, government is banking upon Pradhan Mantri Jan Dhan Yojna, under which more than 20 crore accounts have been opened. This is perhaps most significant step toward financial inclusion till date as unbanked population has been halved to 233 million. Subsidies under PAHAL scheme, pensions under National Social Assistance Plan and wages under MGNREGS are being credit to newly opened Jan Dhan account of the people. It also provides for overdraft facility of Rs. 5000 after use of 6 months and Rs. 100000 accidental insurance. These incentives have created a massive demand for opening of accounts. One benefit is that overdraft by account holder will regularly get repaid by automatic transfer of various subsidies in the account. This reduces the risk of default to negligible levels.

However, lakhs of villages doesn’t have any brick and mortar bank branch. In these villages mobile penetration is steadily growing. India has more than 900 million subscribers and out of these about 370 million users are based in rural areas. Rural subscriber base is growing at 2.8 million a year. Currently internet penetration in India is about 40% and is expected to grow spectacularly once national optic fiber network is in place. This all will be developed into digital mobile or internet based cash transfer mechanism.

Further, RBI has opted for differentiated banking by rolling out licences for Payment and Small banks. A bank licensed as a payments bank can only receive deposits and provide remittances. RBI last year issues 11 licences for payment banks to various corporate giants, telecoms and most importantly, India Post. India post is having about 155000 branches mostly in rural areas.

Apart from this, in-principle licences for Small Finance Banks have been granted to 10 entities. Small finance banks are a type of niche banks in India. Banks with a small finance bank license can provide basic banking service of acceptance of deposits and lending. The aim behind these to provide financial inclusion sections of the economy not being served by other banks, such as small business units, small and marginal farmers, micro and small industries and unorganized sector entities. Accordingly, it is likely that within few years subsidies will find way to bank accounts of all beneficiaries.

Now, to be sure of identity of beneficiary, Adhaar card base is blessing in disguise. Atleast 93 crore Adhaar cards have already been issued and it will take some more time for universal coverage. Biometrics captured in this card ensures that there is no duplication and no wrong claim is made. Earlier Supreme Court banned use of Adhaar card on privacy concerns, but on government’s appeal it allowed its use provided it is not made mandatory.

Apart from these initiatives, behavioral and technical remedies may be of immense use to control and target subsidies better. Under ‘Give it up’ campaigning, about 50 lakh LPG users have voluntarily given up there subsidy entitlements. On technological side, Urea is being neem coated, which while enhancing agricultural productivity, makes it unfit for industrial use.                                  

Subsidies are meant for poor people and they shall ensure equitable redistribution of resource. Subsidies extended to rich are regressive. They help in keeping poverty intact and create inefficiencies in economy which culminates in inflation and corruption. In such case economy is retarded as we have seen in India’s case. When India grew in first decade of millennium at average rate of 7.5% it was found that this growth was jobless and unsustainable. India’s economy faced supply side constraints, which didn’t increase productivity as compared to GDP. RBI had to then control spiraling inflation by steep hikes in interest rates. Rationalization of subsidy regime will improve markets in India which will then attract more investment. This in short, can turn the wheel of a virtuous economy which creates more employment and attacks poverty at its roots.