Subsidies and the pricing problem

Subsidies and the pricing problem
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First Published: Thu, Dec 08 2011. 10 54 PM IST

By Jayachandran/Mint
By Jayachandran/Mint
Updated: Thu, Dec 08 2011. 10 54 PM IST
The bane of public policy in recent years has been the penchant for governments to interfere with prices in markets where goods or services are subsidized.
By Jayachandran/Mint
Such price distortions abound in India. Since statutory services are delivered cheap, middlemen emerge and capture the higher willingness to pay. Low property taxes make municipal services unviable. Low electricity and water tariffs reduce the incentive to optimize usage. Cheap public distribution system (PDS) foodgrains and kerosene spawn black markets. Subsidized urban housing is sold off and beneficiaries revert to squatting. Low-priced public transport tickets push state transport corporations towards bankruptcy. Wage guarantees distort labour incentives and prevent their efficient allocation.
Econ 101 teaches us that price signals are the fundamental marker in the efficient allocation of resources. Conversely, price distortions create market failures. However, efficiently determined prices cannot always ensure fairness in distribution, the touchstone for acceptability in a political democracy. It, therefore, becomes necessary for governments to often intervene and ensure that underprivileged consumers can access goods and services at affordable, below market-determined prices.
The preferred strategy to achieve fairness in allocation is subsidization of prices of goods or services. The subsidy can be universal, as is the case with public transport and fertilizers, or targeted, as in the case of PDS. Apart from bleeding public finances, universal subsidies distort the incentives for producers and consumers. Targeted subsides fail in precisely that—targeting. It also creates dual-price markets—government delivers goods and services at subsidized prices to certain citizens, whereas others purchase the same at its regular market price.
The most widespread cause of inefficiency related to subsidies is dual-price markets. In many cases, there exists a considerable price differential between the two distribution channels. This price differential naturally generates far-reaching incentive distortions. In the case of goods, such distortions are manifested as illegal diversion of supplies, adulteration, and the emergence of parallel markets. In services, it creates middlemen and encourages bribery to access the service illegitimately.
Price caps on tariffs and user charges adversely affect the finances of the entities producing these goods or services. Utility service providers—electricity, water and sewerage, and public transport—are the worst affected. This is symptomatic of the finances of most utility service providers across the country. They have little incentive to invest in new technologies and productivity improvements. Consumers have even less incentive to optimize their consumption. Inefficiencies abound everywhere.
It is the prerogative of governments to determine whether to subsidize a good or a service. However, such interventions have to balance the often conflicting requirements of fairness and efficiency. A sense of fairness requires that public policy should intervene to ensure that certain essential goods and services, which are otherwise expensive in the market, be made available at affordable prices for the poorest. This has to be weighed against the demands of efficiency, which stipulate that the same objective be achieved at the lowest cost and with the least distortion. Subsidies should deliver bang for the buck. Unfortunately, far too often, in the pursuit of the former, the latter is overlooked.
There are no easy or magic-bullet solutions to ensuring both fairness and efficiency in the delivery of subsidies. Fundamentally, any policy that seeks to achieve this objective should be designed to align incentives of all stakeholders so as to moderate the possible distortions arising from subsidized delivery.
For example, harassment corruption in the delivery of statutory services can be mitigated by differential pricing of service delivery—higher fee for faster and door-step service. This helps institutionalize and legally capture bribes. Water and electricity services should be metered with increasing block tariffs, with a generous tariff for initial basic consumption. Cash transfers are more effective in targeting most product subsidies. Replacing ownership with rental vouchers can reduce the distortions in the urban housing market. Labour market distortions can be minimized if wage guarantees are replaced with unemployment insurance.
The most effective approach to minimizing such distortions is to eliminate price subsidies and replace them with direct equivalent cash transfers. The preferred categories of citizens will be provided additional purchasing power to buy these products from the regular market. This cash can be transferred through vouchers, either directly to the beneficiary’s account or as a back-end subsidy to the seller. If dual-price markets have to be retained, as would still be the case with certain products and services, it requires rigorous and foolproof targeting.
In this context, the Aadhaar number provides an exciting opportunity to simplify subsidy administration. It eliminates ghost, duplicate and impersonation of identities. It can form the anchor for linking multiple government databases and, thereby, derive analytics that can address inclusion and exclusion errors in targeting. Cash subsidies can be transferred into the beneficiary’s Aadhaar-linked bank account or reimbursed to a similar account of the service provider on receipt of Aadhaar-linked vouchers from the subsidy beneficiaries.
None of this is to dispute that even with the most efficient targeting, it may be necessary to continue with universal subsidies in some areas such as public transport, school education, and primary healthcare.
Gulzar Natarajan is a civil servant. These are his personal views.
Comments are welcome at theirview@livemint.com
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First Published: Thu, Dec 08 2011. 10 54 PM IST
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