Fixing the subsidies deadlock

Two numbers stand out in the new budget presented by finance minister P. Chidambaram last week and they capture the essence of what has gone wrong with Indian public finances in recent years.

add_main_imageNumber one: The biggest reason why Chidambaram could keep the fiscal deficit within the level he promised was that he ensured that the government spent ₹ 60,000 crore less than what was budgeted for in February 2012.

Number two: The austerity clearly did not extend to the subsidy bill, which overshot its budgeted target by ₹ 67,000 crore.NextMAds

There is, thus, good reason why many economists believe that sorting the subsidy problem is the central task of fiscal reform. The subsidy bill since fiscal year 2004 has grown nearly six times, far more than the growth in the underlying economy in nominal terms. The gross number is even starker: the two Manmohan Singh governments have spent a cumulative ₹ 11.82 trillion on various subsidies over the past decade.

Total government spending over these 10 years has grown at a slower pace than spending on subsidies. This essentially means that the government has to cut back on other items so that subsidies are untouched.

The opportunity costs of this choice have been high. Subsidies have crowded out spending on public goods. Just ask yourself what could have been built if at least half of those ₹ 11 trillion had been redirected to build new infrastructure. As I had pointed out in an earlier column, building a kilometre of a good rural road costs about ₹ 5 crore per km, which means that India has effectively given up around 20,000km of new rural roads, assuming one-tenth of the subsidy spending since 2004 had been used to build new rural roads. One could come to similar conclusions about new schools or drinking water schemes or public toilets.

Not all subsidies are wasteful. Merit subsidies for education, public health, nutrition support, roads, etc., are beneficial for economic growth in the long term. The same cannot be said about non-merit subsidies such as those paid for petrol, diesel or electricity. They create deadweight losses by tinkering with market prices.

Many of them also serve the better off rather than the genuinely poor, so fail the equity test as well.

Higher user charges will always be political dynamite, which is why the political class balks at increasing prices till a fiscal crisis stares it in the face. One solution is to take pricing decisions out of the realm of politics. sixthMAds

The Fourteenth Finance Commission headed by former Reserve Bank of India governor Y.V. Reddy has been asked to look into this. One of its terms of reference says: “The need for insulating the pricing of public utility services like drinking water, irrigation, power and public transport from policy fluctuations through statutory provisions.”

The railway budget presented by minister Pawan Kumar Bansal last week did seem to take a stab at depoliticizing freight rates, though passenger fares have been kept out. Bansal said he will link tariffs to fuel costs; the two will move in tandem, either way. The more permanent solution will be an independent regulator who will fix prices for all railway services.

More generally, a fractured polity such as ours does not encourage tough decisions. India needs to move to a system of rule-based pricing of many public services, replacing the current system of discretion. That will help put public projects on firmer financial footing.

That still leaves the puzzle about why Indians prefer subsidies to public goods. After all, paying less for diesel is attractive in the short term but damages economic vitality in the long run by starving everything from schools to roads of extra funds. Look at what China has built in the past five years: 19,700km of new rail lines, 609,000km of new roads or 31 airports, as our Quick Edit on page 1 points out.

Part of the answer could be in the global fact that people cannot discount the future properly. They prefer immediate gains to benefits that lie across the horizon. But there could be some India-specific factors at play as well.

The economist Mancur Olson showed many years ago that complex societies see the rise of sectional interests who aim to grab money to their advantage. In India, the problem is particularly rampant thanks to our complicated matrix of caste, religion and language. The political economy of subsidies, thus, draws its strength from a fractured society that cannot agree on the provision of public goods that can help all Indians. Organized groups prefer subsidies that benefit their members.

The explosive growth in subsidies has not only put public finances under pressure but also effectively blocked funding for essential public goods. It is far more important right now to have good schools than cheap petrol. The government has tried to cap its subsidy bill in recent months, but only because it was warned that a fiscal crisis loomed. That is not a sustainable approach.

A better approach would be a system to change user charges based on clear rules. A very tentative start does seem to have been made.

Niranjan Rajadhyaksha is the Executive Editor of Mint. Your comments are welcome at cafeeconomics@livemint.com

To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics