Subsidies in India: Freebies or Solution to Problems

22 Feb 2020

Category : Economical Issue

Topic: Subsidies in India: Freebies or Solution to Problems

A subsidy, often viewed as the converse of a tax, is an instrument of fiscal policy. However, their beneficial potential is at its best when they are transparent, well targeted, and suitably designed for practical implementation. Subsidies are helpful for both economy and people as well. Subsidies have a long-term impact on the economy; the Green Revolution being one example. Farmers were given good quality grain for subsidised prices. Likewise, we can see that how the government of India is trying to reduce air pollution to subsidies LPG.

Like indirect taxes, Subsidies can:

  • alter relative prices
  • budget constraints
  • affect decisions concerning production, consumption
  • decision regarding allocation of resources.

  • Subsidies in areas such as education, health and environment at times merit justification on grounds that their benefits are spread well beyond the immediate recipients, and are shared by the population at large, present and future.
  • Subsidies also cause of inefficiencies or are of doubtful distributional credentials. Subsidies that are ineffective or distortionary need to be weaned out.

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 and masses lived in abject poverty and illiteracy.

India just after Independence:

  • not producing enough food to meet our people demand,
  • life expectancy was 30+ years;
  • there was crisis in every sphere, be it:
    • agriculture,
    • industry,
    • health or
    • education due to British-Raj.

Given such circumstances, founding fathers of democratic India rightly envisaged Indian state to be a welfare state. However, 70 years down the line problems not solved but seems to increased, and other problems cropped up and poverty still stubbornly remains a pressing problem. In this context, govt. economic survey (2019) 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 fight poverty but non-targeted also benefitted. Main concern 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: Its benefits and associated problems

  • Aims of Subsidies
    • Making basic necessities affordable to poor people through extension of consumer services.
    • 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. In such case government do handholding by supporting private sector by extending subsidies and withdrawing subsidies when private sector becomes competitive.
    • Subsidies should be aimed at specific development objectives and should withdraw when subsidies objectives are meet. Subsidy once extended to poor and deprieved becomes a politically sensitive issue and governments suffer huge political risk even if govt. think to phase out such subsidies.
    • Higher amount of subsidy 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 earned less than spending. 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.
    • 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.
    • 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.

  • Subsidies and its opportunity costs
    In economics, debate between two alternative uses of money:
    • Consumption
    • Investment is quite old.

In India 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 13.8% of GDP
Revenue expenditure (consumption) 12.1% of GDP
Capital expenditure (investments) 1.7% of GDP
Non-Plan expenditure (out of revenue expenditure)
Non-Plan expenditure had following breakup:
  • Interest payments – 36.9%
  • Defense Services – 12.1%
  • Subsidies – 24.2%
  • Grants to states and U.T.s – 6.3%
  • Pensions – 7.3%
  • Others – 13.2%
9.5% of GDP

It is in the interest of nation to minimize this consumption part of expenditure and increase allocation to capital expenditure. 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.

Subsidies Distortion

  • Ground-Water Decreasing
    Water and Electricity for agricultural use are heavily subsidized by governments. Again, vote-bank politics led this economic cause and most governments have failed to take rational policy decision and sustainable use of subsidized water and electricity. Due to this, in large parts of India, groundwater is being extracted indiscriminately as electric pump consume subsidised electricity that is almost free. This has led to lower groundwater levels and still decreasing. Water extracted from deep earth often gets contaminated by arsenic, fluoride and other mineral. This, together with erratic rainfall in monsoon due to climate change, has pushed rural India in deep distress.

    Solve 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 and focus on promotion of ground-water harvesting.

  • Subsidies on 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. Urea still under govt. subsidy basket even when real costs of production have risen significantly. On the other hand Potassium and Phosphorous are covered under the scheme (NBS) and a fixed subsidy as per content of nutrients is given to suppliers and they change Maximum Retail Price (MRP) as per market dynamics. Secondary and other Micronutrients are also covered under the scheme.

    As a result, actual use of NPK is in ratio of around 8:3:1 while recommended use is 4:2:1. This excess use of urea can degrade soil and harm crop instead of benefits. 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. 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. Another problem of rich states like Punjab, Haryana use excess of these fertilisers and other states uses less than sufficient fertilisers and other problem of suffiecient sufficient supply of water to crop while India still more than 60% rain-fed and depend on monsoon to meet its water demand.

  • Cultivation of Food Crops at the cost of coarse and other nutritious crops:
    Consumption patterns in India are shifting rapidly from calorie rich diet to protein and vitamin rich one. 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.

    Ironically, pulses are water efficient crops with capacity to rejuvenate soil by process of nitrogen fixing and farmer chooses crop like sugarcane which will not be beneficial to farmers in future. Sugarcane is suitable to be grown in areas of Bihar and Bengal given abundant water, but here also problem 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.

  • Railways:
    Many countries offer subsidies to their railways because of the social and economic benefits that it brings. The economic benefits can greatly assist in funding the rail network. Rail subsidies vary in both size and how they are distributed, with some countries funding the infrastructure and others funding trains.

    Subsidization and Cross- Subsidization
    Between 1993 and 2011, the wholesale price index (WPI) rose by 295% and the fares of sleeper class and second class travel not rose commensurately. Consequently, railway runs at heavy loss, which can be construed as subsidy to passengers of the railways and railway has failed to expand capacity and improve quality to serve needs of booming Indian economy and passengers. There is problem of poor service, security and modernization of Indian railways, When British left India had network of 45000 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 which put burden on our industrial and manufacturing sector and make Indian product uncompetitive due to high input cost. 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 is much costlier, more polluting and more time consuming. This has made our economy a lot more uncompetitive.

  • 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. There is other govt. support to farmers like free or lower prices of electricity, loan waived which put burden on govt. exchequer.

    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 mainly rich farmers take benefits than poor 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. Banks prefers to rich farmers and other industrialist associated in agriculture directly or indirectly because of the risk on capital to become NPA if loan disburse to small farmers.
    • Third, agriculture credit is getting concentrated on peripheries of urban areas, which means that money is being diverted to nonagricultural use.

  • Food inflation:
    Fact that India produces surplus foodgrains doesn’t mean that these are available to consumers at cheaper prices or farmers getting adequate prices of their products. It is only middle men who reaping undue benefits at the cost of farmers and consumers. Rather, India till couple of years back witnessed spiraling double digit inflation driven by expensive food, even when we had more than sufficient to meet the demand of people and 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 and high input cost due to poor infrastructure like road, cold chain and ware-houses. 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 means there is shortage of grains in open market which push prices upward and millions of tons of grains stored in FCI godowns.

Direct Benefit Transfers as solution

  • 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 and other infrastructural 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, this will prove to be a low hanging fruit. Other problems like banking coverage in remote and rural areas, infrastrucural issues like electricity, internet, people illeteracy and people love for cash and conservation on online banking.

  • 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 and selling of subsidised food to middle-men in other neighbouring countries. 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.

  • 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.

  • 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.

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.
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. 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.