Economy: Subsidy Reduction: No Reasons for Regret

India Today, February 15, 1999
Feb 15, 1999

SUBSIDY REDUCTION
No Reasons for Regret

Don't groan over the hike in administered prices. The alternative may have been a self-propelled spiralling of prices, rising interest rates or higher taxes.

By Rohit Saran

So, once again an insolvent government has cut into your pockets just a month before the presentation of the Union budget. For a finance minister faced with sagging revenues and bloated expenses, the spate of administered price hikes (44 per cent for wheat, 64 per cent for rice, 5 per cent for sugar, 10-12 per cent for LPG and 11 per cent for urea) obviously comes as succour. True, the roughly Rs 2,700 crore saved through the subsidy cuts in the next 12 months -- after the partial rollback -- is minuscule when compared to the over Rs 1,00,000 crore fiscal deficit (assuming a 10 per cent growth over fiscal deficit in 1998-99) that Yashwant Sinha is likely to be confronted with. Nonetheless, price hikes are a welcome relief for the beleaguered bureaucracy in North Block which is battling to balance the books.

But what about the common man? Should he regret or rejoice? Having endured a whopping food-price inflation through the second half of 1998, a government-engineered price rise was least expected. Especially so, since the BJP's electoral reversals in November 1998 were partly due to the then galloping vegetable prices.

But what if the alternative to administered price rise was a self-propelled spiralling of prices, or rising interest rates, or higher taxes, or all three? For all this -- and more -- could have been inflicted if the Government were to eschew the price hike now. Warns B.B. Bhattacharya, professor at the Institute of Economic Growth (IEG): "Largesse doled out of empty coffers could have been disastrous for the people." Sample the five alternatives to administered price hike to know why.

Higher prices in the future
Abysmally low administered prices swell the subsidy bill, which bloats the revenue-expenditure mismatch and leads to the excess of money over goods and services available. More simply, it implies a situation of too much money chasing too few goods -- a classic prescription for stoking inflation. Independent estimates show that for every percentage point rise in the fiscal deficit, the inflation rate rises by two to three percentage points. How soon? And of what kind? That's uncertain and therein lies the real danger.

Unlike the predetermined, commodity-specific price rise that happens when administered prices are raised, the deficit-induced inflation could be of any magnitude and encompass any product or service. For instance, an unchanged LPG price or sugar subsidy today could have meant costlier cement a month from now. And since the latter is a big ticket item, the net outgo from a household budget that consumes all three items could have been higher. Explains Ashok Gulati, nabard professor at the IEG: "The choice is between knowing what you are being robbed of and how much versus being robbed of unknown things and uncertain amounts randomly."

A rise in the cost of capital
If the Government were to borrow to keep the administered prices below costs, it would drive up lending rates across the market spectrum -- short-term to long term. The consequences of such a move would be numerous. First, higher lending rates would raise manufacturing costs of all industrial products, which could be disastrous at a time when Indian industry is fighting a prolonged demand recession. Second, interest rates on hire-purchase would rise, making credit-buying more expensive. Third, higher lending rates for the household sector will also hit the already subdued real-estate market, restricting private investment in construction and housing. Already, shrivelling government finances have raised public borrowings above the danger mark. Warns D.K. Srivastava, professor at National Institute of Public Finance and Policy: "Any more borrowing to foot the subsidy bill could prove to be catastrophic for the economy."

A fresh dose of taxes
If the fallout of higher interest rates were to prevent the Government from funding subsidies through borrowing, an alternative would be to raise taxes. But which particular tax will finance what subsidy will not be certain. Moreover, having adopted a policy of low tax rates since the early '90s, no government would be in a position to raise direct or indirect taxes substantially and specifically to keep administered prices low. Unless Sinha opts for a specific surcharge on a tax dedicated to fund a subsidy. But that will amount to taking back from one hand the benefits of lower administered prices offered through the other. Besides, such a move will also be non-egalitarian, for even those poor who are unable to avail of subsidy could have to pay the tax imposed to fund the subsidy. Says Srivastava: "Fundamentally, we have moved away from tax-and-spend regime, so a tax specifically imposed to fund a subsidy would be neither desirable nor practical."

Erosion in quality
If funds for sustaining low administered prices are not available, a way out is to lower the quality of the products and services being provided. Already the quality gap between subsidised and non-subsidised varieties of commodities and services is stark. Though absence of subsidy is no guarantee for quality improvement, its presence is surely a great deterrent. The sale of substandard wheat, sugar and rice through the public-distribution system (PDS) is a case in point where a recurring erosion in quality ensures that consumers get lower grades of commodities at "stable" prices. Avers S.L. Jain, general secretary of the Indian Sugar Mills Association: "It's unfair to think that sugar mills could provide good quality sugar at below-cost price for sale through the PDS."

The sale of LPG at below cost price is another instance of subsidy hindering quality improvements. The persistence of subsidy on LPG cylinders -- which is about Rs 60 per cylinder even after the latest round of price hikes -- has stonewalled the expansion of private LPG distributors. Of the dozen-odd in business, all are making losses despite providing connections over the counter. One of the largest private distributors, the Ahmedabad-based Gujarat Gas, sold out its LPG business in the last week of January 1999.

Injustice to the poor
Most subsidies purport to transfer wealth from the HAVES to the have-nots. In reality though, the transfer flow is often the reverse with the rich benefitting more from subsidies than -- and at times at the cost of -- the poor. Incidentally, the rollback of the price hike on rice and wheat sold to the people below the poverty line could to arrest the reverse flow of wealth.

Ideally, the poor should be insulated from all price rises, while the non-poor should not be entitled to any subsidy at all, assuming of course that what is allocated for the poor really reaches them. Says agriculture economist C.H. Hanumantha Rao: "A sudden and sharp rise in the prices of commodities for distribution among the poor was wrong, especially when the employment opportunities and income growth in the economy are stagnant."

If they happen in fits and starts, though, hikes are bound to be sudden and sharp. It was in 1994 that the sale price of wheat was last raised. But the procurement price of wheat (the price at which the government buys foodgrains from farmers) has risen by 66 per cent ever since.

While that may be desirable since the government purchase of foodgrains protects farmers from price fluctuations, the purchase price cannot keep rising if the sale price is static. The urban and rural non-poor must move away from the subsidy net so as to let the benefits trickle down to the real needy.

By force or by will, the January hike in administered prices attempts to do just that. Prime Minister Atal Bihari Vajpayee said so while explaining the Government's stand on the subsidy cut: "My Government's philosophy on subsidies is that they should be limited to those who are poor whereas others should pay for what they consume."

All things considered, a reduction in subsidy through an increase in administered prices is beneficial both for the Government and the common man. And if that is so, an outright elimination of all price supports will be a boon.

But that cannot -- and will not -- be attained by price hikes alone. The other significant component of high subsidies -- the inefficiencies in government purchase and distribution -- must be rooted out as well. Points out IEG's Gulati: "The subsidy bill depends as much on what the consumer pays for commodities, as on what it cost the government to supply those commodities. In raising the administered prices, the Government has only addressed the former issue and not the latter."

It is only when the operational inefficiencies of the PDS are removed and administered prices are increased in a planned and gradual manner that the problem of subsidy will subside.

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