When does a social necessity become a social evil? With each budget likely to see social sector spending on the rise, this is going to a dilemma staring our governments more starkly in the face. And that's mainly because the funds that are granted for a particular social purpose find their way into unproductive loopholes, as has happened in the case of subsidies in India.

Subsidies can be a very powerful welfare-augmenting instrument of fiscal policy.However, the benefits can be reaped only when the policies are transparent, well-targetted and suitably designed for practical implementation.A look at the expenditure charts will show that expenditure on subsidies forms a major block of government finances but very little of this is revealed fully in the budget documents.

Since a major chunk of subsidies remain implicit in the provision for social and economic services, they easily grow out of control putting further pressure on the fiscal deficit.Today, the volume of subsidies has grown. Since a major part of it is input-based, there is a tendency for management inefficiency to creep in.Thus, it becomes more of a macro problem than a micro one. Since its ramifications are large, it becomes difficult to control or comprehend their impact fully, giving rise to concerns about their economic efficiency, income distribution and fiscal deficits.

Subsidies in India, unlike elsewhere, have a direct linkage to government activities, in the sense that as government activities increase, the scope of subsidies also rises simultaneously. With the government having a presence in activities that brings it in competition with the private sector, recovering costs has become a major problem. So, what is absolutely essential is for the government to quantify the extent of unrecovered costs, disaggregated across a spectrum of government activities.

Why does the government subsidise a loss-making exercise? Subsidies are advocated when the social benefits of a particular service or commodity are greater than the sum of private benefits of the consumer.This difference between the social benefits and sum of private benefits arises due to what economists term as as externalities.A few examples in this regard are vaccination and innoculation drives against infectious diseases, sanitation, environmental protection and basic education.Because of the gap between private valuation of benefits of such services and their true value to society, normal market mechanisms are insufficient to ensure an appropriate level of such services and subsidies are advocated to provide the necessary corrective.

On the other hand, it is very difficult to justify subsidies on fertiliser, diesel, electricity and higher education since in these cases, there are normally no significant differences between private and social valuation in these areas.

If the subsidies are not well-targeted, they can lead to persistent large fiscal deficits and consequently higher interest rates.If there is a high level of subsidisation, it reflects in corresponding low user charges which can produce serious micro distortions in the economic functioning as well.It gets reflected in excessive demand for subsidised services and distortions in relative prices and misallocation of precious resources.In the case of input-based subsidies, these get manifested further.If the distribution system is plagued with leakages then it can neither ensure equity nor efficiency.

The government is committed to bringing down the expenditure and achieving a fiscal deficit of less than 4 per cent of GDP. It has other commitments, too: bringing in a moderate tax structure so as to encourage savings to promote faster and healthier growth and motivate tax payers' voluntary compliance. To achieve these targets, it will have to bring in greater efficiency in raising non tax revenue through better user charges.This will help the government in bridging the revenue and expenditure gap.Resources generated through this route can then be diverted towards fulfilling the government's committment of providing social and infrastructure facilities.

The rationale
But first, what is a subsidy and what is the rationale behind government providing a subsidy? In effect, a subsidy is the opposite of an indirect tax.While indirect taxes raise the price of the taxed commodity with tax revenues flowing to the government's exchequer, a subsidy is expected to lower the price of a commodity since the government bears the extra cost.Subsidies can be provided to the consumer, producer or it can be a service subsidy or a subsidy on the inputs that go into the production of a particular commodity.Subsidies are usually for a specific good the price of which is lowered by the subsidy vis-a vis other goods.Thus, subsidies encourage greater production/consumption of the commodity. The government normally uses subsidies to re-distribute income and to ensure minimum needs for all. These subsidies are provided on those goods that involve large externalities and fall in a special category of their own.These goods are classified as public goods (these are goods the benefit of which cannot bedenied to anyone).If one takes the case of the defence services, their social benefit is tremendous but the market mechanism would break down completely if it had to bear the cost of this public good. Thus, in such cases, the government has to bear the full cost of the service provision.

But the going is not very easy.For identifying goods for subsidisation, it is very essential to see that the nature of the good being subsidised merits such subsidisation. Otherwise,it can lead to a heavy financial burden which can be totally unproductive.If the government has to function rationally, it should weigh the costs and benefits of the subsidy which requires a periodic review of the subsidy regime regularly so that there is maximum enhancement of welfare within the overall budgetary constraints of the government.

Where successive governments in India have faulted most is that they have not developed a transparent and efficient distributive network.Maximum leakages result in high costs and reduce the social benefit for which the subsidy was awarded.The easiest form of a subsidy is the cash subsidy to producers and consumers. Sometimes, the government to avert a crisis, may procure foodgrains at higher than market prices or it may sell in the market at lower prices.Both these involve subsidies.Subsidies are not just targetted towards foodgrains and services. Instances of the Reserve Bank of India or any financial institution bearing an exchange risk also involves a subsidy burden. But these are off budget-subsidies and do not reflect in the budgetary provisions.

Sometimes, to rationalise the welfare to consumers, the government undertakes cross subsidisation. Under this mechanism, it resorts to pricing a particular commodity higher for a particular section of the higher income group so that the benefit that accrues from this can be utilised by pricing the same commodity lower for the poorer sections of society.This is referred to as cross subsidisation.

Sometimes the government is burdened with unforeseen expenditure like defence, cyclone which are national priorities.This adds up to the expenditure burden and forces the government into granting more subsidies.Any reduction in the quantum of non merit subsidies would have a direct and immediate impact on fiscal deficit.Thus, if the government speeds up its recovery mechanism by reducing the number of loopholes and making the system more transparent it can get in the much required revenue which can be then redirected towards more profitable ventures.

Poor usage
We see that there is a high allocation of resources by the Centre and towards the states for pro poor schemes which is a necessity but the end results are not very encouraging .Today also huge sums are spent on education, health but still mortality rates are high and literacy is not very impressive.So where do all the so called allocated funds go ? A look at the budget figures will show that most of the funds that are allocated are not used and this amounts to huge costs or in most cases the benefits do not accrue to the targetted groups who are left behind.This reflects in the growth indicators not showing up. Even today the recovery rates in India are not very encouraging.The administrative mechanism of the government is still not efficient enough to get back the allocated funds.As long as the true benefits do not accrue to society there will always be a drop in the welfare which reflects in the non merit recovery rate today being as low as 5 per cent and for social services only 12 per cent.So ifthegovernment wants to contain its fiscal deficit and make it more comfortable to manage it, it will have to pep up the user charges which will reflect in higher user prices and thus a direct reduction in the quantity demanded.This will automatically reflect in the government figures where the burden of subsidies will come down.There will be a positive secondary effect on fiscal deficit.

Year after year, finance ministers present a rising subsidy burden in the budget.Social subsidies and pro poor schemes are the ones where the maximum allocation is made. Health and education add to the overall welfare of the nation raising the standard of living of the masses and making the environment physically fit. The 1999-2000 budget provides around 6-7 per cent of the subsidy and a major part of it is provided by the states as education is a concurrent list subject.Around one fourth of the subsidies of the state are on education.Such a large part of the subsidies go towards education but this does not reflect in the literacy rate.This again shows that educational subsidy benefits do not reach the poor classes and usually get sucked by groups which are not needy.The recovery rate again in the education sector is very low at 1 per cent.As most of the educational institutions are non profit making, this becomes a difficult task for the government to handle as revenue does not flow into this sector.Anothermajor part of the subsidy burden for both the Centre and the states is towards health.Around 2 per cent of the central funds and 8 per cent of the state funds gets channelised into this segment.The subsidy rate for the health sector is little above 96 per cent for the centre and 98 per cent for the states.

Today, indirect taxation and subsidies account for 30 percent of GDP.This represents the extent of indirect fiscal intervention in the economy.Itis difficult to control ultimate distributional impact in case of indirect taxes as well as subsidies.Thus, the government has to examine the progressivity/regressivity of the tax/subsidy configuration within the fiscal regime if it has to bring in fiscal discipline.

Very often, it is seen that although the government has allocated sufficient resources for subsidy, the net benefit is nil. That is because subsidies have a urban bias and considerable leakage and low coverage of the poor reduces the magnitude of the benefit of the poor.Also, a lot of cross subsidisation takes place which makes subsidy estimation a difficult task especially in the case of the power sector where there are six categories of users and different tariff structures.

The government will have to play its cards right by setting up a proper administrative mechanism which will not only look into the end use of subsidy but will also help in the recovery mechanism.As the volume of subsidies is large and is rising year after year, it will not be long before the government finds itself in a fiscal trap.

Unless and until the level of subsidy is reduced and focus is not administered, the whole exercise will only be another expenditure-ridden one.

Thus, the government will have to bring in a more professional mechanism into the handling of the whole subsidy issue.If user charges are not increased in a phased and calculated manner and if the targetting exercise is not properly handled it will only result in a drain in precious resources which will not be a very favourable option.

Oil pool subsidy
The government is criticised today for raising the prices of kerosene, diesel, etc., which are considered to be poor man’s fuels. But a look at the figures will show that this segment is very highly subsidised for which the government is bearing the costs. The government is committed to phasing out the subsidy on kerosene by 2002-03. Diesel in the present budget has already been brought towards the market mechanism and the government is raising the price in phases so as to reduce the subsidy burden.

Again, this segment is politically a very ticklish issue and it raises a lot of opposition each time the government makes an announcement of a rise. Every year the total petroleum subsidy rises by nearly 100 per cent as the government has to bear the brunt of the cost, especially at a time when international crude prices rise. This time, the government is quite committed and has announced that it would not bring down prices even if there has been a drop in the international prices of oil and petroleum as it is already bearing a very high subsidy burden on these items. LPG is subsidised by over Rs.125 per cylinder and rightly the government has raised the price per cylinder by around Rs.30. Today, the consumption of diesel has also increased as industrial activity is picking up and the price of diesel is low. It was with good intentions thatin July 2,1996, the government announced an across the board hike in prices in petroleum products and proposed a 30 percent increase in diesel prices. The intention was tobring down the diesel subsidies to zero. But there was stiff opposition and a roll back had to be announced, which resulted in the proportion of diesel subsidy in the total petroleum subsidy increasing from 6.55 percent to 45.22 percet between 1994-95 and 1996-97. Kerosene is basically used as a domestic fuel. More than half of its domestic consumption requirements are met by imports. It was 56 percent in 1995-96 and today the figure is as high as around 65-70 percent. With the depreciation in the value ofthe rupee and rising international prices of crude, this imposes a huge burden on the government. A large proportion of the total kerosene consumption is distributed through the public distribution system.

It is here that a lot of wastage takes place as it does not go to the poor sections. Kerosene consumption through the PDS also shows a clear urban bias.

According to the latest census, the figures are quite revealing: kerosene usage for cooking was 25 per cent in urban households and a mere 2 per cent in rural households.Optimising benefits
There are four effects which the government has to carefully consider if it wants to maximise benefits from the subsidy programme.

Allocative effect -- Here, the government has to carefully scrutinise the alocation of resources as subsidies help draw more resources towards the subsidised sector.

Redistributive effect -- Subsidies can be misdirected towards those sections of society that least deserve them so government has to look at producer - consumers, urban-rural,rich-poor, and see to it that only those sections that are justified get the subsidy benefit.

Fiscal effect -- The bulk of the subsidies emanate from the Budget, which has a direct effect on fiscal deficit .Subsidies may also indirectly affect the Budget adversely by drawing resources away from tax-yielding sectors towards sectors that may have a low tax revenue potential.

Trade effect -- These take place because often a regulated price which is substantially lower than the market clearing price may reduce domestic supply and lead to an increase in imports.