THE ECONOMICS OF SUBSIDIES

Economics III

Submitted by
Rudra Pratap Tripathi
SM0115044
3rd Year & 5th Semester

National Law University, Assam

1
 Table of Contents

Introduction3

Scope and Limitations....4

Objectives...5

Research Questions5

Research Method....5

Review of Literature...5

Central Government Subsidies in India.6

Meaning of a Subsidy...7

The Rationale Behind Providing Subsidies .....7

Harmful Subsidies........................................................................................................8

Consumer Subsidies in India.......9

The Kelkar Committee Report.....................................12

Conclusion.......13

Bibliography.....15

2
Abstract

Subsidies are a major instrument of government expenditure policy. At the domestic level,
subsidies affect resource allocation and income distribution. At the international level,
subsidies distort resource allocation and affect competition. The National Common Minimum
Programme pledges that all subsidies will be targeted sharply at the poor and the truly needy
like the small and marginal farmers, farm labour and urban poor. There are three major
types of subsidies that the Government of India provides, viz., food subsidies, fertilizer
subsidies and petroleum subsidies. Containing and targeting subsidies constituted an
important element of the 1991 reforms. The benefits can be maximised only when the
subsidies are transparent, well targeted, and suitably designed for effective implementation
without any leakages. This research paper shall deal with the concept of subsidies as a fiscal
policy tool, the major subsidies provided by the Central Government of India, the expenditure
incurred by the Government for the same and the distortions in international trade (if any)
caused by the subsidies provided by the domestic government and the possible repercussions
in relation to the World Trade Organisation.

Keywords: Food Subsidies, Fertilizer Subsidies, Petroleum Subsidies, Export Subsidies and
WTO, Impact of Subsidies, Harmful Subsidies.

Introduction

Subsidies are a major instrument of government expenditure policy. At the domestic level,
subsidies affect resource allocation and income distribution. At the international level,
subsidies distort resource allocation and affect competition.1

The Central Government of India, in a report prepared with the assistance of the National
Institute of Public Finance and Policy stated that containment and targeting of subsidies,
which is an essential element of fiscal reforms strategy, can serve the following objectives,
namely, remove economic distortions, thereby improving economic efficiency and growth,
achieve redistributive objective, reduce budgetary burden, etc.2

The National Common Minimum Programme pledges that all subsidies will be targeted
sharply at the poor and the truly needy like the small and marginal farmers, farm labour and
urban poor. There are three major types of subsidies that the Government of India provides,

1
Mr. Gerd Schwartz et al., Government Subsidies: Concepts, International Trends, and Reform Options, IMF,
1995
2
http://finmin.nic.in/reports/cgsi-2004.pdf

3
viz., food subsidies, fertilizer subsidies and petroleum subsidies. Subsidies are financed either
from tax or non-tax revenue, or result in a deficit. The expenditure on Major Subsidies by the
Government of India was Rs. 25860 crores during the year 2000-01. It increased to Rs.
243811 crores during the year 2015-16 (BE) showing an increase of Rs. 217951 crores during
the period from 2000-01 to 2015-16. In percentage terms, the overall growth was 842.81%
during the period. The annual rate of growth in percentage terms was 56.19% during the
period from 2000-01 to 2015-16.3

The Economic reforms of 1991 had also aimed at, among other things, reducing fiscal
imbalances and improving efficiency in matters of allocation. Containing and targeting
subsidies constituted an important element of the reforms. Subsidies are the converse of
indirect taxes and are specific to goods and services. Subsidies are different from transfer
payments, which are straight income supplements to individuals, who are normally the poor
and the vulnerable. Providing minimum consumption entitlement to the poor by subsidizing
the items consumed by them is an extremely important welfare dimension of fiscal policy.
However, the benefits can be maximised only when the subsidies are transparent, well
targeted, and suitably designed for effective implementation without any leakages4.

This research paper shall deal with the concept of subsidies as a fiscal policy tool, the major
subsidies provided by the Central Government of India, the expenditure incurred by the
Government for the same and the distortions in international trade (if any) caused by the
subsidies provided by the domestic government and the possible repercussions in relation to
the World Trade Organisation. The paper would also include an analysis of the economic
impact of subsidies and whether the Government of India should continue to bear such a huge
amount to provide these subsidies.

Scope and Objectives

The scope of the present research paper is limited to the analysis of the economic impact of
subsidies on the expenditure of the Government of India.

The Objectives are:

1. To study the impact of subsidies on the expenditure of the Government of India

3
https://community.data.gov.in/interest-subsidies-and-defence-expenditure-of-indian-government-from-2000-
01-to-2015-16/
4
http://finmin.nic.in/reports/cgsi-2004.pdf

4
 2. To analyse whether the Government of India should continue to bear huge expenses
for providing subsidies.
3. To study the major subsidies provided by the Government of India and the objectives
that the Government seeks to achieve by providing them.

Research Questions

1. What is the impact of subsidies on the economy of a nation like India?

2. Are subsidies necessary for the Indian economy?
3. How have subsidies impacted the life of the common man in India?
4. Should the Government continue to incur huge expenses for providing subsidies?
5. Does providing subsidies create problems for India with the WTO?

Research Method

The method adopted for the purpose of the present research is the analytical method. Both
primary and secondary sources will be used for the collection of data and the review of
literature.

Review of Literature

Mr. Gerd Schwartz et al., Government Subsidies: Concepts, International Trends, and
Reform Options, IMF, 1995
D. K. Srivastava et al., Budgetary Subsidies in India: Subsidising Social and Economic
Services, National Institute of Public Finance and Policy, (2003) New Delhi
Ronald J. Herring, The Oxford Handbook of Food, Politics, and Society, (OUP 2015)
Central Government Subsidies in India, Report prepared with the assistance of the
National Institute of Public Finance & Policy, Government of India, Ministry of Finance,
Department of Economic Affairs, December 2004, http://finmin.nic.in/reports/cgsi-
2004.pdf

India: Selected Issues, International Monetary Fund

Staff Country Reports, International Monetary Fund, 2008
OECD Economic Surveys: India 2011

5
Central Government Subsidies in India

Subsidies are used to modify market outcomes, especially to take account of positive
externalities, and, sometimes, to sub-serve certain well-defined redistributive objectives.

Subsidies are an important fiscal tool for modifying market-determined outcomes. Subsidies
are the converse of an indirect tax. While such taxes reduce ones disposable income,
subsidies inject money into circulation. The impact of subsidies can be seen through the
commodity market, where the relative price of the subsidised commodity is lowered, thereby
generating an increase in the demand of that commodity. However, with an indirect tax, the
price of the taxed commodity increases. Taxes appear on the revenue side of government
budgets, and subsidies, on the expenditure side.5 Thus, the government collects revenue from
the public by means of taxes and incurs expenditure in the form of subsidies in order to
perform the functions of a welfare-State.

In a welfare State like India, subsidies have an important role to play. Subsidies can have a
major impact in augmenting the welfare of the society, provided these are designed and
administered efficiently to serve a clearly stated set of objectives. However, inefficiency and
lack of proper designing can result in the same subsidies taking a toll on the expenditure of
the government, without serving the purpose for which they were introduced in the first
place. Thus, improper implementation will not only prevent the benefits of subsidies from
percolating down to those who are actually in need of the support, but also result in a
considerable wastage of time and resources of the government.

Subsidies in education, health and environment are supported on the grounds that not only the
immediate recipients, but also many others shall benefit from them. This would also mean
that the population at large shall benefit from these subsidies, in the present as well as the
future. By providing education at a subsidised rate, the government facilitates access to it and
thus, makes it possible for many to be able to get an education that would eventually help
them get better lives and improve the standard of living of not only those who are the direct
recipients, but also their dependants.

Another objective that is sought to be achieved through the provision of subsidies is

redistribution, particularly for ensuring the minimum consumption levels of food and other

5
D. K. Srivastava et al., Budgetary Subsidies in India: Subsidising Social and Economic Services, National
Institute of Public Finance and Policy, (2003) New Delhi

6
basic needs. Supporters of distributive justice would therefore, find subsidies an effective
instrument for achieving the purpose.

Meaning of Subsidy

Defining a subsidy is not an easy task. Economists have used the term in different contexts,
with different meanings and connotations. The dictionary meaning of the term is money
granted by State, public body, etc., to keep down the prices of commodities, etc. For
environmental economists, subsidies are uncompensated environmental damage arising from
any flow of goods and services. It had been commented way back in 1974 that economists
have not settled upon a commonly acceptable definition of subsidy. Thus, it can be
understood that the definition of a subsidy is just too elusive to even attempt to define.

The Rationale behind Providing Subsidies

Generally, subsidies are advocated because of the positive externalities. In other words, when
a subsidy is consumed, the social benefit from the consumption from such subsidy is greater
than the sum of the private benefits to the consumers. Prime examples of positive
externalities are primary education and preventive health care. In these cases, private
valuation of the benefits from such goods or services is less than their true value to society,
and normal pricing mechanism will not produce efficient outcomes.6 Subsidies can provide
the necessary corrective in such cases.7 Another reason for advocating subsidies is the
achievement of redistributive objectives, i.e. to ensure that the minimum level of food,
nutrition and other basic needs reaches all sections of the society. This is perhaps the most
important reason for providing subsidies, which its advocates and supporters rely on to justify
the expenditure that governments have to incur in this respect. Subsidies would make basic
necessities available at a price which makes such commodities accessible to people belonging
to every strata of the society. This would ensure that everyone has access to food and
nutrition, basic health-care facilities, energy and education. Thus, provision of subsidies
would not only benefit the people who receive it directly, but also those who depend on them.
In the long-run, the benefits from subsidies would not remain limited to the generation who
receives them, but also generations to come. An example of this would be providing
education at a subsidised rate. This will not only make the direct recipients capable and
better-equipped to land a job that would not only meet his requirements, but also help

6
D. K. Srivastava et al., Budgetary Subsidies in India: Subsidising Social and Economic Services, National
Institute of Public Finance and Policy, (2003) New Delhi
7
Ibid

7
improve his standard of living. A direct consequence of this would be the different living-
style of his children, who would have in all probability, had a completely different life if their
father had not been educated in the first place and had not received proper guidance and
training at a later stage. Thus, subsidies become the first important drive towards the
achievement of many goals and objectives, and also ensure that the public is well-fed, healthy
and educated.

These subsidies need to be financed. They may be financed through additional taxation or
borrowing. Taxation leads to reduced welfare, since it reduces the disposable income.
Therefore, whether introducing a subsidy is a welfare augmenting measure or not can only be
judged in terms of additional welfare resulting from the subsidy against welfare loss from
additional taxation. The implications of additional borrowing also need to be considered in a
macro framework because of the pressure it may exert on interest rates and on crowding out
of private investment.8

The provision of subsidies is not a costless exercise because these need to be financed
through taxation. Further, since markets in the economy are linked, the effect of introducing
a subsidy in one market will affect the other markets through forward and backward
linkages. Since taxation involves dead weight losses, every increase in tax rates would
involve a welfare loss, which needs to be matched by the welfare gain through the subsidy. As
long as the subsidy-induced welfare gain is more than the tax-induced welfare loss,
subsidisation may be recommended. But it is important that the welfare and efficiency losses
associated with the cost of financing subsidies are taken into account.9

Harmful Subsidies

In the context of the environment, subsidies are often viewed as opportunity costs which arise
due to negative environmental externalities.10 For example, when farmers spray pesticide,
they introduce toxic effluents into the commonly shared ecosystems. Over-subsidisation often
leads to an adverse effect on the environment. The concept of environmentally perverse
subsidies has been widely recognised in recent times and there is considerable concern at the
international level about environmentally harmful subsidies. Researchers have argued that
perverse subsidies have the capacity to have a highly distortive impact on the global

8
D. K. Srivastava et al., Budgetary Subsidies in India: Subsidising Social and Economic Services, National
Institute of Public Finance and Policy, (2003) New Delhi
9
Ibid
10
Ibid

8
economy, while at the same time inflicting injuries on the environment. A recent study
identified the subsidies having a bearing on the environment, and these include the subsidies
on irrigation, fertilisers, pesticides and chemicals, which have the potential of resulting in
significant adverse effects on the environment.

Consumer Subsidies in India

The principal consumer subsidies are those provided for the consumption of food, fertiliser
and fuel.

Food Subsidies in India

One of the most commonly applied policies to improve nutrition among the poor is a food
subsidy.11

Food subsidies in India are delivered through the public distribution system (PDS). This
system consists of a network of retail outlets (popularly known as ration shops) through
which the government sells grain (principally, rice and wheat). Grain sales occur at a fixed
price called the issue price, which is typically lower than the market price. Two conditions
govern the sale of subsidized grain: the buyer of grain must possess a ration card; and grain
purchases are subject to a quota. The PDS is supported by a procurement operation that
procures and funnels supplies to it. Through the Food Corporation of India (FCI), the
government procures grain at the procurement price and then stores and transports it to the
various consuming locations. The Indian model is not unique. Comprehensive rationing
schemes, where the state is the single intermediary between consumers and producers and
has monopoly over all domestic and foreign trade, was prevalent in the erstwhile socialist
states. In developing countries, it is usual for subsidy transfers in kind to operate along with
private food markets. Supplies may come from imports, foreign aid, or domestic procurement.
Food subsidies may cover all or some consumers.12

Food subsidies in India comprises subsidies to farmers through support prices and purchase
operations of the Food Corporation of India, consumer subsidies through the public
distribution system (PDS), and subsidies to FCI to cover all its costs. Food subsidies are
mainly in account of paddy and wheat. The increase in food subsidy in recent years can be
attributed to what is called the economic costs of food-grains, which include the minimum

11
Effectiveness of food subsidies in raising healthy food consumption: Public distribution of pulses in India
12
Ronald J. Herring, The Oxford Handbook of Food, Politics, and Society, (OUP 2015)

9
support price paid to farmers in the procurement process.13 Government notifies the FCI
about the purchase prices of the relevant food-grains that it has to observe for the coming
agricultural marketing season. These prices, known as Minimum Support Prices (MSP) are
based on the recommendations of the Commission on Agricultural Costs and Prices
(CACP).14

A common strategy to reduce the burden of food subsidy, without affecting the interests of
the poor, is to build in specific features that target the poor. Consumers below the poverty
line (BPL) pay a lower price and receive a higher quantum of food-grains than those above
the poverty line (APL).15 India is not unique in providing either producer subsidies or
consumer subsidies in the food-grains sector. Several countries, including the developed
ones, provide subsidies in the area of agriculture and allied operations at levels that fairly
high compared to that in India. The main benefits of food subsidies are the resultant food
security provided to the citizens, particularly the poor at affordable prices, and incentives to
the farmers to keep food-grains production at a comfortable level. However, a comprehensive
analysis of food subsidies in India leads to the conclusion that there are problems which arise
from the relatively high MSPs.

Nevertheless, the importance of food subsidies cannot be overlooked merely because of the
problems that arise because of the MSPs. In the absence of such subsidies, it would be
extremely difficult for thousands of farmers to sustain themselves and their families.

Fertilizer Subsidies in India

Subsidized fertilizer (primarily urea) is available to farmers on a universal basis. The retail
price of fertilizer is fixed and uniform throughout the country, with producers compensated
for the difference between the retail price and the cost of fertilizer production. Expenditure on
the fertilizer subsidy was about percent of GDP in 2006/07, about a third of which went to
producers. In the light of the rising cost of fertiliser subsidies, the government has on various
occasions considered phasing them out.16

In order to control the fluctuations in fertiliser prices, the Government of India regulates the
fertilizer market through the RPS. The RPS was first introduced for nitrogenous fertilizers in

13
Central Government Subsidies in India, Report prepared with the assistance of the National Institute of
Public Finance & Policy, Government of India, Ministry of Finance, Department of Economic Affairs,
December 2004, http://finmin.nic.in/reports/cgsi-2004.pdf
14
Ibid
15
The current system relies on household poverty as the basis for targeting.
16
India: Selected Issues, International Monetary Fund

10
November 1977, and extended to complex fertilizers in February 1979. The plant specific
retention prices (RP) revised every quarter so that price increases in plant inputs can be taken
into account. The retail price of fertilizers is fixed and uniform throughout the country. The
difference between the retention price and the price at which the fertilizers are provided to the
farmer is paid back to the manufacturer as subsidy. 17 In the case of fertiliser, both farmers
and fertiliser industry have been subsidized.

Petroleum Subsidies in India

Fuel subsidies are available on a universal (untargeted) basis, and vary by product. They are
highest for kerosene, which is used most intensively by lower-income households and in late
2007 was being sold at about 40 percent of the market price. LPG, which is widely consumed
by higher income households, was available at about half the market price, while other fuels
(gasoline and diesel) have been subsidized to a much lower extent (about 10-20 percent). The
cost of fuel subsidies has risen sharply in recent years, reflecting the growing difference
between administered and world oil prices. There appears to be ample room to cut back
expenditure on fuel subsidies without unduly affecting the poor. The subsidy on kerosene,
which is the only product consumed primarily by the poor, accounts for only one quarter of
the fuel subsidy bill. In 2006, the Rangarajan Committee on Pricing and Taxation of
Petroleum Products has recommended restricting kerosene subsidies to BPL families. The
Committee also recommended that the subsidy on LPG be eliminated gradually (since this
fuel is mainly used by non-poor families), while for gasoline and diesel, subsidies should be
eliminated altogether.18

As per the OECD Economic Surveys (India 2011), Indias energy subsidies distort markets
and entail an inefficient allocation of resources with negative consequences for economic
performance. Subsidies also result in a higher consumption of oil products relative to the
level of consumption at world prices, which pushes up global prices and damages the
environment. Pervasive state involvement also runs contrary to the central governments aim
of creating a regulatory environment consistent with competitive markets for petroleum
products (Planning Commission, 2008). By artificially lowering prices, Indias energy
subsidies blunt incentives to economise on petroleum products in response to increases in
international crude prices. As in other countries that subsidise petroleum products, Indias
17
Central Government Subsidies in India, Report prepared with the assistance of the National Institute of
Public Finance & Policy, Government of India, Ministry of Finance, Department of Economic Affairs,
December 2004, http://finmin.nic.in/reports/cgsi-2004.pdf
18
Staff Country Reports, International Monetary Fund, 2008

11
subsidy regime effectively acts as a negative price for carbon that keeps fossil fuel
consumption and greenhouse gas emissions higher than would otherwise be the case.19

According to a report prepared by the Ministry of Finance (Department of Economic Affairs),

with the assistance of the National Institute of Public Finance & Policy, in 2004, the domestic
LPG and PDS kerosene subsidies seem to be ineffective in serving the desired objectives.
Therefore, the domestic LPG subsidy may be gradually reduced or at least substantially
restricted, while a more cautious approach should be pursued in the reduction of kerosene
subsidies. Since, only state-owned oil companies have been permitted to market subsidized
domestic LPG and PDS kerosene. This has stifled competition by curtailing the entry of
private retailers. A market environment encouraging fair and healthy competition is the most
effective way to expand the supply and availability of competitively-priced kerosene and
LPG.

The Kelkar Committee Report

Expenditure on subsidies is a major portion of Government expenditure and has witnessed

major expansion in the recent past. Of the overall subsidies, the subsidies on Petroleum,
Fertilizer and Food make up more than 90 per cent. It was planned in 2012-13 to contain
subsidies within 2 per cent of the GDP.

The Committee, after discussions with the Ministry of Petroleum and Natural Gas, and
Department of Fertilizers, suggested measures for reducing subsidies to 2 per cent in 2013-14
and 1.8 per cent in 2014-15. The Committee recommended that our policy objectives should
at a minimum aim to eliminate half of the diesel per unit subsidy during the same year by
March 31, 2013. Their recommendation was also to immediately increase the price of diesel
by Rupees 4 per litre, of kerosene by Rupees 2 per litre and of LPG by Rupees 50 per
cylinder. The strategy that the Government should adopt is to keep adjusting the price on a
regular basis in incremental steps towards eventual deregulation of diesel and affordable level
of subsidy on LPG and kerosene. Regarding LPG, there was a recommendation on direct cash
transfer of subsidy headed by Shri Nandan Nilekani to cap the number of subsidized
cylinders.

According to the Committee, the most reform required on the fertilizer subsidy front was
revision in the price of urea. This would not only reduce the subsidy burden but would also

19
OECD Economic Surveys: India 2011

12
reduce the unsustainable imbalance in the current consumption pattern of fertilizer in the
country. This was most important from the viewpoint of long term soil quality and
agricultural productivity.

On food subsidy, the Committee recommended that there was a need to increase the Central
Issue Price (CIP). The Minimum Support Prices (MSP) are decided every year and it is
advisable that every time the MSP is revised, the CIP should be revised in the same
proportion as the MSP. It would also help to reduce the administrative cost and it should be
possible to effect reduction in food subsidy through more efficient food-grain delivery
operations. The Committee also stressed that the Government needs to initiate measures to
direct the subsidies to the beneficiary. Even with reduced budgetary allocations it may be
possible to leverage full benefits by proper targeting of subsidies. In that regard, the
Committee stated that a growing body of evidence suggested that the introduction of direct
transfer of cash subsidies might be a more efficient way of reaching the beneficiaries.

Conclusion

The provision of subsidies is not a costless exercise because these need to be financed
through taxation. Further, since markets in the economy are linked, the effect of introducing a
subsidy in one market will affect the other markets through forward and backward linkages.
Since taxation involves dead weight losses, every increase in tax rates would involve a
welfare loss, which needs to be matched by the welfare gain through the subsidy. As long as
the subsidy-induced welfare gain is more than the tax-induced welfare loss, subsidisation
may be recommended. But it is important that the welfare and efficiency losses associated
with the cost of financing subsidies are taken into account. As per the OECD Economic
Surveys (India 2011), Indias energy subsidies distort markets and entail an inefficient
allocation of resources with negative consequences for economic performance. Subsidies also
result in a higher consumption of oil products relative to the level of consumption at world
prices, which pushes up global prices and damages the environment. A comprehensive
analysis of food subsidies in India leads to the conclusion that there are problems which arise
from the relatively high MSPs. In the context of the environment, subsidies are often viewed
as opportunity costs which arise due to negative environmental externalities. Nevertheless,
subsidies are advocated because of the positive externalities. In other words, when a subsidy
is consumed, the social benefit from the consumption from such subsidy is greater than the
sum of the private benefits to the consumers and providing minimum consumption

13
entitlement to the poor by subsidizing the items consumed by them is an extremely important
welfare dimension of fiscal policy.

14
BIBLIOGRAPHY

Books

Mr. Gerd Schwartz et al., Government Subsidies: Concepts, International Trends, and
Reform Options, IMF, 1995
Ronald J. Herring, The Oxford Handbook of Food, Politics, and Society, (OUP 2015)

Reports

Central Government Subsidies in India, Report prepared with the assistance of the
National Institute of Public Finance & Policy, Government of India, Ministry of Finance,
Department of Economic Affairs, December 2004, http://finmin.nic.in/reports/cgsi-
2004.pdf

India: Selected Issues, International Monetary Fund

Staff Country Reports, International Monetary Fund, 2008
OECD Economic Surveys: India 2011
D. K. Srivastava et al., Budgetary Subsidies in India: Subsidising Social and Economic
Services, National Institute of Public Finance and Policy, (2003) New Delhi

15