The ill effects of subsidy

In India, the government protects the end consumer of sectors like fertilizers and oil and gas from the variations in the prices of end products. The various reasons sighted by the government for controlling the end product prices are as follows

1. To protect poor consumers who do not have access to electricity, so they have to use kerosene for lighting purposes.
2. To provide consumers clean cooking fuel like natural gas, LPG, kerosene to replace use of biomass based fuels such as firewood and dung.
3. Insulate domestic economy from the crude oil price volatility. Full pass through of crude prices may lead to inflation.

The point by point contra logic of the points is as follows

3. Insulate domestic economy from inflation: The consumer has to pay the end prices of various products. Consider for example toothpaste, soaps. Does not HUL, PNG increase the prices of their products when the raw material prices increase. Are not these products used on a daily basis, does not the prices increase in these products passed on to the end consumer. The logic of inflation for petrol prices fails miserably because petrol is a final item of consumption and hence has very few linkages with the the inflation as against diesel which is used in a lot of intermediate stages resulting in higher inflation effects.

1. Kerosene in india is available at very subsidized rate of Rs. 9/liter whereas in the neighboring regions it is available at close to 24/liter leading to black market movement of kerosene from one place to another

2. Kerosene being cheaper is mixed with diesel and is sold in the open market, this puts a huge negative impact on the 23500cr capex that the refineries in India have spent in order to make their fuel euro IV compliant as when diesel is mixed with kersosene the amount of pollution released in the atmosphere is higher.

3. Most of the villages in india have been electrified, so if the intended purpose was to provide electricity then only those villages should be given diesel at cheaper prices which are not electrified.

The burden of diesel price increase on agriculture depends on where it is used. In 2008-09 12% of total diesel went to agriculture. The cost of diesel in agriculture would be accounted for by the government while fixing the MSP for major crops. Therefore any increase in the cost of diesel is taken into account while calculating the MSP. Higher diesel price resulting in higher MSP will increase subsidy in PDS, but it would be much less than the reduction in under-recovery on diesel.

Though the intentions are good and the previous experiment of the government with decontrol of potassium and potash fertilizers resulted in skewing of the NPK ratio from 5.9:2.1:1 to 9.5:2:1 and the government had to immediately give discounts on the prices in order to restore the balance used of fertilizers. Secondly, the vote bank politics comes into the picture if the prices are raised, the ruling party always have the fear of not being voted back to power.

The ill effects of subsidy are as follows

1. The company who sells the products at subsidized price, do not realize the full price at the point of sale, there is a delay in receipt of the balance amount which leads the companies to borrow short term funds from the market in order to fund their working capital requirements thus leading to higher interest costs and hence stretched cash flows. To the extent, the level of self sufficiency in domestic oil production increases, the impact of international oil prices on domestic economy would be reduced. Thus, keeping domestic oil firms viable and in good financial health and providing and environment in which they can grow are also important policy objectives.
2. Inefficient use of the end products: since people donot realize that the actual price of the product is far more than what it is sold at, it promotes inefficient usage. The diesel prices in India are very low which leads to their inefficient usage for example in diesel generation sets.
3. Lowers private sector participation: The artificial prices set by the government does not give a fair playing ground to the private players, who cannot match the low prices and hence does not promote efficiency in the sector as a whole.
4. Subsidy in India is paid out through the government accounts, leading to fiscal burden on the government or the upstream companies in case of the oil and gas sector. In short the cost of financial intervention has to be borne by someone.
5. Even if subsidized products are to be given to the end consumer, you have to give it in limited quantity but consider the case of LPG, which is given in unlimited quanitites to the users. The usage of LPG has grown from 9.3MMT in 2003-04 to 12.3MMT in 2009 out of which sale of subsidized LPG constituted 86.5% of total LPG. Now the intention of giving LPG at discounted rates is to prevent the poor households and make them switch to cleaner fuels but according to NSSO survey, the top 3 declies in the urban areas, comprising some 22 million houselholds use nearly 40% of the LPG and spend less than 5% of their total expenditure. The households get a large part of the subsidy even though they have the capacity to pay for their usage.