India: Streamlining public expenditure
This article presents issues related to streamlining of public expenditure in the nation of India; however, many of the issues herein are pertinent to developed countries throughout the world.
The price of crude oil has breached the $110/barrel mark. The price of urea is hovering around US$ 415/tonne, diammonium phosphate (DAP) shot up to more than US$ 750/tonne and potassium chloride to US$ 620/tonne. The wholesale price index during the late 1990s and early 2000s shows inflation is running at higher than seven percent and creating a feeling that the Indian economy is at the risk of slowing down.
Inflation is a result of mismatch between demand and supply. To lessen the inflation, the Reserve Bank of India has adopted the route of tight monetary policy (increases in CRR to 8%). Moreover, Government has chosen the route of freezing the domestic prices of petroleum products, fertilizers and rationed grains when the global prices are skyrocketing.
In 2007-08, the subsidies for petroleum products and fertilizers were Rs 780 billion and Rs 470 billion, respectively when the average annual crude price was about US$72 and urea price was less than US$300. If the increasing trend in global prices continues, as expected, the subsidy burden for these items may be around 5 percent of GDP in 2008-09. This route has its costs and asks to make a choice between growth and inflation.
The streamlining of the government expenditure can be another route, which has potential of increasing supply without creating a trade-off between growth and inflation.
Government expenditure is broadly classified into two categories: expenditure on ‘pure’ public goods and the expenditure directed to palliate the impact of market imperfections and provide minimum consumption entitlements to the poor by subsidizing the items consumed by them. The first category comprises the goods and services that are non-rival and non-excludable such as defense and law and order. Non-rivalry implies that the consumption by one user does not reduce the quantity available to another, and non-excludability implies no individual consumer can be excluded from the consumption of the good. Public goods are, throughout the world, provided by the governments and are financed through general taxation. The second category of expenditure involves more complex analysis.
To streamline public expenditure/target subsidies, Government of India commissioned various studies at different points of time since the early 1990s. The subsidies are comprehensively defined in these studies as the unrecovered costs of the goods and services provided by the governments. According to the latest study the magnitude of subsidies provided only by the Central Government was about four percent of GDP. This does not include expenditures by the State Governments. This figure is almost constant since early 1990s.
Per se, subsidies are not always bad, and they are sometimes designed to improve the welfare of society by encouraging the consumption/production of goods and services with significant positive externalities (social benefits of consumption are higher than private benefits) such as education, health care, etc. and to provide minimum consumption entitlements to the poor and vulnerable section. The criterion of ‘externality’ determines what commodities and services should be subsidized and to what extent.
Merit versus non-merit goods
In the 2004 study of subsidies the commodities are classified as merit and non-merit category. Merit goods contain positive externalities of varying degrees and should be subsidized differently. The share of merit goods in total subsidies was about 45 percent in 2003-04 and the share of merit-I (such as, elementary education, primary health care, prevention and control of diseases, soil and water conservation, ecology and environment, etc.) goods and services was about 5 percent in total subsidy burden. Merit-I subsidies accounted only for 0.25 percent of GDP. Most of the subsidies are appropriated by mon-merit goods and services. Thus, the Government is generating the demand for non-merit goods by keeping their prices below the equilibrium level and giving incentive to the inefficient allocation of resources.
About one third of the total population is below poverty line. Subsidization of merit goods and/or supply of pure public goods generate benefits that tend to disperse across alike irrespective of the rich or poor. But subsidizing of non-merit goods may benefits more special interest groups such as big unions or big industry. Examples of non-merit goods are: fertilizer subsidies, petroleum subsidies, grazing subsidies, electricity and water subsidies.
Higher level of expenditure on subsidizing non-merit goods and services implies either under-supply of public goods or lower subsidies for merit goods or increase in taxes or increase in government borrowings or use of any combination of these mechanisms. Regardless of the mechanism used to finance the improperly targeted subsidies the efficiency losses arise. Various study have shown that investments in merit- and/or pure public goods have extremely high returns with likely negative effects on poverty.
According to a recent study the biased composition of subsidy expenditure towards non-merit category creates various forms of crowding-out effects and lowers the economic performance.
In defining the subsidy burden one should not restrict oneself only to direct public expenditure only, subsidies should also include corporate tax concessions/exemptions. Various study across the globe have shown that subsidies and corporate tax concessions targeted to specific firms are ineffective in promoting investment and technological innovations and, in some case proved counterproductive.
Subsiding of non-merit goods and corporate tax exemptions reallocate investment towards the goods and services that could have obtained high private rate of return due to the presence of subsidies but there is low social rate of return. Thus encourage investment in socially undesirable areas.
There is complementarity between provision of public goods and private investment. Higher subsidies for non-merits goods leave lesser resources for public/merit goods and thus crowds out private investment due to lesser availability of infrastructure and public goods.
The inefficiency can be reduced through proper targeting the subsidies. Subsidy reforms should be targeted at limiting the subsidies to merit (especially merit-I) categories while eliminating the non-merit subsidies. The elimination of non-merit subsidy implies increase in user charges for those goods and services. Thus the increase in user charges and thereby reduction in subsidies on non-merit goods can reduce demand and help in moderating the inflation. Similarly, increasing the supply of merit goods through higher expenditure on this category has a large positive impact on growth of income, reduces certain undesirable environmental effects and contributes to poverty alleviation.
Lower subsidies/investment for education (even for the higher education because the failure of credit markets may cause inefficiency and aggregate under investment in human capital), R&D, sanitation and environmental protection negatively affects long-term growth of the economy. The income of the poor is highly dependent on their human capital and on the supply of natural and environmental resources, thereby subsides for merits goods also lower the incidence of poverty.
Moreover, even if the non-merit subsidies are financed through higher taxes then also they may be regressive. In India, the tax system is not progressive since it relies heavily on indirect taxation and there is wide prevalence of tax evasion, which implies that the additional taxes needed to finance non-merit subsidies would be paid by the poor.
The government can settle down the feelings of slowing down of the economy through properly targeting the public expenditure by eliminating the subsidies on non-merits goods and by taking away the corporate tax exemptions/concessions. This strategy not only streamlines the current demand but also stimulate the supply in the economy in medium- and long- term basis.
- ^Surender Kumar, Tapas Sen, N. J. Kurien and others (2004), Central Budgetary Subsidies in India, National Institute of Public Finance and Policy, New Delhi. This study formed the basis of the paper that was placed in the Parliament on December 23, 2004 by the Ministry of Finance, Government of India.
- ^Lopez, et al. (2007), Should governments stop subsidies to private goods? Journal of Public Economics, 91, 1071-1094.