Last Wednesday, Professor Raghuram Rajan took over as the new Chief Economic Advisor to India's Finance Ministry. He has firm views on the policy changes that the Indian government needs to make. In a speech in April in Prime Minister’s presence, Professor Rajan stated one of the short-term steps that the government must take: “Raise fuel prices to international levels in a set of quick steps, then completely deregulate them. Announce this as soon as politically possible, and do not roll back.”
But he is not alone, or the first prominent economist, to ask for an end to fuel subsidies. Apart from economists, the Planning Commission, the Reserve Bank of India and the PM’s Economic Advisory Council are strong advocates of subsidy reform. In 2010, a government appointed expert committee, headed by Deepak Parikh, had also recommended rationalisation of fuel subsidies.
At Rs 68,481 crore, fuel subsidy was the biggest expenditure in Indian government’s balance sheet last year. By late July this year, Reuters reported, the government had already spent most of the Rs 43,580 crore allocated for fuel subsidies in 2012-13.
Fuel subsidies add to the fiscal deficit, which in turn causes inflation. Reducing fuel subsidies would improve India’s fiscal balance and create fiscal space for increased investment in infrastructure and other development activities. Environmental damage caused by the steady rise in the sale of diesel vehicles due to price differential between diesel and petrol can also be reversed over time.
With benefits of removing fuel subsidies known to everyone, it eventually boils down to the political economy of reform. David Victor of Global Subsidies Initiative says governments give subsidies as part of a political bargain — they are “a visible way to deliver benefits in exchange for political support”.
Because they are a symbol of populist action by successive political leaders, these subsidies, once started, get permanently locked-in.
The problem for the UPA is compounded by the ‘commitment problem’ in subsidy reduction, an aspect alluded to by Mathew Lockwood. Even if subsidies may free up resources for development, people have little confidence that this will happen given high levels of corruption in the UPA government. The UPA government would dread the scenes witnessed on Nigerian streets this January where people came out with banners saying “Remove corruption, not subsidy”.
Although India subsidises diesel, LPG and kerosene, any subsidy reduction plan will have to start with diesel. In July, the Prime Minister himself described raising diesel prices as “a very delicate issue” and stated that, “if you try to raise the prices of diesel, it has a cascading effect on the economy. We are trying to work out a solution where it impacts the economy in the least manner but also brings down the fiscal deficit.... It’s extremely difficult for us to absolutely decontrol diesel at the moment because it would impact the economy in a very, very serious manner.”
If fuel subsidies are meant to help the poor, then they are very poorly targeted. International Energy Agency estimates that of the $22.5 billion spent by India on fossil fuel subsidies in 2010, less than $2 billion helped the poorest 20 per cent of the population. But even if poor households get only a small portion of direct subsidies, the effects of subsidy removal on their incomes is far higher than for richer households. This is partly because raising diesel prices has a significant impact on inflation and cascading effects throughout the economy, via sectors such as transport and agriculture. Forget the coalition allies of the UPA, will the Congress party headed by Mrs. Sonia Gandhi ever agree to such an ‘anti-poor’ step?
But the problem of removing fuel subsidies is not limited to chaotic democracies. Even China was unable to fully pass on fuel price increases at all times during 2010 and 2011. Elsewhere, attempts at fuel subsidy reduction were reversed within a few days in Ghana in 2008 and in Nigeria in January, and postponed in Indonesia earlier this year.
Overcoming political and public opposition to fuel subsidy removal will be a huge challenge for Raghuram Rajan. The current regime of broad spectrum subsidies is a very blunt instrument of providing relief. If subsidies can’t be removed, it will be prudent to use sharper administrative tools for targeting them. The answer to Professor Rajan’s woes perhaps lies in a project headed by another lateral entrant to the government, Nandan Nilekani. Aadhar identity scheme is the foundation on which India’s subsidy reduction plans must be gradually constructed.
Sushant K Singh is Fellow for National Security at the Takshashila Institution and editor of Pragati-The Indian National Interest Review