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The Balance Sheet: India’s own fiscal cliff – Fuel subsidies

This article is part of an ongoing series of articles by EPG in India Incorporated, entitled The Balance Sheet – Taking Stock of India. This article was first published here.

India Incorporated

In my last article, I wrote about how India was living beyond its means, but how this could be said of many other countries too. I argued part of the problem was political gridlock, as well as the 2.5% of GDP handed out in mainly food and fuel state subsidies. As fiscal deficits persist, India’s policymakers have been pushed to take measures to reduce deficits by cutting the hugely inefficient fuel subsidies. Just this week, the Finance Ministry asked the Petroleum Ministry to price motor and kitchen fuels to facilitate a substantial subsidy cut.

India paid Rs 81,000 crore (US$18 billion) in fuel subsidies for year 2010-11, with the majority made up of under-recovery of revenues from government and upstream oil companies. The direct cash subsidies made up only Rs 3,000 crore (US$637 million). In 2011-12, the combined level of subsidies to fuel, fertilizer and food increased by nearly 27%. Despite talk about reducing subsidies, by late July 2012, most of the budget allocated for fuel subsidies had been spent seven months into the year, before the fuel subsidy was cut in September. The three state-run fuel retailers suffered losses in 2012 that were four times that of the previous year.

Political influence, coalition politics and public anger form a nexus that discourages the establishment of a pricing mechanism that can reflect market prices in the prices that are charged to consumers.

[pullquote] Political influence, coalition politics and public anger form a nexus that discourages the establishment of a pricing mechanism that can reflect market prices [/pullquote]

There are good economic arguments for doing so. One is to improve India’s fiscal position, in the face of the very real threat of a ratings downgrade, which would make financing India’s existing debt more expensive. Freezing prices when world prices increase, like in India and China in 2010-11 simply mean the need for steeper increases in the future. It would reduce perverse incentives that has led 70% of cars sold in India to be diesel-powered vehicles (40% of India’s fuel subsidies are for diesel). Given that diesel is more polluting than petrol, this would increase energy efficiency and reduce pollution levels. Finally, corruption in selling fuel on the black market for inflated prices would dramatically decrease.

In practice, it’s not so easy. Raising fuel prices is a delicate matter. Diesel, in particular, is the poor man’s fuel and reduced subsidies on this would hit the poorest hardest. Rajiv Pratap reddy, a leader in the opposition BJP party, announced last year that cutting the subsidy amounted to “financial terror.” A weak rupee has meant higher import prices for fuel, which has merely widened the fiscal safety net required. Although cutting subsidies drives up inflation in the short-term, it also cuts the fiscal deficit (a structural driver of inflation), meaning inflation should fall in the longer term.

But removing subsidies that have led to inefficient resource allocations for too many years too quickly means, in effect, a massive income transfer from all strata of Indian society to the government. This should be offset by other government transfers to the strata of society that require them most – the Aadhar-based cash transfer scheme. The national government could study the case of Gujarat, which consistently increases energy tariffs by 3% a year and where the energy suppliers are profitable and more efficient.

Combining these cash transfers with localised educational and practical schemes to support households move to cleaner fuel sources could save the government money, make India’s economy function more efficiently, and create a considerable positive social impact.

This article was published by India Incorporated here.

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