Budget 2012: Price controls, open-ended subsidies throw budget allocations off-kilter

Fiscal consolidation is the need of the hour, and the finance minister should rationalise subsidies. The best way forward is to end price controls for items like urea and diesel, since these constitute the most irrational, lopsided way of allocating subsidies.

In every democracy, politicians will subsidise some sectors or items. Some subsidies are explicit (so much per tonne of urea). Others are implicit (free education in primary schools).

All reasonable people will agree that Budget outlays should be decided after taking into account the demands of different sectors. This entails a debate between government departments and political parties on how much subsidy or public spending each sector deserves. The final decision will represent a careful weighing of priorities.

This is not how things happen in practice. Not all subsidies or spending are equal. Some are more equal than others, and totally distort priorities set at Budget time.

Price controls constitute one sort of subsidy. For instance, the government has not allowed manufacturers of urea to raise their prices for many years. The difference between the imported price and the controlled price is subsidised by the government.

The same is true of some petroleum products like diesel, kerosene and cooking gas (LPG). In all these cases, the import prices may shoot up but controlled prices will not change automatically, so the difference has to be subsidised by the government.

This does not happen with other kinds of subsidies. Consider, for instance, potassic and phosphatic fertilisers. These are sold at market-related prices. The government gives a fixed subsidy per tonne of potassic or phosphatic fertiliser, bringing down the price to the farmer. But this subsidised price fluctuates up and down with the market. This constitutes a fixed subsidy per tonne, and so, actual spending roughly conforms to Budget expectations.

The subsidy for urea, however, is open-ended, not fixed. If the import price goes up, the difference is automatically subsidised without limit. So, if the world price rises sharply, the subsidy can double.

This destroys the careful priorities set out in Budget allocations, which balance the claims of different sectors. Subsidies for education and health are fixed (or subject to minor variations) while the subsidy for urea is open-ended.

At Budget time, the government may decide that priorities are best served if the central subsidy for health is equal to the subsidy for urea. But if the world price increases, the urea subsidy can become double the health subsidy. This will constitute a complete change of priorities, without any debate or discussion within the government or Parliament.

The subsidy for urea is open-ended while that for potassic and phosphatic fertilisers is fixed. The result is that urea has, in relative terms, become far cheaper than the other two. Good agricultural practice requires farmers to use abalanced mix of the three fertilisers.

But because of the distortion caused by urea price control, farmers have slashed use of potassic and phosphatic fertilisers and maximised that of urea. This wrong mix is destroying the quality of soil across the country. This can hardly be the aim of price control, yet is the consequence.

Price controls on diesel, kerosene and LPG are also open-ended subsidies. Every time the global price of oil rises by $1 a barrel, the implicit subsidy borne by the government and its oil companies rises by 7,000 crore a year. Every time our currency depreciates by 1 per dollar, the implicit subsidy rises by 3,500 crore a year.

In recent months, oil has risen by $14 a barrel, translating into an additional implicit subsidy of 98,000 crore. This is far more than the food subsidy and two and a half times the NREGA outlay. This makes nonsense of stated priorities. Yet, politicians are most reluctant to let go of price controls.

Just as bad but less transparent are cross-subsidies. Government oil marketing companies (IOC, HPCL and BPCL) and crude oil producers (ONGC and Oil India) have to foot up to two-third ofthe implicit (hence, non-transparent) subsidy for diesel, kerosene and LPG.

In a rational set-up, the profits of these companies would go into the common government pool, and would be divided between different ministries according to government priorities. But the cross-subsidy means that a big chunk of their profits is arbitrarily diverted entirely to consumers of diesel, kerosene and LPG, without any discussion on priorities in spending.

Politically, this sort of cross-subsidisation within a sector (like oil) is uncontroversial, and so often resorted to. In fact, this is a highly irrational, non-transparent destruction of priorities.

Diesel should be decontrolled. Artificially cheap diesel isused for adulterating petrol. Cheap kerosene is used to adulterate both diesel and petrol. Adulterated fuels cause massive pollution and ruin the health of humans as well as engines.

Kerosene is used for rural lighting, but it\’s better to give free solar lanternsto every rural household and abolish the kerosene subsidy. Supply of subsidised LPG should be capped and ultimately eliminated in cities, which should get unsubsidised natural gas.

Any attempt to lift price controls will produce screams of protest from the Opposition. To meet critics, the finance minister should emphasise that every rupee spent on subsidising diesel or urea is a rupee taken away from education, health, employment and transfers to state governments. Opposition politicians may love open-ended subsidies, but government revenues are not open-ended.