If the Government of India wants to stimulate the automobile sector any more (and the roll-out of Nano should be a large enough stimulus for the sector), then it should be taking a leaf out of the European "cash for clunkers" scheme, instead of doling out benefits by way of economically inefficient tax cuts.
In Europe, the French and Spanish governments have been running "cash for clunkers" scheme since last year, and Germany and Italy joined them early this year. In all these countries, the program has been designed mainly for smaller fuel efficient cars and have been an unqualified success in stimulating the automobile sector. It is estimated that 30-40% of new car sales in France are coming in as a result of the scrapping deal. German car sales jumped 21.5% in February, with mass market manufacturers recording a 37% surge, whereas sales of premium cars fell 19%. The Obama administration too is proposing a similar plan to revive the ailing auto sector in the US. The proposed legislation in the US calls for rebates of $2,500 to $5,000, roughly in line with the 2,500 Euro ($3,317) plan in Germany.
Princeton economist Alan Blinder has made the most coherent theoretical case for cash refunds for those willing to trade their older vehicles for new ones. He has argued that besides being an effective economic stimulus, it would also be environment friendly (by both removing polluting vehicles and reducing gas consumption), equitable, and improve road safety. Steve Levitt though has reservations about the success of this approach.
The program can be designed for either the government to directly buy up the clunkers or encourage/incentivize dealers and manufacturers to introduce exchange offers. Further, the incentives and refunds can vary depending upon the age of vehicles returned/traded and the fuel efficiency of the new vehicles purchased.
The program offers interesting possibilities in India, nowhere more than in the Government departments itself. All government departments and even Public Sector Units (PSUs), have massive fleets of vintage ambassador cars and open/semi-covered jeeps, the overwhelming majority of whom are well past their retirement date. These vehicles undergo frequent repairs, have very low mileage, are mobile smokestacks, and pose dangers to both its passengers and other vehicles. The government spends huge amounts on their maintenance and fuel, all of which can be easily recovered in a couple of years if replaced with a new, fuel efficient vehicle.
Instead of the government buying these vehicles, it can float long term tenders (say three to five years) for hiring these vehicles from private contractors. This program, by itself, without any government support, would provide enough of a stimulus for the automobile sector. The government may have to spend a little more than what it is spending now every month, as the monthly hire price for the new vehicle. If it wants to encourage private contractors, it can even offer incentives like payment of insurance premiums for the period etc. And the amounts involved are staggering given the fact that there are atleast 500 plus old vehicles ready to be condemned in each of the 611 districts of the country.
For private vehicles, it can offer incentives like interest subvention subsidy for people willing to trade their clunkers for new fuel efficient vehicles. Car dealers and manufacturers can be offered direct subsidy, by way of refunds (So as to ensure targeting and ease of administration), so as to come up with innovative exchange offer to incentivize people to trade their old vehicles.
There are two main dangers with such schemes. First, there is the strong possibility that these old vehicles will be minimally repaired/retrofitted and then shipped for sales to the developing countries. This would effectively shift pollution and other problems from developed to the developing countries, besides exerting a negative effect on the auto sector in the importing country (since it displaces the demand for new vehicles).
Second, as the US legislation before the Congress envisages, there is a strong possibility that individual economies may restrict its benefits to local car makers. This is especially so for America where the big three US makers do not have much presence in the market for smaller and fuel efficient cars.
Greens feel that cash for clunkers is not as green as being made out and is a corporate gift to car makers. Sample George Monbiot here and William Buiter here (from Niranjan).
NYT has this report which reports that a substantial share of the cars that were supposed to have been junked are finding their way to markets in Africa and Eastern Europe, thereby neutralizing any environmental benefit.
Economist summarizes cash for clunkers across diferent countries.
Vox article on cash for clunkers finds a few problems with such policies.
Update 5 (10/4/2010)
Christina Romer and Christopher Carroll claim that the cash for clunkers program did work.