Tuesday, March 16, 2010

Addressing petroleum and diesel subsidies

I have blogged recently about how developments in UID and TFI opens up considerable opportunities in re-designing various subsidy disbursement channels to both improve targetting and increase its economic efficiency. This includes the possibility of transferring subsidies directly as cash (into the UID-linked bank account of the beneficiary) and thereby dismantle price controls or more accurately target the subsidy (like in case of PDS) towards its intended beneficiaries.



However, addressing the most salient and much-debated petroleum subsidies could be much more difficult. Since petroleum is directly or indirectly consumed by everyone in different forms, accurate targetting becomes very difficult. Apart from the difficulty of estimating the relative impacts of the higher prices, such direct cash transfers are also too complex to administer.

Compounding the problem is that eliminating price controls, while politically difficult, will also have a ripple-on effect on the economy. Unlike all subsidized products, petroleum is a critical input in the production of most other goods and services. Its price is a function of the cost of production of all these goods and services. Most critically (and politically damagingly), a sudden dismantling of the subsidy will surely have a cascading impact on the prices of food and other essential commodities.

Here are a few possible theoretical solutions. The first one to have a dual pricing system (a la PDS for petrol and diesel) and then target the subsidies as cash transfers through UID-linked accounts is both a step backwards and comes up against the aforementioned problem of cascading effect. The second one is to eliminate price controls and disburse subsidies, using the UID-linked bank accounts, as a revenue-neutral cash transfer to an identified group of beneficiaries. This will mitigate any possible inflationary impact of rise in petroleum prices and thereby smoothen the sudden shock arising from it. The cash transfer can have a built-in sunset clause whereby the subsidy would decrease continuously and expire over a period of time.

Another alternative would be prepare a widely-debated (build some level of consensus) self-acting action plan (even a legislation, linked to say the Fiscal Responsibility and Budget Management Act!) to gradually phase out the subsidies. This action plan can be back-ended and fairly long-drawn out to mitigate any adverse impact and manage inflationary expectations. Finally, a more optimistic alternative is to wait for global petroleum prices to fall to $30 a barrel and then use the resultant price cushion to dismantle price controls and thenceforth let the domestic retail market prices respond to the global market prices. But the problem with this approach is that when the reckoning comes, instead of dismantling the price controls, the clamour will be to pass on the benefits of lower price to the consumers!

The government's current policy on petroleum subsidies is clearly to make piece-meal increases when the crisis deepens. Such efforts come up aginst stiff political opposition, even within the ruling party's, and for every successful effort there are possibly three or four failed ones!

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