Subsidies, Merit Goods and Fiscal Space

Subsidies, Merit Goods and Fiscal Space
Sep 2020 , by , in Interviews

Sudipto Mundle & Satadru Sikdar, National Institute of Public Finance and Policy

Large fiscal deficits and even larger public-sector borrowing requirements are a regular feature of the fiscal landscape in India. In this context, rationalisation of the prevailing large volume of non-merit subsidies should constitute a major component of deep fiscal reforms. Doing so could free up the fiscal space needed to address the challenge of declining growth.

The Indian economy is chronically under fiscal stress. While total tax revenue (Centre plus states) has remained below 18% of GDP (gross domestic product), total expenditure has progressively risen to 29% of GDP (Government of India, 2018).

Large fiscal deficits and even larger public-sector borrowing requirements are a regular feature of the fiscal landscape. In this context, we argue that rationalisation of the prevailing large volume of non-merit subsidies should constitute a major component of deep fiscal reforms. Such reforms could free up the fiscal space needed to address the challenge of declining growth since 2017-18 – a challenge that has been greatly aggravated by the Covid-19 shock, and the stringent nationwide lockdown which followed.

Estimating budget subsidies

The total volume of subsidies on all services is given by direct transfers, concessional interest rates, concessional prices of land or other assets, and tax concessions or exemptions (tax expenditures), are not included in the estimate. Thus, the concept of budget subsidy is strictly confined to the unrecovered cost of government services (goods) other than pure public services (goods).

The incidence of total subsidies (Centre plus states) declined from 12.9% of GDP in 1987-88 to 10.7% in 2011-12, and further to 10.3% in 2015-16, that is, a 20% decline in 28 years. The decline was more pronounced for the central government, going down from 4.9% in 1987-88 to 2.9% in 2015-16, that is, a decline of over 40%. The average level of the states’ subsidies declined from 9.4% of the gross state domestic product (GSDP) in 1987-88, to 7.8% in 2015-16, that is, a 17% decline. The distribution around this average ranged from 6.5% (Maharashtra) to 15.3% (Bihar including Jharkhand) in 1987-88. In 2015-16, it ranged from 5.1% (Tamil Nadu) to 11.8% (Madhya Pradesh including Chhattisgarh).

Discussion

There is a robust inverse relationship between the incidence of subsidies and per capita income. Comparing across states, this inverse relationship is statistically significant at 1% level3, and has persisted for nearly 30 years. This cross-sectional regression result is consistent with the decline in incidence of subsidies with rising per capita income (GDP) observed longitudinally from 1987-88 to 2015-16 at the all India level. It is also evident in longitudinal comparisons for most states. The incidence of subsidies was higher in 2015-16 compared to 1987-88 in only two states, namely, Uttar Pradesh and Madhya Pradesh5.

In some states, the incidence of subsidies is much higher than the expected level. These include Uttar Pradesh, Madhya Pradesh, Andhra Pradesh, and Karnataka. Conversely, subsidy incidence is much lower than the expected level in West Bengal, Punjab, and Tamil Nadu. In Bihar, which still has the highest incidence of subsidies, this was much higher than the expected norm in 1987-88, and in 2011-12. But it had come down to the expected level by 2015-16.

Not all subsidies are undesirable. For some goods and services, the social benefit of private consumption exceeds the private benefit, for example, basic education. For such items, a subsidy is socially desirable to induce private consumption beyond the level dictated by the private cost-benefit calculus at market prices.

Such goods and services with positive externalities are called merit goods or collective goods, and the subsidies provided to induce their consumption may be described as merit subsidies. Such merit subsidies should be identified conservatively. Otherwise, a positive externality can be claimed for virtually any good or service to justify a subsidy.

The incidence of merit subsidies has remained about the same at 4.5% of GDP (2015-16) as compared to 4.6% in 1987-88. The incidence of non-merit subsidies declined from 8.3% of GDP in 1987-88 to 5.7% in 2015-16, but these still account for over half of total subsidies. The bulk of these non-merit subsidies are in economic services (4.5% of GDP), and most of these are provided at the state level (4.1% of GDP).

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