Sukumar Mukhopadhyay: Subsidy is better than exemption

I have chosen two contentious issues regarding subsidising petrol and export for making out my case in this article.  But that is not because they are the only two but because they are  the most topical issues. My proposition is of course that subsidy is not economically viable for anything except in rare cases and that too temporarily. But in a continuing basis no subsidy is economically viable.

Take petrol first. Diesel also comes in the same category. If the international price goes up to more than say 100 dollars per barrel, the cost of production increases so  much that if the finished product , that is, petrol and diesel, are sold at a fixed price then the manufacturers and distributors suffer a heavy loss. The government has to subsidise these manufacturing companies. Who pays the subsidy? It comes from the revenue that the government collects from the indirect and direct taxes. Who pay these taxes? Indirect taxes are mostly paid by the middle class and the poor. No poor man can afford not to buy soap or bulb or some prepared food or cloth. On all of them they are paying indirect taxes without knowing . When I asked my household help if he was paying tax or not, he said, no. But when I asked him if he buys soap or cloth , he says, yes. Then I explained to him how he pays tax . He understood that he does pay tax. Even a large part of direct taxes are paid by the middle class and  higher middle class. So the tax collected by the government from the lower, lower middle and higher middle class is being used for subsidizing the price of petrol which is mostly used for cars which are used by higher middle and higher class. Again a large percentage of cars are run on diesel now. For trucks the higher cost is borne by the carriers of goods and ultimately the purchasers of goods. These good are bought by all classes of people and so the effect is neutralised. But in the case of cars run on petrol or diesel the effect is largely that  the poor are subsidising the rich.

              Now coming to exports, a bone of contention between economists and Ministries such as Finance and Commerce is whether subsidy to export is economically worthwhile.  One view is that exports have to be encouraged not only by zero-rating of export but even by giving subsidy.  The concept of “export or perish” is taken too seriously by this school of thought. They do not mind even subsidizing export to achieve a substantially high target always comparing with the height reached by China.  Here I am not discussing any individual scheme but only examining how and why economically it is not worthwhile to subsidize export. 

            A study by Arvind Panagariya, (January 2000 “Evaluating the Case for Export Subsidies,” Policy Research Working Paper 2276, World Bank Development Research Group Trade) has shown that export subsidies are a more costly instrument of achieving export expansion than other policies.  In India, several export-subsidy schemes have been in place for many years.   But even then significant break in exports came only after substantial import liberalization and Real Foreign Exchange Rate (RFER) depreciation were achieved in the 1990s.  A study by Anil K. Lal and Thomas C. Lowinger in journal of Economic Integration, Vol.17, No.2/June 2002 pages 397-415 concludes that it is likely that liberalization of an exchange rate regime coupled with liberalization of trade may act to improve export in a most sustainable manner.

            India’s experience shows little impact of export subsidies on exports.  The comparative experience of Mexico and Brazil shows that export subsidies are a costly instrument of export diversification.  This has been showed in the study by Julio Nogues, (1989 “Latin America’s Experience with Export Subsidies,” Working Paper 182, World Bank Working Paper Series).

One of the important reasons why export subsidy is advocated is that       subsidy neutralizes the cost due to other taxes such as entry tax, tax on electricity, Central Sales Tax etc generally charged by the States which are not rebated in the existing system of Drawback and EPCG.  The same purpose can be served by including it in a duty neutralization scheme for which, however, there are legal hurdle namely that Central Govt. cannot refund an amount which it has not collected by the Centre but by the States.  If the States agree to reimburse the amount to the Centre, then an elaborate agreement between the Centre and the State is necessary.  This, however, can be achieved by an understanding arrived at under the umbrella of the Finance Commission which can now include it as a part of the study they are about to undertake.  If this can be achieved it will neutralize the cost due to other taxes without giving any subsidy.  It will then be exactly compliant with the WTO.

Subsidy encourages over valuation of exports. For by overvaluation the exporters get more credit of duty. In India cases have been noticed where a cheap ball point pen sold in the retail market for Rs.10/- has been over valued at the export stage as Rs.50/-. 

            Subsidy increases the fiscal deficit, which itself is a serious limitation to this instrument.  Under perfect competition, a country attempting to retaliate against export subsidies by its trading partners with export subsidies will only hurt itself.

            Finally it leads to countervailing duties being imposed by the other countries.  In the case of India, countervailing duties have been imposed on the anti-biotic by European Union, on PET resins and PET films by EU and USA and on steel by USA. 

            On the whole, subsidy is not quite an economically viable proposition because it is a cost of export which may be far in excess of the benefit. 

            Subsidy is justified in some rare cases such as new inventions where the cost is so prohibitive at the initial stage that there will be no innovation without subsidy. One example is solar energy and another is electrical car. There can be more of  such examples. Solar energy is highly prohibitive is it is not subsidised. We are now having the benefit of warming water for household use and even for use in swimming pool.  But much more important use of solar energy is in producing electricity (as a substitute for electricity for domestic and industrial use) and electricity produced at distant and mountainous ranges where electricity cannot be generated from coal  or other conventional sources.  However, once the solar energy becomes economically viable, there should be no subsidy thereafter.  Similarly, electrical car or similar innovations like car run by air or other elements not so far discovered need to be subsidised by the Government since no private company is likely to spend so much money to invent something the success of which is not definite.

            Having said all that I must also point out that subsidy is better than exemption.  While subsidy is transparent, exemption is hidden, that is non-transparent.  Even an exemption is a subsidy but it is given in a way that is not exactly known to the people.  Subsidy is also more easy to administer since it is transparent and is more easy to end since it attracts the attention of people.  An example is the exemption given to Konkan Railway or Delhi Metro Rail Corporation.  People do not know that huge exemptions have been given to subsidise them.  Had it been given as a subsidy, some day we could think of reducing or withdrawing the subsidy so that transport by metro train or by other train would no longer remain subsidized.  That would bring the pricing to be market oriented.   

            The conclusion is that market oriented pricing of goods and services is the best. For there is no subsidy involved.  However, subsidy is better than exemption.  Subsidy is also necessary to promote innovation.  But subsidising manufacture and distribution of goods leads to economic distortion.  Subsidizing export is not economically worthwhile.