Yesterday’s Indian Express carried a piece by me on the perverse oil subsidy that the government of India provides. I begin that piece with my favorite Douglass North quote: “Economic history is overwhelmingly a story of economies that failed to produce a set of economic rules of the game (with enforcement) that induce sustained economic growth.” I used that quote in the other piece published in Mint today.

The reason I like that quote it because it goes to the very heart of the problem of India’s economic development. Indians as a collective are no less than other collectives around the world; India is endowed with natural and human resources; yet India is desperately poor. Why? Because we have failed to develop a set of rational rules to play by. Refusing to acknowledge that failing will ensure our continued poverty.

Anyway, here’s the text of that India Express piece.

Perverse Subsidy for the Rich

Nobel prize-winning economist Douglass North observed that “economic history is overwhelmingly a story of economies that failed to produce a set of economic rules of the game (with enforcement) that induce sustained economic growth.” Producing a set of rational economic rules is a political rather than an economic process. Frequently basic economic truths are willfully disregarded in a myopic but cynically calculated process of short-term electoral gains. In the long run, however, the persistent practice of politically motivated economically unsound policies has the unsurprising and unfortunate effect of impoverishing the economy.

India is a case in point. Despite being endowed with substantial human and natural resources, it has failed to provide a vast majority of its citizens the basic necessities for a decent life. It is hard to avoid the conclusion that what India mainly lacks is a rational set of economic rules. An important contemporary example of a flawed economic policy is the subsidy that the consumers of petroleum enjoy.

The price of a barrel of crude is hovering around US$ 100 a barrel and yet the price of petrol at the pump remains essentially what it was when crude was selling at half that price about a year ago. The resultant gap between the cost and the price has to be bridged through a subsidy that is estimated to be around Rs 70,000 crores this year. The case is made that by keeping the price artificially low, the so-called “common man” benefits. But that is certainly not the case. It is a perverse and regressive subsidy for a number of reasons.

First, it is the “uncommon man” who actually benefits directly from the subsidy. In fact, the wealthier you are, the more vehicles you own, the more subsidy you capture. For every litre of petrol or diesel you consume, you benefit by around Rs 10; for every cylinder of LPG, someone else chips in Rs 250. The really poor person does not own cars nor has a gas connection.

Second, when distorted low prices do not reflect the full costs, it sends the wrong signals and consumption is more than is socially optimal. India meets about three-quarters of its petroleum needs through imports at an approximate cost of US$ 50 billion a year. Increased consumption inflates that import bill and is economically wasteful.

Third, the burden of the opportunity cost of the subsidy falls squarely on the people who cannot reap its benefits. The resources that the subsidy consumes are not available for services that the poor benefit from such as subsidies for public transportation systems, primary health and education.

Fourth, the subsidy is financed by bonds issued to oil marketing companies. These bonds represent a future liability. Essentially it is a mechanism employed by the present voting generation to secure benefits that will be paid for by the future generations who do not have a vote and therefore do not have the option to reject that burden.

Fifth, if prices were more aligned to true costs, alternatives such as better public transportation system can have a fair shot at being developed. It would also send the right signals for more conservative use of private cars, leading to less congestion and pollution.

The basic economic truth is that there is really no such thing as a free lunch. Today’s subsidy comes at a cost that will only grow larger the longer the delay in pricing petroleum products at full cost. It is fairly simple to remedy the situation. Raising the price at the pump is the simplest but the most politically risky. The UPA government knows that and will definitely not risk losing power even if raising prices is for the larger benefit of the economy.

But those subsidies have to be reduced, if not totally abolished overnight. A start could be made immediately to reduce the subsidy to the rich while continuing it for the poor. A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use. Depending on the size of the engine and average fuel consumption, an annual fee could be assessed which has be paid to maintain registration. So if a particular make and model of car typically consumes, say, 1,000 litres of petrol a year, the tax could be Rs 10,000.

This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched. Since it is usually the common man who uses public transportation, the common man would continue to enjoy the subsidy.

Implementing rational economic policy is not impossible for India even though for decades on end we have been burdened with flawed policies. We are moving slowly towards a more rational way of running an economy. Whether we persist on along that path is a political matter which can only be determined ultimately by the enlightened self-interest of an educated population.