In a piece I had written for the Indian Express (see “How we subsidize the rich“, Feb 15, 2008), I had advanced a tentative solution to the problem of how fuel subsidies benefit those rich enough to afford cars at the expense of the poor. Here I will address a few objections raised against the idea.

But first, here’s the recommendation:

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.

Veeru in a comment on a Pragmatic Euphony post objected saying in essence that the scheme will penalize car owners who drive less than the average number of miles (for a particular make and model) and subsidize those who drive more than average. In short, there will be a cross-subsidy. He made his case using a hypothetical Maruti van owner who only uses it for the occasional family weekend outing, as opposed to another owner who uses his Maruti van extensively for business.

Sure, in a world where it would be costly to figure out exactly how many liters of subsidized fuel every car driver uses (and then impose a tax calculated to negate the subsidy), one is forced to go with averages, and that immediately forces a cross-subsidy. But here’s the point: if you know that you are a low mileage user, knowing that you are subsidizing others will enter into your calculation on whether to keep that car or not. It is up to you whether you wish to keep the infrequently used car which on average is used extensively by others.

Imagine that I like to drive the tractor of an 18-wheeler once a year for 100 kms just for kicks. So I own one. But, on average those tractors rake up 100,000 kms a year and (suppose) that the annual fuel surcharge is Rs 20 lakhs. It is up to me to decide I want to belong to that club.

One cannot base policy on outliers.

S Karthik makes a point that is somewhat related to Veeru’s point. He says that since a car owner who drives lower than average miles is forced to pay the same fixed cost of the average annual surcharge for that make and model of car, that fixed payment is a sunk cost and therefore will not enter into the calculus of how much he will drive. Karthik thus concludes that this will not reduce the number of miles driven.

The flat per-car tax that Atanu proposes will have no negative impact on the amount that people drive. It is a fixed cost every year. Thus, at the margin, the driver doesn’t know the true cost of the extra kilometer he drives. Thus, he will tend to drive more than what is optimum from the point of view of subsidies, etc.

Another problem with Atanu’s plan is that it creates perverse incentives. Light users of the road end up subsidizing heavy users of the road. Yes, there is still a substantial cost of driving which prevents a “true” tragedy of the commons from occurring. Still, this kind of incentive is likely to only increase the amount that people drive.

A plausible argument but not correct.

Fixed costs do not enter in the picture ex post but do enter ex ante. If the flat-tax is imposed on me after I have bought the car, it will not substantially change the number of miles I drive. But note there is an “income effect” — by paying that fixed cost, I have less money and therefore I will drive a little less.

Nor will my decision to buy or to buy a particular car (or even any car at all) be affected if I did not know that such a flat-tax may be imposed. However, if I know before hand that I will be paying a flat-tax as a fuel surcharge, it will affect my decision to buy or not, and also affect how much I actually drive. The last thing I would do is to increase my driving so as to creep as close to the average miles driven: it would be akin to cutting off my nose to spite my face.

A Larger Issue

Car owners in India today not only get subsidies for the fuel they use, they also impose substantial negative externalities. These externalities negatively impact those who have nothing to do with cars. Cars emit pollution. The driver benefits from the engine running the car and the airconditioner but the (literally and figuratively) poor pedestrian suffers the exhaust from that engine. Roads are costly to build and maintain, and take up enormous amounts of space. Those costs are not fully paid for by car owners. In India, parking is not fully priced: I have seen car parking fees as low as Rs 10 an hour in Mumbai — where the space occupied by the car probably sells for a few lakhs and therefore the correct parking fees should be around a hundred rupees.

I like the solution that Singapore has. (What else is new?) They have a huge upfront tax on cars. I believe that cars there cost approximately three times what it costs in the US. This discourages people from owning cars. On top of that, Singapore invests heavily in public transportation and gives people an incentive to use them by keeping prices low, frequency and quality of service high, etc.

The last time I was in Singapore, I took the train to the airport. At the start of the journey I paid S$ 5 and when got back S$ 3 at the end of the journey when I turned in the card at a smart card machine at the airport. The ride was fast, comfortable, and cheap. When I arrived at Mumbai, I took a cab from the airport. The ride was slow, uncomfortable, and expensive.

Related post: “The price of oil and the wages of stupidity“.