A Scheme for Efficient Subsidisation of Kerosene in India

The distortions in price based subsidisation are very severe. The direct fiscal cost of ensuring that a rupee of value is delivered to all household users of kerosene is as high as Rs.3 and when the consideration is the benefit that finally reaches the poor “below the poverty line” consumers it is much more. This is well known. This excludes the indirect costs in the form of negative externalities imposed by adulteration, and environmental costs. Worse still are the “third order” effects of entrenched rent seeking and corruption of distribution networks and the conversion of retailing to patronage. In such situation reform and deregulation become problematic. At the core of all these failures in the “price arbitrage” that arises when price based subsidies are resorted to. The total fiscal losses on account of kerosene subsidisation are in excess of Rs. 24,000 crore far above the conventional estimates (around Rs. 8000 – 10,000 crore) which do not recognise the fiscal cost of diversion and adulteration. This paper studies the current design of the public distribution system and price based subsidisation to bring out the perversities, and argues that a complete replacement is called for. The Public Distribution System (PDS) which had value in an era of shortage and rationing has no role today. Market based distribution can bring down the direct costs since now kerosene distribution could then enjoy the synergies of oil and provisions distribution channels. There is clear evidence that a significant percentage (about 40) of kerosene is diverted out of the PDS and sold at higher prices. The commission paid to the distribution channel, in particular to the retailers of kerosene does not make the business financially viable. The rents being earned by those associated with the distribution channel for kerosene are very large. The rent extractors have become so well entrenched over time that it is plausible that other agencies in the system and even the regulatory process itself may be hostage today to their influences. The indirect losses from use of sub-optimal fuel mix, product mix and investment decisions are very large and may harm the economy significantly in the long term. The subsidy through uniform low pricing of kerosene, though intended for the poor, is in fact not reaching them as they are in no position to buy much of the kerosene allotted to them even at the low issue prices being charged by the fair price shops. It is imperative to bring into play information and communication technologies so as to break the stranglehold of the distribution channel by capturing information at the point of sale and thereby creating a permanent audit trail of all relevant transactions. Only by empowering the target segment, the BPL families, by providing them with the freedom to choose the manner in which they would like to consume the subsidy intended for them can the problem be overcome. The well-documented failure of TPDS (Targeted Public Distribution System), implemented on an experimental basis, clearly demonstrates that tinkering with the existing system would not achieve the twin goal of benefiting the really poor and not-benefiting the non-poor. The direct subsidy scheme, which is based on free market pricing of kerosene, and therefore a radical departure from the current method of uniform low pricing is the answer for achieving effectiveness of subsidization. The subsidy is to be disbursed to the poor through smart cards and the accounting of disbursal is to be done using systems similar to those used by credit card companies. The purchasing power put in the hands of the beneficiaries would allow them to use it for spending on their choice of commodities and services and thereby not only enhance the use of subsidy to the full but would also add greatly to their welfare. The proposed system would almost completely eliminate the indirect losses arising from distorted choices since the price of kerosene would be market determined and therefore not relatively cheap compared to alternate fuels. A task force (TF) must be set-up for implementation, with wide-ranging powers and full financial backing of the government of India so as to be able to function autonomously. The task force should consist of eminently qualified individuals with diverse skills and known for their integrity and appreciation for the significance of the task to be performed. The critical task of identifying the beneficiaries at micro-level should be done using all possible sources of data and information (outlined in the report) so as to minimize both, Type I and Type II errors, that is, chance of exclusion of genuine beneficiary and chance of inclusion of spurious beneficiary in the list of target beneficiaries. There are interesting ways by which private information can be brought to bear, and incentive compatibility ensured in correct identification. The disbursement of subsidy should be such that the disbursement is recorded at the point of transaction and get immediately captured in a large centralized database, thereby creating a permanent audit trail, akin to operation of credit cards (details outlined in the report). The activities associated with initial identification of beneficiaries, disbursement of subsidies and updating the list of beneficiaries is to be done by well-qualified private agencies. The operations of the system should be monitored by an SPV to be specially created for the purpose and working under the broad supervision and direction of the task force. The SPV and the TF should ensure full transparency of operation of the private vendor and the scheme by making public all relevant information on the operation of the system and opting for periodic audit of operations. The appropriate organisation design and policy framework for the same is elaborated. The immediate gain to the exchequer from the proposed system, due to market based pricing of kerosene would be an estimated inflow of Rs. 14000 crore per year by way of additional taxes. This gain from additional taxes, based on certain assumptions, is expected to rise to over Rs. 37000 crore in 2010-11, at Jan. 2006 petroleum prices. The gain to the economy and society at large from elimination of indirect losses due to sub-optimal choices of fuel-mix, product-mix, and asset mix would be immense as they would be completely eliminated in the new system. The most important gain however is that the beneficiaries would be in a position to fully utilize their entitlements and spend the same on products and services of their choice, significantly enhancing thereby the utility of their consumption. This should also make direct subsidies politically rewarding.