Indias Governments Need to Function Under Subsidy Caps

India’s Governments Need to Function Under Subsidy Caps

The proliferation of operational subsidies in the Union and State budgets is holding back India’s economic progress. Over subsidization squeezes out government investments that are necessary for long-term growth.

Thus, it is essential that the total amount of subsidies in Union and State government budgets is held back to levels where adequate government investment is feasible. Let’s call these limits as Subsidy Caps.

The core idea underlying Subsidy Caps as a numerical constraint on governments has many precedents in India. For example, India has adopted a cap on the number of ministers in Union and State governments. And there is a cap on caste-based reservations. In the economic context, the Reserve Bank of India (RBI) has set for itself a numerical target range for inflation. This target limits the RBI’s freedom in implementing monetary policy.

The most relevant precedent for Subsidy Caps is the Fiscal Responsibility and Budget Management (FRBM) Act. The overall FRBM idea is to limit government budget deficits. Specifically, the FRBM targets say that budget deficits should not be more than a stated percentage (currently 3%) of the GDP.

Although the FRBM targets are a precedent for Subsidy Caps, the two are different. The FRBM targets focus on the deficits, and don’t pay any attention to the makeup of the government budget expenditure. The Subsidy Caps focus on the makeup of the government expenditure, and do not pay any attention to the extent of the deficit.

In short, we have two types of concerns about government budgets: too much expenditure, and too much of a particular type of expenditure that slows down economic growth. We need two different instruments – the FRBM targets and the Subsidy Cap – to address these two concerns.

The Subsidy Cap concept is implicit in the IMF’s analysis of a country’s budget and does show up explicitly in many IMF loans. In particular, the IMF often requires the borrowing government to limit subsidies that the IMF thinks are not well-targeted for the poor. Overall, like the FRBM targets, the IMF is looking to limit government deficits, and cutting back poorly targeted subsidies can be one way of limiting deficits.

Thus, the Subsidy Cap is loosely related to the IMF’s approach to subsidies, with many differences. The most important difference is that the IMF’s approach is designed to rescue failing economies, while the Subsidy Cap is designed to promote faster growth in economies like India that are not failing, and don’t need IMF loans.

Unlike the FRBM targets, which are defined with GDP in the denominator, the Subsidy Cap would be defined with the budgeted expenditure in the denominator. The Subsidy Cap’s numerator would be the total operational subsidies in the budget expenditure.

We need several new developments to make Subsidy Caps practical. First, we need a workable definition of operational subsidies. Second, we need a broadly accepted number for the Subsidy Cap. Finally, we need to say what happens when governments fail to meet the Subsidy Cap. Since the concept itself is new, it’s too early to formulate these details; we need quite a bit of analytical and empirical work to work them out. Yet, even at this stage, we can specify some details that would help create a workable definition.

In simple terms, operational subsidies are government expenditures, excluding wages and debt service, that do not aim to promote higher growth, more jobs, or asset creation. Examples are energy subsidies, MGNREGA expenditures, and continuing, routine funding for higher education institutions. Typically, the values of these expenditures are available in the budget documents.

This is a narrow definition of total operational subsidies. It does not capture the reality that some subsidies could take the form of reduced revenue generation. For example, the Railways have a very high operating ratio, which means that they do not generate enough revenues because they subsidise passenger traffic and their workers. A broad definition of operational subsidies would capture these subsidies.

In short, the Union and State governments need to function under Subsidy Caps for India to boost government investments and the economic growth rate. It is time to start thinking seriously about formulating workable ways to define and implement Subsidy Caps.

About the Author

Subodh Mathur, an economist (Ph. D. MIT), with worldwide experience in using economic concepts to resolve real-world issues. He is the author of the book called ‘India's Path to Prosperity 2022-2047: A Workable Agenda for the Next 10-15 Years’.

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