Amina El Refai
The World Trade Organisation (WTO) defines a subsidy as arising “any time a government programme benefits private actors”. A subsidy can be direct or indirect help from the government. Direct assistance includes cash and interest free loans whereas indirect includes insurance, tax breaks and insurance. A subsidy in this context refers to a direct subsidy from the government to help Indian industries, businesses or individuals. The effect of a subsidy is important since it ends up reducing the final price of a good so that it is cheaper for consumers. It does this by reducing costs for the firm and thus allowing the firm to charge lower prices.
In this case, this is a consumption subsidy as it influences the activity of a consumer and this decreases the final price of the fuel energy. Therefore, a fuel subsidy is a government action that decreases the final price of fuel energy. The subsidy lowers the cost of production and increases fuel quantity traded at a lower market clearing price. The implementation or elimination of a subsidy is a highly contentious topic with many advantages and disadvantages.
A subsidy protects the vulnerable and therefore it is a form of government intervention for when the market has failed to produce socially desirable results. It could also prevent social upheaval for when the population feel their needs are not satisfied. It is a form of agreement between people and the government to share natural resources.
A subsidy is studied with regards to the final price of goods and services. By making intermediate goods cheaper (energy) this means less risk of cost push inflation. With subsidies, cheaper fuel reduces firm’s costs and stimulates economic activity and economic growth. Furthermore with lower costs of production higher profits will be achieved hence firms will be incentivised to engage in R&D, which would lead to more innovation and economic growth on the long run.
A subsidy increases disposable income meaning increased chance of demand led growth in the country. This is crucial for developing countries like India because the middle class’s consumption activities will increase with increased disposable income which is vital to development and the global economy. Subsidies also impact food prices because food is transported from agricultural and rural sectors of the country to the urban population; therefore if fuel prices rise then the cost of transporting would be higher and so the final costs of food rise too. With people’s salaries staying the same this would make it much harder to sustain the same standard of living. As a result alot of those in the middle class could relapse and fall back into poverty. Furthermore oil prices fluctuate and therefore a subsidy ensures a relative degree of stability. This is important for developing countries where people’s consumption would be strongly affected by fluctuations in price and inflation.
Fuel subsidies affect everyday utilities (i.e. water and electricity) making them more affordable and therefore the system becomes more inclusive (adequate provision of electric and energy for the majority). It also makes cars more affordable for people and meets the needs of certain consumers.
The most significant disadvantage associated with a subsidy is the opportunity cost it presents. The budget allocated to subsiding fuel can be diverted to other sectors of the country which would have positive long term effects. For instance, provision of public goods and services like infrastructure, health and education. Infrastructure is important as poor infrastructure is an obstacle to growth while health and education are crucial for building human capital in the long run.
Criminal behaviour, such as smuggling, may also arise as a result of subsidised fuel. For example, because diesel costs are much higher in Pakistan than in Iran, a black market has evolved where people smuggle from Iran to Pakistan to make profit (thus, the Indian government is subsidising Pakistani fuel consumption and it is a waste of budget).
Subsidies lower prices of fuel and therefore they discourage carpooling and public transport use. This increases traffic and congestion in cities that are already busy. By discouraging people to carpool or use public transport levels of pollution increase. With regards to the usage of resources, fuel is a fossil fuel and it is non-renewable resource. Therefore, by subsidising it, the government is subsiding polluting activity and also contributing to unsustainable use of resources. Furthermore fuel subsidies discourage people from research and development and hence hinders the discovering of alternative environmentally friendly technology, which would result in sustainable economic resource and the conservation of non-renewable resources.
Subsidies become a more difficult topic to assert when they are applied to necessities, such as fuel or other energy sources. Based on the pros and cons presented above it is evident that the Indian government has done the right thing. By removing the subsidy, the country will gain all the aforementioned advantages and, in theory, should free up funds in order to invest in useful and long-term investments. These investments could be beneficial, as further investment in human and physical capital leads to sustainable economic development and economic growth because of their long term impact on productivity.
However, by removing the subsidies, consumer surplus will dramatically drop. Even though this may be offset by lower costs for the government, the government will have to anticipate a social backlash, especially by those that are at the lower end of the income spectrum. This however could be compensated for by provision of direct grants which would make the marginal benefit of the decisions taken by the government visible to the people and will alleviate some of the social pressure; hence increasing credibility in the government’s decision.
Nevertheless fuel subsidies are almost non-existent in the developed world and since India is on the way to development it should apply similar doctrines to developed countries to stimulate the development process. Economic theory claims that subsidies are actually a burden on the government and society. Even though subsidies decrease prices of consumer goods, the cost of placing it exceeds the benefits of higher consumer surplus. This excess burden on society does not actually maximize social welfare.
Subsidies lead to over dependence on government assistance and with its elimination people begin to experience higher costs and hardship, which could result in social upheaval. Yet in the long run, after consumers and producers adjust their behaviour to the supply shock, there will be less need for subsidies as the government will have used freed up fund to invest in the economy which will increase level of national income which makes higher priced goods more affordable. This however will require efficient and effective governing to reallocate resources efficiently.