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Why are petrol prices not decreasing?

Why are petrol prices not decreasing with the fall in global crude oil prices?

Why are petrol prices not decreasing with the fall in global crude oil prices?

A common refrain from most motorists is that petrol prices should have reduced considerably with the fall in global crude oil prices. Even though global prices have fallen from well above $100 per barrel to less than about $30 per barrel in the past 1-2 years, the price that we pay for a litre of petrol in India has not reduced proportionately. Are the oil PSUs fleecing the consumers and raking in super-normal profits by buying low and selling high? Not quite.

Firstly, it is extremely important to understand that petrol prices in India is highly regulated and controlled by the government. The individual firms (be it private or government) have little say in fixing petrol prices.

Also, it should be noted that global crude oil prices is just one side of the coin. All oil imports are priced in dollars, which makes the exchange rate of the rupee with the dollar extremely important. The rupee has been depreciating continuously against the dollar and this affects the price of petrol as well. Let’s assume that the price of 1 barrel of crude oil is $30. At an exchange rate of Rs.60/$, it would be Rs.1800, where as it would jump to Rs. 2100 per barrel, if the exchange rate jumps to Rs.70/$ (where we are inching towards).

Second, only about 40% of the price you pay is for the actual price of petrol. The rest of it is taxes. The cost of a basic litre of crude oil is around Rs.13.5. Then, of course, the crude oil has to be refined and there are various costs involved in this. At the first level, there is entry tax, refinery processing, margin and landing cost from refinery to the Oil Marketing Companies (OMC). Then, there are costs which the OMCs have to bear such as transportation, freight, landing to the dealers and finally, their own margin. All of this put together adds Rs11 to the price of oil, of which the OMC margins are less than Rs.2 per litre. The petrol pumps takes a commission of about Rs.2.25 per litre.

Then comes the first of the big taxes – the excise tax. The excise tax charged on one litre of petrol by the Union government is close to Rs.20 (which was hiked recently by the government). Thus, the dealer (the petrol pumps) pay about Rs. 45 for one litre of petrol . Then, there are a flurry of state taxes and cesses. Around 33% of what you pay for one litre of petrol goes towards state taxes, of which, state sales tax accounts for 25%, state entry taxes account for about 5%. All of this broadly falls under the state VAT. Additionally, there are other various cess that are levied both at the centre and the state. (Karnataka levied a monorail cess in the 1980s and though the project has been shelved in the early 1990s, the cess continues to this date).

Petrol Prices Breakup

One question that can always be asked is why does the government charge such a high rate of excise duty? The simple reason is to balance its fiscal books. Excise duty on oil is one of the major sources of revenue for the central government. When faced with a scenario of an impending fiscal deficit, the central government tends to raise excise duty. By a recent hike of excise duty by 75 paisa, the government hoped to raise Rs.17000 crores in revenue for the purpose of infrastructure. The government aslo used revenues from these taxes to cross-subsidize other fuel costs (diesel). Further, the PSU oil companies understand that they are in this for the long term. When prices were high, many oil companies witnessed significant losses and petrol prices were subsidised by the government. When oil prices fall, the government does not quickly pass the benefit to the consumer, instead it prefers to allow the oil companies to build a cash reserve for the next hike in prices.

Now, back to the question at hand. With the paying nearly 60% of the price towards taxes and nearly 35% towards operating costs, there is not much room to cut prices. The only way that the price that consumers pay for petrol can come down is when the government reduces the taxes it levies. For that, its budget has to be in a much better shape than what it is now. And for the budget to be in a better shape, it has to decrease its spending on the myriad of welfare schemes and subsidies: it can remove the LPG subsidy and decrease the price of petrol, but not many would favour that either.

Anupam Manur is a Policy Analyst at the Takshashila Institution and tweets @anupammanur

Note: Figures are approximate and keep changing with the change in oil prices, as taxes are a percentage of the price.

Tax rates and calculations derived from: Know how fuel cost is computed to Consumer.


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Distortionary Public Policy

Bad public policy creates severe distortions in the economy, can lead to macroeconomic imbalances, and often has large societal costs.

Badly designed public policy can cause a lot of harm. It can cause severe distortion in the economy, misalign incentives, and finally produce bad outcomes in the economy and society at large. Take one example of a large US federal scheme that is worsening the drought conditions in the West coast.

The US states of California and Arizona are facing one of the worst droughts in recent history. It has received sparse rainfall in the past four years, less than 34% of expected rainfall, and there is a severe water shortage in the desert land. With experts claiming that the drought like situation could last for a few more years to come, this has already been termed as a ‘megadrought’.

California Drought: Before and After

California Drought: Before and After

Exacerbating the natural crisis is the pattern of agricultural land use. The preference of most farmers in the region is to grow cotton, which is one of the thirstiest crops, in a desert landscape. Each acre of cotton planted here demands six times as much water as lettuce and sixty percent more than wheat. That precious liquid is pulled from a nearby federal reservoir, siphoned from beleaguered underground aquifers and pumped in from the Colorado River hundreds of miles away. Ironically, billions of dollars have been spent on building reservoirs, aqueducts, and power stations to push water from the Colorado river to the dry states of Arizona and California. Similarly in California, production of almonds, another exceedingly thirsty crop, is expanding and it now accounts for nearly 80% of global production. However, it also consumes more than 10% of the state’s annual agricultural water use – or more than what the entire population of Los Angeles and San Francisco use in a year.

The reason that farmers are growing water thirsty crops in the middle of the desert during a harsh drought like situation is basically misdirected government policy. A relict from the dust bowl era in the 1930s, the US Farm Bill, provides misdirected incentives to farmers to grow certain crops, though it may not be in the societal interest at large. No American law has more influence on what, where and when farmers decide to plant. And by extension, no federal policy has a greater ability to directly influence how water resources are consumed in the American West.

The Bill offers monetary incentives to farmers planting cotton seeds in the ground; it also provides heavily discounted loans, which they do not have to repay in case the crop fails. Further, the government provides insurance cover on the entire cotton crop, guaranteeing that the farmers will be financially protected even when natural disasters like drought prevents a good harvest. In total, farmers in Arizona and California have received $4.1 billion in cotton aid.

The subsidies are bad enough in creating a fiscal strain and in creating incentives that draw farmers away from growing other crops. Also, due to the implicit government guarantee on the crops, banks are more willing to lend to farmers growing cotton than any other crop. However, the bigger damage it does is in distorting water usage and providing incentives to use more water than would be used in an open market. The final push comes in the form of providing water all the way from the Colorado River, a distance of 230 miles, for a minimal price. The government is also considering building a billion dollar desalination plant to purify ocean water and feed the crops.

If farmers were charged for the water, as well as for the cost of transporting water (using generators to pump the water, cost of building the infrastructure, etc), no farmer would even consider planting a water intensive crop.

In their textbook, Tyler and Alex Tabarrok dwell on this subject:

Farmers use the subsidized water to transform desert into prime agricultural land. But turning a California desert into cropland makes about as much sense as building greenhouses in Alaska! America already has plenty of land on which cotton can be grown cheaply.  Spending billions of dollars to dam rivers and transport water hundreds of miles to grow a crop which can be grown more cheaply in Georgia is a waste of resources, a deadweight loss. The water used to grow California cotton, for example, has much higher value producing silicon chips in San Jose or as drinking water in Los Angeles than it does as irrigation water.

Closer to home, there are several governmental agricultural policies in India that have similarly changed the incentive structure for crop choice. The Minimum Support Price, the minimum price paid by the government to the farmers for their produce, has introduced severe economic distortions. Rice and wheat have a higher MSP than most other crops, which naturally tilt the preference of farmers towards them; rice is a fairly water intensive crop and despite this, it is grown in arid areas across India. Pulses, which do not get much support from the government, are not grown in adequate quantities. There is a chronic shortage of pulses on the Indian market, prices have risen and it has to be imported in large quantities.

As the example of Farm Bill and MSP show, bad public policy and unnecessary government intervention creates severe distortions in the economy, which leads to macroeconomic imbalances and often has large societal costs.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Constituent assembly debate on reservation

By Apoorva Tadepalli

The concept of reservation, which was discussed in great detail during the Constituent Assembly debates, is much older than the drafting of the Constitution. The Members of the Assembly, along with many of the minority groups that they represented, were wary of the implications of reserving seats in the Legislative Assembly, claiming that it would serve to exacerbate differences that people felt with one another and increase separatist tendencies. They also identified that promoting reservations, ironically, came with a certain degree of exclusion.

There was exclusion of religion. The motion originally did not apply to many Christian, Sikh or other non-Hindu groups. Lower or backward castes of different religions had to institutionalise themselves into the group “Scheduled Castes” just to be able to express that they had been oppressed and needed representation. There was exclusion of lower caste communities that were less populated than others and had less probability of representation. And finally, there was exclusion of poor people of upper castes.

With this, most Members of the Assembly expressed worry that reservation was not the ideal way of achieving true representation. Even Muslim and Sikh Members knew that it would create a series of sub-castes that would further worsen the relations between and within the existing communities, making it difficult to achieve adequate representation. Further, many believed that trusting the elected representatives, even if they were part of majority communities, was a part of democracy.

The Members of the Assembly also believed that a fundamental part of democracy was the changing nature of the public. This comes through in Vallabhai Patel’s certainty that social justice would be seen in democracy’s natural course, without the need for political intervention, which is apparent when he says, “What brought about the abolition of slavery? Was it safeguards granted to them by anyone? No, it was the awakened conscience of the various countries.” As with other social evils worldwide, he believed that caste discrimination would eventually become unacceptable in Indian society.

The Members talked about uplifting the backward classes. But the fact that identifying these people was a point of contention shows the ambiguity of the term. Mahavir Tyagi said, “The term Scheduled Castes is a fiction…there are some castes who are depressed, some castes who are poor, some who are untouchables…How is Dr Ambedkar a member of the Scheduled Castes? Is he illiterate? Is he an untouchable? Is he lacking in anything?…I do not believe in the minorities on community basis, but minorities must exist on economic basis.”

This identified the final goal of reservations, which was and is to provide equal opportunities and representation to everyone, irrespective of social status. As Brajeshwar Prasad said, the Scheduled Castes’ “downtrodden nature is not political, it is cultural and economic and educational.” Clearly this is an economic problem in our country, as shown by Tyagi’s further assertion: that it was not the scheduled castes that needed special provisions “but “cobblers, washermen, and similar classes,” along with farmers, who did not enjoy this very urban provision. Many identified it as an economic problem in our country, including Dr P S Deshmukh, who said, “there are millions of people in our country whose obstacles are in no way different from those of the Scheduled Castes; and I wish to leave room for such people.”

Reservations were finally agreed upon even by those who were uncomfortable with it, because it was initially only supposed to be in place for ten years, and because the reasons expressed for the need for them could not be disputed – it could not be denied that lower castes and minorities had faced appalling atrocities from other communities in their history, and needed justice. However, no distinction was made between social and economic backwardness in the drafting of the articles. It may have just been easier to distinguish the latter from the former because of the significant overlap. It is also important to note that the Poona Pact had already taken place by this point and that reservations in the Assembly had been acknowledged as preferable to separate electorates, which would have been even more dangerous for the notion of equality.

Interestingly, it was also brought up during the debates that the sense of justice with which Indians were judging caste discrimination, was a product of British rule, and that the myriad of communities and their relations had been reduced to the British-introduced majority-minority binary. This binary made the extent of discrimination all the more apparent.

The fact that reserving seats in the Legislature has not eradicated the social evil that is the caste system supports the contention that social evils and economic inequality cannot be solved with political changes. What the Members of the Assembly fundamentally wanted was to provide some form of equality. There are more appropriate ways to achieve the same goals as political representation without the use of political representation. This is particularly desirable in the current context, wherein placements in government enterprises are less valuable than they were fifty years ago. Identifying people on the basis of income level or standard of living, and providing them with education, land, employment or subsidies, as many contemporary programs do, offers more empowerment to individuals than does political representation. Providing backward castes with “functional capabilities”, as Amartya Sen defines them, brings about a more sustainable approach to real progress and equality.

Apoorva Tadepalli is an intern at the Takshashila Institution. 

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Errors of omission and commission — how VLSI relates to subsidies

Second choice problem involves making a choice between two solutions – both of which involve costs.

The fundamental concept behind any testing is to prevent a faulty product from reaching the end consumer. A well-designed test is the one that accurately identifies ALL types of defects in the product. Very often though, this is not possible as tests may not cover the exact range of defects that might actually exist. In that case, the suite of tests leads to the errors of commission or omissions. The interesting question, then is – which of the two errors is acceptable?

An illustration

This second problem can be explained using a fairly simple scenario from “Design-for-Testability” theory used in all integrated chip (IC) manufacturing companies. Consider a firm that makes the processor chips going into your laptops. Every single processor chip goes through a set of tests to identify if the chip is good or bad. Four scenarios result out of this exercise:

Errors of commission and omission

Errors of commission and omission

The two scenarios marked in green are the best-case scenarios. In the first of these, all the designed tests are unable to find any fault with the chip. At the same time, the chip itself does not show any defects after reaching the end consumers. When such awesomely functional chips reach your laptops, the chip making companies make profits.

In the second “green” scenario, the tests indicate that there is a problem with the chip. Further debugging (involves greater costs) concludes that this chip is actually manufactured erroneously. It is then the raison d’être of the tests to throw away these chips so that they do not reach the customers.

However, when tests are unable to identify any problem with the chip even though it is bad, we end up in the second choice problem 1 scenario or the “error of commission”. This is the scenario you encounter when your laptop crashes within a few days/weeks/years (within the guarantee period) after purchase. Obviously this makes the consumer lose trust in the product and dents the manufacturing firm’s image.

On the other hand, there is the second choice problem 2, where tests are designed so thoroughly that they start eliminating chips which are actually not dysfunctional. This is the error of omission. The cost involved with this error is that it leads to loss of revenue as many good chips are just thrown away based on faulty tests. It also lowers the confidence of the firm.

The above illustration shows the two errors that are commonly encountered in the chip manufacturing business. Which of them is tolerable is a function of the company’s image in the market, the end application of the product and the costs involved. For example, if the chip is being manufactured for use in mission-critical automobile systems like auto-braking or fuel injection, the preferable error is the error of omission as there’s a life and personal safety at stake. On the other hand, if the end application is a low-end mobile phone, the company might settle for a higher error of commission and avoid the extra costs of rejecting lots of chips.

Application – Subsidies

The above illustration can directly be applied to a subsidy case to explain the effect of identifying beneficiaries incorrectly. Using the framework above, we can visualise a subsidy program as shown in the figure below:

Subsidy conundrum

Subsidy conundrum

From the framework above, which would be your second choice? The first option would be to start with very few beneficiaries being fully aware that there will be a definite error of omission. The next step would be to work on reducing this error rate itself. The problem here will be that there might be some people who, even though needy are not attended to urgently.

Another option would be to start with a large number of beneficiaries being aware of the errors of commission. A subsequent step would be to try and reduce this error rate. The costs involved here are that the free-riders might sideline the really needy. Such schemes will also require huge sums of capital as they will start by serving a huge number of people. This is the path that most of Indian government’s subsidies follow. And schemes like Aadhaar will help in reducing this particular error.

If you were to design a subsidy scheme, which would be your second choice scenario?


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On Cash Transfers

Abhimanyu Sanghi

Introducing a sunset clause in all central government subsidies, and holding a large-scale two-year pilot program on direct cash transfers.

In the Financial Year 2012, the total central government subsidies accounted for INR 190,015 crore of government expenditure (approximately 2 percent of GDP). This is expenditure that is used for sustaining the country, and does not contribute to the development of the country. In addition, the amount borrowed for subsidies accrues interest, which is an additional amount that is taken away from the development of the country. Subsidies are not targeted, and therefore the middle class is a large unintended beneficiary of the subsidies. India’s current fiscal deficit at 5.9 percent does not allow us the leeway to continue with the high amount of non-targeted subsidies. Food and fuel subsidies account for 49 percent of total subsidies.

Therefore, my first proposal on subsidies is to introduce a sunset clause – a ten-year progressive decrease in subsidies to zero, that is, a reduction in subsidies of ten percentage points every year for the next ten years. This proposal is bound to face opposition. To offset this opposition and have a sustainable targeted safety net program in India, my second proposal is to hold a two-year large-scale pilot of direct cash transfers to the poor in multiple states.

Conditional cash transfers have been successful in poverty alleviation in countries in Latin America and Africa. What makes it challenging in India is the high population density and difficulty in tracking conditionality. On unconditional cash transfers, the sample data points are fewer in number and the available data is less convincing. However, both programs provide a more sustainable means of social welfare than untargeted subsidies.

Abhimanyu Sanghi is a Delhi-based investor and a classical liberal.

(The above piece was written by Abhimanyu in April 2012, as a student of The Takshashila Institution.)

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