Subject: Economics

What is Fiscal Capacity?

It’s simply ability to generate revenues. As majority of the revenue of governments around the world is through taxes (other from various fees/user charges/ dividends etc), Tax to GDP ratio is often taken as proxy for the fiscal capacity of a govt.

Survey argues that state capacity and taxes are crucial determinants of long run political and economic development. But Why?

Govt can only spend as much as it earns (plus some limited amount of borrowings). So fiscal capacity i.e tax to GDP ratio also determines it’s spending capacity.

Political development-If spending is about the entitlements of citizenship in a democracy, taxation is about the obligations of citizenship <rights and duties>. As more and more people come into the tax net via some form of direct taxation <in indirect taxation, people don’t feel like they are paying. Don’t we all generally think, only some 4% of India pays tax while every one who buys something pays some form of indirect tax>, they will more actively take part in nation building<their money is at stake>.

Economic development- Democracy is a contract between the state and its citizens. The state’s role is to create the conditions for prosperity for all by providing essential services <such as law and order, enforcing contracts, roads, transport, health, education etc, for instance without enforceable property rights markets can’t function> and protecting the less well-off via redistribution <subsidies etc, providing minimum standard of living and reducing inequality>

What is citizen’s role in this contract?

• The citizen’s part of the contract is to hold the state accountable when it fails to honour the contract <provide essential services and redistribute to reduce inequality>
• But a citizen’s stake in exercising accountability diminishes if he does not pay in a visible and direct way for the services the state commits to providing <esp essential services. He is not paying, what does he care if state does not provide>
• If a citizen does not pay he either becomes a free rider (using the service without paying) or exits (not using the service at all). Both reduce the accountability of the state.

For instance, not many taxpayers send their children to state run schools i.e exit from the service, thus reducing accountability which leads to further deterioration in the quality of schooling. They simply don’t have stakes in the system. That’s why some promote banning or reducing to the minimum the role of private sector in primary education. And it is for this reason that Allahbad High Court ordered public servants to compulsorily send their kids to Public school. Indian express link here <whether order was complied with or not, I have no idea, May be UP wale can help us>

Taxation is not just about financing public spending, it is the economic glue that binds citizens to the state in a necessary two way relationship.

Precocious Indian phenomenon of economic development lagging political development

In terms of democracy index, India is highly developed with periodic free and fair elections, a very noisy and vibrant democracy but in terms of economic development India lags far behind the OECD countries.

Difference in taxpaying <only 4% of voting age population paying direct tax> and voting <universal adult franchise with >60% voting> might explain the phenomenon in India of there being reasonably effective episodic accountability <regular elections with non performing govts being shown the door> as opposed to ongoing accountability <reflected in corruption, law and order problem>.

• For instance, there has not been a single famine in independent India <Amartya Sen’s famous theory that famine simply don’t occur in democracies as they can’t afford it. Govt will simply lose power after a famine> but malnutrition remains a major challenge <discussed in chapter 4, women and children>. <Reason is simple, malnutrition is not as dramatic as famine so doesn’t attract media attention and in India accountability is episodic not ongoing>.
• Or the Indian state can organize mega-events <commonwealth games, gigantic elections> but routine safety for women is not ensured.
• Or state responds effectively to floods and tsunamis but finds water and power metering more challenging <can not perform routine tasks which calls for ongoing accountability but performs heroically in dramatic events which remain in public memory and thus public enforces accountability at the time of election i.e periodic accountability>

So does India tax and spend less as liberals/ left leaning commentators (Amartya Sen and Dreaze argue)?

Learn these facts and analysis by heart and reproduce them in essay / general studies /interview.

• India taxes (16.6%) and spends (26.6%) less than OECD countries (34% and 43%) and less than its emerging market peers (21% and 31%)
• For it’s level of economic development (countries with similar per capita income), India does not  tax and spend less
• But controlling for both the level of economic and political development (democracy), India seems to tax less and spend less and this is most significant with respect to social expenditure (on health and education) 
• India spends on average about 3.4 percentage points less vis-à-vis comparable countries on health and education <that’s a huge amount, India spends about 3.3% of GDP on education and 1.3% on health i.e 4.6% total while comparable democracies at similar level of economic development spend 8% on health and education>

Democracies tax and spend more, in part because they face greater pressures to redistribute and India lags behind here.

India’s tax to GDP ratio has increased by about 10% over the past six decades from about 6% in 1950-51 to 16.6% in 2013-14 (very slow growth)

This analysis seems like indictment of the Indian development experience since India has been a democracy for nearly 70 years. But in most of the advanced democracies, the big increases in fiscal capacity have been in response to wars (world wars) or in response to extreme crises (Great Depression of the 1930s) which led to a sharp expansion of the welfare state and the need to finance it. Independent India has not experienced shocks of such large magnitudes that created pressures to enhance state capacity.

western democracies have also had a much longer period of political evolution <USA became republic in 1789 v.s Inda in 1950> allowing them to build state capacity <taxation and expenditure institutions>

Now that we have established India taxes and spends less compared to other democracies, should India start taxing and redistributing more?

• The history of Europe and the US suggests that typically, states first provide essential services (physical security, health, education, infrastructure, etc.) before they take on their redistribution role. Why?
• Because unless the middle class in society perceives that it derives some benefits from the state, it may be largely unwilling to finance redistribution
• In other words legitimacy to redistribute is earned through a demonstrated record of effectiveness in delivering essential services
• if the state’s role is predominantly redistribution, the middle class will seek to exit from the state, will avoid paying taxes and coccon themselves in walled communities <state’s redistribution role is perceived as illegitimate as they pay taxes but state can’t even provide them essential services such as infrastructure, law and order, decent primary education>

As we saw earlier, in India they already send their kids to private schools thus reducing the pressure on the state <ongoing accountabilty is absent, lower class i.e poor are unable to hold state accountable for they don’t even have enough time to invest in these matters>. They thus reduce accountability and legitimacy of state even further.

A state that prioritises or over-emphasises redistribution without providing basic public goods, risks unleashing this vicious spiral.

Point is that India should invest more in essential services, law and order, infrastructure, pollution, congestion, health, education to earn the legitimacy before taking on big re-distributive role.

Number of taxpayers in India (Too few or adequate)

In India roughly 5.5% of earning individuals or 4% of voting age population is in the tax net.

Controlling for level of economic development, India does not have too few taxpayers but again if we compare India with countries with similar level of income but those who are democracies (political development), India seems to have too few taxpayers. It should be 23% while India only has 4%.

Top personal income distribution (Inequality in India)

Inequality is generally measured by Gini coefficient (more on that in separate back 2 basics economics article some other day). Other measure is to compare income of top quintile (20%) with bottom quintile (20%). But of late, greater focus has been on income and wealth of top 1%, even more of top 0.1%.

We can see from the figure below that increasingly there is greater concentration of income among top 1% and even more so among top 0.1%. In 2012 top 0.1% held 5.1% of national income up from 3.6% in 1998.

Moving To A Better Equilibrium On Taxation And Spending

India has not fully translated its democratic vigour into commensurately strong fiscal capacity <As we saw India taxes and spends less among democracies>

Reform through inaction — Do not increase exemption threshold. As income rises, more people would automatically come into tax net.

Additional 1.65 crore people would have been in the tax system and tax-GDP would have increased by 0.32% by 2013 if govt had not raised exemption threshold from 1.50 lakh to 2 lakh.

But beyond this low hanging fruit of not increasing exemption limit, to increase fiscal capacity (tax more) state must also increase it’s legitimacy.

• Government’s spending priorities must include essential services that all citizens consume: public infrastructure, law and order, less pollution and congestion, etc.<so that middle class does not exit v/s redistribution>
• Reducing corruption must be a high priority not just because of its economic costs but also because it undermines legitimacy<if citizens think public resources i.e their hard earned money going for taxes is being wasted, they would try to avoid paying taxes>
• Subsidies to the well-off (1 lakh cr, disccused in chapter 6) need to be scaled back.
• Tax exemptions Raj which often amount to redistribution towards the richer private sector will also need to be phased out. <govt announced phasing down of exemption and reducing taxes but not much guidance from the budget>
• Reasonable taxation of the better-off, regardless of where they get their income from—industry, services, real estate, or agriculture–will also help build legitimacy<presently agri income is not taxed and we all know politicians show all their black income as income from agriculture and plantation>
• Property taxation needs to be developed. Property taxes are especially desirable because they are progressive <rich owns more property, will pay more>, buoyant and difficult to evade, since they are imposed on a non-mobile good, which can with today’s technologies, be relatively easily identified.

Higher property tax rates can be the foundation of local government’s finances, which can thereby provide local public goods and strengthen democratic accountability and more effective decentralization. It would also put sand in the wheels of property speculation. Smart cities require smart public finance and a sound property taxation regime is vital to India’s urban future.

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In the article on fiscal policy (click here to read) we discussed conceptual framework behind subsidies. A good subsidy will be on merit goods (for everyone) and should be well targeted (to poor). If the subsidy is not well targeted, it can result in inclusion error (well offs getting benefits) and exclusion error (poor not getting benefits). We also discussed govt should be most sensitive about exclusion errors as they affect poor directly <poor woman not getting kerosene won’t be able to light up her home>. In the JAM chapter of the economic survey, we read JAM trinity has the potential to weed out ghost beneficiaries and thus minimize inclusion error. In this chapter we shall discuss, subsidies which leak to relatively well off sections of society <above bottom 30% in income distribution>.

Performance of a subsidy programme can be judged on two criteria

1. Equity- i.e subsidizing those goods and services that account for a large share of expenditures of poorer households <for instance food account for >50% share of household budget of poor but very little share of rich, subsidisng food or not taxing it at all will be proportionately more beneficial for poor than rich>.> On the other hand subsidizing a good/ service such as airfares/ ATF (aviation turbine fuel) which is mostly consumed by rich will not benefit the poor and thus will not be equitable>
2. Effectiveness– depends on how well targeted the subsidy is .Suppose a good is consumed by poor such as kerosene but also used in other industries <adulterating diesel for instance>, not targeting well will result in leakage. Higher the amount used by non targeted goods, lesser the effectiveness of subsidy.

Based on these aspects, let’s discuss the bounties for the well off by the govt.

The government spends nearly 4.2% of GDP subsidising various commodities and services. this data is from last year’s economic survey. This considers all implicit as well as explicit subsidies at both central and state level such as subsidised passenger fares, subsidised electricity etc. This is not how subsidies are shown in the budget. As we discussed in the fiscal policy article, govt budgets about 10% of expenditure as subsidies i.e about 1.6% of GDP (only major explicit subsidies are considered there).

Case of small savings – These schemes were created to mobilise saving by encouraging “small earners” to save, and offered above market deposit rates in accessible locations like post offices.

We discussed that one distortion of small savings rate where rate is decided by govt is incomplete transmission of monetary policy (click here to read more about monetary policy and transmission) by banks but the issue here is are these schemes even benefiting small savers i.e. poor.

First things first, these are not just small. There are three types of schemes-

1.  “actually small” schemes- Eg. postal deposits, schemes for the elderly and women <poor people deposit small amount>
2. “notso-small” schemes- Eg. Public Provident Fund (PPF) <generally tax payers deposit upto 1.5 lakh rs limit i.e not so small amount and tax payers are at the top 5% of income distribution in India i.e not at all poor, not even middle but rich>
3. “not-small-atall” schemes– Eg. tax-free bonds issued by Public sector Companies <generally rich people deposit on avg 6 lakh per person i.e not small and poor don’t have 6 lakh rs to deposit>

Moral of the story so far is that we should not grudge first type of small schemes (post office savings schemes) for they are for the really needed i.e equity principle holds true.

But the benefit these schemes confer are much beyond the difference b/w rates of interest. Actual benefit is because of tax concessions and here they become even more iniquitous <poor even middle income groups are so poor, they don’t pay income tax. Only top 5% of population pay income tax>

How are savings taxed

Savings can be taxed at three stages

1. Contribution stage <when you deposit the amount>
2. Interest accrual <interesting earnings>
3. Withdrawal stage<when you take out principal and interest>

Income tax is inherently biased against savings; it leads to double taxation in so far both the savings and the earnings are taxed <taxation of deposits as well as interest earnings>. So to eliminate this bias and promote savings, tax incentives are given. So savings may not be taxed at all in what is known as EEE (exempt exempt exempt) i.e exempt from taxes at all three stages of taxation. Or they can be taxed at deposit and earning stage (TTT). Or tax at the time of withdrawal only (EET) or making earnings tax free (TET)

Note that, TTT or TET does not mean you are tax both at the time of deposit and withdrawal. Same income won’t be taxed twice. Hence taxation at the time of contribution is deemed to be taxed at the time of withdrawal.

Let’s understand this with example

Clearly EEE scheme (provident fund) and TET (tax free bonds) give higher returns. Survey calculates that implicit subsidy is about 6% (R 12,000 crore) on Provident fund (not so small savings) and 3.7% on tax-free bonds (not at all small saving and investment by largely rich).

This is based on data that only 5.8% of population earns more than 2 lakh rupees to come under income tax net. Even more starkly, major benefit is reaped by those in 30% tax bracket (income more than 10 lakh) who are among top .5% of population. IN developed countries, greater proportion of population pay taxes and thus these schemes benefit middle class as well.

So how should savings be taxed?

Case for concessional tax treatment of savings -tax concession for savings # higher post-tax return for the investor # positive substitution effect in favour of savings rather than current consumption. <higher savings # higher investment # good for economy esp for a capital starved economy like India>

But problems with the way scheme is designed in India

• It also creates a disincentive for savings (income effect), since the higher returns now require lower savings to meet the lifetime savings target. <If a person needed to save 1lakh rupee for his old age, he now will have to invest less to save equivalent amount>
• Tax incentives for savings, as designed in India, do not encourage net savings (contribution plus accumulation minus withdrawals) since withdrawals are also exempt from tax <no incentive not to withdraw full amount at the maturity>
• Tax incentives for savings distort the interest structure and choice of saving instruments. They just divert funds to specified savings instruments.
• They also increase the interest rate at which households are willing to lend funds to banks (i.e., make deposits) , thereby adversely affecting investment.<depositors won’t lend to banks at lower rates hence banks unable to pass rate cuts to consumers>
• regressive as they provide relatively higher tax benefits to investors in the higher tax bracket; in fact, the real “small savers”, who are largely outside the tax net, do not enjoy any form of tax subsidy on their savings.

Overall, tax incentives for savings, more so as designed in India, are economically inefficient, inequitable and do not serve the intended purpose. Hence, there is a strong case for review of the design of the tax incentives for savings schemes.

Economic survey suggests EET method of taxation for following reasons-

1. savings (contribution) reduce cash flow # the ‘ability’ to pay # taxation would create hardship # disincentive to save.<if I save 100k, consumption decreases by equivalent amount and over that govt taxes me, why would I save>. Taxation at the point of withdrawal (principal or earnings) occurs when the ability to pay is greater and therefore, justified on principles of taxation <after all, now my income is actually increasing>
2. TEE # taxation at the point of contribution # no immediate incentive to save # exemption of withdrawals # encourages withdrawal. Under EET # full deduction at the point of contribution and accumulation # incentive for savings # taxation at the point of withdrawal # disincentive for withdrawal.
3. TEE # withdrawals are exempt irrespective of the amount # no incentive for consumption smoothening <will withdraw the whole amount in one go>, Under EET # More you withdraw # come under higher income tax bracket # withdraw in staggered manner # consumption smoothening
4. no uncertainty about the potential tax liability
5. extremely simple in terms of compliance and administration
6. most developed countries and many developing countries are implementing the EET method of taxation of savings

Other bounties

Case of Gold-Top 20% consumes 80% of gold yet gold is taxed at rate of <2% compared to standard tax rate of 26% (centre + states)

Railways– Reserved class is hardly used by poor (bottom 30%), yet upto 34% of reserved class fare is subsidized.

LPG-91 % of subsidies are accounted for by the better-off as their share of consumption of LPG is 91% compared to 9% for poor (bottom 30%)

Electricity– Better off are subisdized about 32% of electricity bill while poor about 49%. But since 84% of electricity consumption is by better off, acutual subsidy amount will be pretty high.

ATF- There’s no point subsidizing ATF or taxing it less than diesel for no poor travels by air. Yey ATF tax is 20% compared to 55% for diesel and industry still keep clamoring for lower taxes on ATF.

Kerosene– 50% of PDS kerosene is consumed by better off.plus adulteration etc

If we add it all total subsidy to well off comes out to be more than 1lakh crore i.e 16b$ (.8% of GDP).rupees and we haven’t yet added corporate tax exemptions. Contrast this with expenditure on health, a merit good, social responsibility of govt, just 1.3% of GDP.

Addressing these interventions and rectifying some egregious anomalies may be good not only from a fiscal and welfare perspective <more govt budget for actual needy i.e poor>, but also from a political economy welfare perspective, lending credibility to other market-oriented reforms. <govt is pro rich barbs whenever any market oriented reforms are undertaken> It is also an opportunity foregone to help the truly deserving.

Criticism of this analysis (personal views)

• Higher taxes on gold hurts the jewelers. But most importantly promote black marketing, black money generation and corruption <people will buy gold at cheaper rate in Thailand and smuggle to India>
• People earning 2 lakh rupees or 5 lakh rupees can not be termed super rich by any stretch of imagination.5 lakh per annum for a family of 5 turns out to be kust 1lakh per capita i.e 8k rupees per person per month. Problem is with super rich(top .1%, not even 1%) and high amount og agri income not being taxed(issue addressed in next chapter)
• Political economy argument-Just as govt reduced interest rate on provident funds, barbs of pro rich, pro-corporate started being labelled on govt. Fact is that voice of vociferous minority(salaried middle class, super rich according to survey) is much more than silent minority(poor) as we discussed in chapter on exit problem.

This marathon article follows article on inflation and monetary policy. If you haven’t read them, read them first by clicking here. Inflation explained, monetary policy explained. This article is very important for exam and essential to understand subsequent economic survey cahpters.

In the last article we saw role of RBI in controlling money supply and interest rates and thus influencing growth- inflation dynamics. Government similarly affects this dynamics through its policy known as fiscal policy.

What is fiscal policy?

fiscal policy is the use of government revenue collection (mainly taxes but also non tax revenues such as divestment, loans) and expenditure (spending) to influence the economy.

Fiscal policy thus contains essentially two components-

Revenue Collection- (primarily taxation)- Govt collect taxes which are of two types

Source- Quora

1. Direct tax -A direct tax is generally a tax paid directly to the government by the person on whom it is imposed. Eg-. Income tax<your income, you pay tax>, corporation tax<Corporate profits, they directly pay tax>, wealth tax<your wealth, you directly pay tax>, capital gains tax<value of your asset increases, you pay tax>, securities transaction tax<you trade, you pay>

2. Indirect tax-An indirect tax is indirectly paid by consumers. Govt taxes goods and services # manufacturer/ seller/ service provider pay the taxes # he increases the prices to recover taxes # indirectly consumers end up paying taxes. In effect, tax is shifted from one taxpayer to another, by way of an increase in the price of the goods and services. Eg. Excise duty<union tax on manufacturing>, custom duty<union tax on imports and exports>, service tax<union tax on services>, sales tax or VAT<state level tax on sale of goods, that’s why price of petrol is different in all the states>, central sales tax<tax levied by union but given to states on interstate movement of goods>

Q. What Is Minimum Alternative Tax (MAT)? Is it a direct or indirect tax? What is the rationale for imposing it?

Indirect tax is generally considered regressive in nature as tax remains the same no matter how much you earn. So, for instance, if tax on diesel is 20%, a poor farmer would have to pay the same tax to run his tube-well as Ambani has to pay to drive his Audi. On the other hand, in direct taxes, less you earn, less you have ti pay<Brackets in income tax>.

Of course, governments try to make indirect tax structure a bit less regressive by taxing luxury products more. For instance, taxes on SUVs are higher than taxes of small cars. Also, govt by way of higher taxes try to shift consumption away from some product such as cigarette, tobacco etc.<sin tax>.

What would happen if govt increased taxes?

When government increases taxes, it basically leaves less money in the hands of people # less money # less consumer demand # apply demand supply principle # less demand for goods # prices fall # corporate will delay investment # job loss # slowdown in the economy

As we saw when RBI raises rates or sucks out liquidity through open market sales of government securities, it tightens money supply and reduces demand resulting in prices fall. It is said to be following dear or contractionary monetary policy.

Similarly when government raises taxes, it reduces consumption demand and it is known as contractionary fiscal policy. On the other hand when government slashes rates to stimulate consumption to kick start the economy, it is known as expansionary fiscal policy.

Expenditure (spending)- Government spend money which also provides demand to the economy. If government decides to spend more by borrowing, it increases aggregate demand and it is known as expansionary fiscal policy.

Basically contractionary policy- increase taxes, slash spending is followed when inflation is high to bring down demand and thus cool down prices and expansionary policies to pump prime the economy by creating the demand through decreased taxes and higher spending.

Estimates of spending and taxation are presented in budget which also mentions various deficits like fiscal deficit, revenue deficit, effective revenue deficit. Want to know more about them, click here

Plan v/s non plan expenditure

Plan expenditure– expenditure on schemes and projects covered by the five-year Plans (road construction, railway line construction etc.)

Non-plan expenditure: Ongoing expenditure by the government not covered by the Plans <routine expenditure to run the govt>. Eg. Interest payment, Subsidies, salaries, pension, defense expenditure etc.

Please note that bot plan and non plan expenditure includes revenue and capital expenditure. It’s not that the plan expenditure is equivalent to capital expenditure while non plan is revenue expenditure. To know the difference b/w revenue and capital expenditure, click here

Q. Plan v/s non plan classification of expenditure should be scrapped. Comment.

Budget is an important part of fiscal policy as revenue and expenditure statements are presented during the budget. Let’s understand in brief, where all the revenue comes from and where all the money goes.

We can clearly see, among non debt creating receipts (not borrowings), maximum earning is from corporate tax followed by income tax.

Always remember these facts on revenue and expenditure side by heart

• direct taxes> Indirect taxes
• Corporate tax>Income tax>Excise>Service tax>custom
• Non plan expenditure> Plan expenditure (more than double)
• Interest payment>>subsidies and defense  <subsidies and defense are almost equal. Every year including this year defense is budget higher amount but eventually, subsidies turn out to be higher during revised estimates>
• Food subsidies>> Fertilizer subsidies >> Fuel subsidies

When government reduces its fiscal deficit, it is known as fiscal consolidation. Learn everything about fiscal consolidation here

Clearly it can be achieved in two ways, reduce spending or increase taxes or combination of two. Here we discuss one component of spending known as subsidy in some detail. Everyday we read about subsidy rationalization, cutting or increasing subsidies and passionate arguments on both sides.

So, What is subsidy?

In a layman’s term, it can be understood as converse of a tax in that using taxation government takes money from consumers while subsidy in effect transfer money from government to consumers.

For instance, taxes on grain would increase their market price from say 10 rs a kg to 12 rs a kg, in effect taking 2 rs from you for every kg of grain you buy. On the other hand subsidy under PDS would reduce price of grain from 10 rs to say 2rs in effect transferring 8 rs to your pocket. In this way, they are converse of indirect taxes.

When government directly transfers money in your bank account without any condition i.e. unconditional direct benefit transfer, subsidy becomes converse of direct taxes.

In India government (central and state) subsidize a lot of things from food to fertilizer to kerosene and LPG etc. Tax concessions can also be considered as implicit subsidy. Subsidies increase government spending and thus puts pressure on government finances.

So what’s the rationale for subsidy?

Like indirect taxes, subsidies can alter relative prices and budget constraints and thereby affect decisions concerning production, consumption and allocation of resources.

So purpose of subsidies is two fold-

1. Increasing consumption of items government considers important such as health, education, nutritious food etc or renewable energy in modern times.
2. Redistributive effect i.e. to provide minimum level of protection to the poor <welfare function, tax the rich, distribute in poor>

For objective one to be fulfilled government should subsidize merit goods.

What are merit goods?

A good which would be under-consumed (and under-produced) in the free market economy

But why are they under-consumed?

They are associated with positive externality i.e. they also benefit public but since consumers and producers will take account of only private benefits, they are likely to consume less than desired. For instance, consider education, not only a person is educated and earns more <private benefit> but more productive individual would also benefit society in the form of higher taxes <societal benefit> 

For objective two (redistribution) to be achieved, subsidies should be well targeted i.e. reach the poor with minimal leakages. This requires proper targeting without which there would be inclusion errors (rich getting subsidy and exclusion errors (poor not getting subsidy). Exclusion errors are the worst since they direct affect the poor <kerosene meant for poor not reaching him, how will she light her house>

Subsidy rationalisation is this process of better targeting to weed out unintended beneficiaries as well as phasing out subsidies on non merit goods.

So, what are the adverse consequences of bad subsidies (non merit, not well targeted)?

1. Fiscal effects– directly increase fiscal deficit and thus total government debt <10% of total govt spending is for subsidies> <While golden rule of borrowing is, borrow to invest >
2. Allocative effects– result in inefficient resource allocation <producers will produce more of subsidized good even when not required>
3. perverse distributional effects endowing greater benefits on the better off people <subsidized diesel being used to run SUVs>
4. Shortages and black marketing <subsidized urea being diverted to non agricultural uses, scarcity leading to black marketing harms the poorest farmers the most>
5. Tendency to self-perpetuate. They create vested interests and acquire political hues <Exit problem discussed in economic survey chapter two, click here to read>

For instance, High MSP for wheat and rice and subsidized water and electricity illustrates all such effects, an example of bad bad subsidy.

• Perverse distributional effects– better off farmers of Punjab and Haryana getting benefited<no procurement from eastern belt, poor farmers of Bihar, Jharkhand not getting benefits>
• Fiscal effects– finances of central as well as state govt getting stretched, discoms in debt <high deficit # high debt # high interest cost # high deficit = vicious circle>
• Allocative effects– pulses and oilseeds are not grown resulting in shortages <procurment only of grains, no incentive to produce pulses>
• environmental effect– water table going down, soil getting salty and arid
• Health effect– Groundwater pollution due to high fertilizer use, burning of husks resulting in air pollution

How subsidies distort the market (in a comical way) is best understood by Railway subsidies <Example from last year’s economic survey> 

• Govt subsidizes passenger fares resulting  in losses. Railways cannot generate sufficient internal resources to finance capacity expansion investments;Result-Trains always run late, very slow services, whole economy becomes unproductive
• Of course the passenger fare is cross subsidized by high freight tariffs . It results in diversion of freight traffic to road transport which is costlier. Result- not only financial and efficiency costs but also acute costs associated with emissions, traffic congestion, and road traffic accident (RTA) <And we all know passengers on two wheeler or those walking die the most in the RTA i.e. poorer segments of society>
• High freight cost raises the cost of manufactured goods that all households, including the poor, consume. <subsidized passenger fare but costly goods, no one knows who gains who losses but these distortions decreases the overall efficiency and thus whole economy suffers.>

What’s the solution?

End perverse subsidies while investing in state capacity to deliver basic goods and merit goods such as health, education, skills etc. Incentivize research and development, environment friendly technologies etc. Borrow only to invest. Adhere to FRBM targets of zero revenue deficit.

• Direct Benefit Transfer (DBT) using  JAM number trinity, read the economic survey chapter here
• JanDhan i.e. Bank accounts, Adhar i.e biometric identification and mobile i.e. mobile banking
• It will result in direct transfer of money to bank account of beneficiaries and cut down leakages as intermediaries are removed.
• Biometric authentication will remove ghost accounts i.e same person getting subsidy twice from two different names.
• Mobile banking will give access to bank accounts for easy deposit and withdrawal

But problem of identification of beneficiaries still remains and it requires better and more robust data collection, publishing names of beneficiaries at gram panchayat level for people to raise objections, jan sunwai (public hearing), social audits and such transparency mechanisms

Pitfalls of DBT

1. Where transfers are unconditional, people may just spend money on desi liquor <objective of changing consumption pattern defeated>. For instance, if govt transferred 6000 rs to every pregnant women it’s possible that money will go in the bank account of husband and instead of better nutrition for pregnant lady, he will buy desi liquor.

solution- transfer money in the hand of oldest woman and provide her information so that she can take informed decision in the best interest of family

2. Conditional transfers might give rise to its own kind of corruption. For instance if money is transferred for check up by a nurse, she might demand bribe for certifying you indeed showed up for check up.
3. Private market may not exists for people to buy goods and services from the market. For instance, if PDS shops are closed, where would people buy ration from?
4. Banking infrastructure poor <as we saw in the JAM article, last mile banking access is jamming the JAM>
5. Real value of subsidy amount will be eroded with inflation. solution- link subsidy with CPI inflation. But generally food inflation higher than CPI, then what?
6. There is concern that biometric fingerprinting may not work for rural manual labourers.

• what happens to corporate tax breaks and subsidies going to not so poor?Government decision to phase out corporate tax exemption while simultaneously bringing down tax rates down to 25% level is welcome in this regard.
• It will remove major distortions and end favours to select few corporate groups

Government should rationalize subsidies so they are targeted better and use money thus made available to invest in physical and social infrastructure.In this way by rationalizing subsidies government can bring down fiscal deficit and overall debt level. Bringing fiscal deficit under control, reduces aggregate demand, this cooling down prices.

Now it’s time to solve some previous year IAS prelims questions 

#1. The sales tax you pay while purchasing a toothpaste is a

1. tax imposed by the Central Government.
2. tax imposed by the Central Government but collected by the State Government
3. tax imposed by the State Government but collected by the Central Government
4. tax imposed and collected by the State Government

#2.To obtain full benefits of demographic dividend, what should India do?

1. Promoting skill development
2. Introducing more social security schemes
3. Reducing infant mortality rate
4. Privatization of higher education

#3. In India, deficit financing is used for raising resources for

1. economic development
2. redemption of public debt
3. adjusting the balance of payments
4. reducing the foreign debt

#4. There has been a persistent deficit budget year after year. Which of the following actions can be taken by the government to reduce the deficit?

1. Reducing revenue expenditure
2. Introducing new welfare schemes
3. Rationalizing subsidies
4. Expanding industries

Select the correct answer using the code given below:

(a) 1 and 3 only
(b) 2 and 3 only
(c) 1 only
(d) 1, 2, 3 and 4

#5. With reference to Union Budget, which of the following, is/are covered under Non-Plan Expenditure?

1. Defense -expenditure
2. Interest payments
3. Salaries and pensions
4. Subsidies

Select the correct answer using the code given below.

1. 1 only
2. 2 and 3 only
3. 1, 2, 3 and 4
4. None

#6. Which one of the following is not a feature of “Value Added Tax”? (2011)

• (a.) It is a multi-point destination-based system of taxation
• (b.) It is a tax levied on value addition at each stage of transaction in the production-distribution chain
• (c.) It is a tax on the final consumption of goods or services and must ultimately be borne by the consumer
• (d.) It is basically a subject of the Central Government and the State Governments are only a facilitator for its successful implementation

#7. Under which of the following circumstances may ‘capital gains’ arise? (2012)

1. When there is an increase in the sales of a product
2. When there is a. natural increase in the value of the property owned
3. When you purchase a painting and there is a growth in its value due to increase in its popularity

Select the correct answer using the codes given below :

• (a) 1 only
• (b) 2 and 3 only
• (c) 2 only
• (d) 1, 2 and 3

#8. Consider the following actions by the Government:

• 1. Cutting the tax rates
• 2. Increasing the government spending
• 3. Abolishing the subsidies

In the context of economic recession, which of the above actions can be considered a part of the “fiscal stimulus” package?

A. 1 and 2 only
B. 2 only
C. 1 and 3 only
D. 1, 2 and 3

#9..Consider the following statements:

In India, taxes on transactions in Stock Exchanges and Futures Markets are

• 1. Levied by the Union
• 2. Collected by the State .

Which of the statements given above is/are correct?

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

Answers 1-d,2-a,3-a,4-a,5-c,6-d,7-b,8-a,9-a.

To read more conceptual articles related to economy click

Economics Concepts Simpified

If you haven’t read first four chapters, read them here first,  Chapter two, Chapter three, chapter four

Despite the high economic growth during the last two decades, India has not been able to improve it’s maternal and child health indicators at the desired pace. We failed to achieve health goals related to Millennium Development Goals(MDGs) and our maternal and infant mortality remains unacceptably high.

India is in the middle of a demographic dividend which is going to last till about 2035-2040 (25 more years or one more generation) and it’s imperative that we invest in human capital to reap the fruits of demographic dividend. This will raise our long run economic growth potential.<What is demographic dividend? How does it help raise long run growth potential? Answer in the comments below.>

In this context, economic survey argues that given fiscal constraint <we can only spend as much as we tax plus some borrowing, never behave like arm chair pundits asking to raise budgetary allocation for everything without raising any taxes or train fares or bus fares> and state’s limited capacity to deliver public services <we know how state i.e. govts mess up almost every sector they get into, just see the performance of public schools i.e. state should not take tasks beyond it’s capacity; first improve capacity and then take additional tasks; just passing RTE or establishing 5 more AIIMS or IITs is not enough>, state should invest in relatively low cost maternal and early life health and nutrition programmes.

What’s the rationale behind investing in mother and child?

Intrinsic reasons– it improves quality of life directly and expands possibilities for the individual <if someone is not born healthy, chances are he would be unhealthy in later life as well>

Narrow economic logic

1. Research has shown that countries with better maternal and infant health “at takeoff” grew faster over the subsequent 20 years. <takeoff stages is similar to takeoff of an airplane, slow growing economy suddenly starts to grow very fast. For instance, China post economic reforms in 1979>
2. Tomorrow’s worker is today’s child or foetus and  events which occur while a child is in the womb i.e inside pregnant mother or very young (<2 yrs) affect cognitive development and health status even in adulthood i.e. if today’s child is weak, chances are tomorrow’s worker would be less productive.

Why does health of new born affects outcome much beyond the childhood?

1. the most rapid period of physical and cognitive development in a person’s life occurs in the womb <rapid development phases are most susceptible to environmental insults>
2. Dynamic complementarities in human capital accumulation- it simply means one human capital for instance health would affect accumulation of other human capital for instance education and training/skill in a dynamic way and vice versa. For instance healthy mother # healthy baby # learns better <cognitive development better in the womb as mother is healthy> and stays on in school longer. Or consider # unhealthy mother # weak baby # learns less and stays in schools for shorter period # less skilled and competent 

• research has shown that low birth-weight children benefit less from early-life cognitive stimulus programs i.e. early we intervene the better i.e. investment in mother and fetus. very young children
• success of subsequent interventions—schooling and training—are influenced by early-life development
• programs targeting younger children also appear relatively cheap in comparison to investments made in older children. For instance, iodine supplementation is way more cheaper compared to improving teacher quality or re-designing institutions to raise school accountability <good for fiscally constrained govt.>, also requires less service delivery capacity from the state, for instance, improving teacher quality would require teacher training, monitoring that they actually show up and teach in schools <investing in mother and child good for capacity constrained govt.>

The Dismal State of (Child’s) Play in India

Height is a good proxy for early life conditions and height is determined by early life environment and net nutrition.

“net nutrition” is defined as the sum total of (i) the nutrition available from the mother in the womb and during breastfeeding, (ii) the quantity and quality of the food that complements breast milk from 6-24 months, and (iii) energy losses due to disease and infection, and poor absorption of nutrients. <part 3 is an important cause of malnutrition in India due to open defecation and subsequent infections resulting in reduced absorption and increased losses in feces as well as due to high metabolism during infections>

Quick statistics

1. 48% of under 5 children are stunted (low height) compared to 39% in Sub Saharan Africa
2. 43% are underweight compared to 20% in Sub Saharan Africa
3. 28% are born low birth weight compared to 13% in Sub Saharan Africa

This data is taken from Amartya Sen’s book An Uncertain Glory which took data from UNICEF(2012). This condition of poor nutrition indicators comapred to much poorer and war torn Sub Saharan Africa is known as South Asian Enigma or The Indian Paradox and the low status of women is cited as one of the explanation.

3 quick points about height for age in India

1. there has been improvement over time in both urban and rural India
2. there is a persistent rural-urban height gap which has not closed over the past decade
3. despite the progress made, India remains a negative outlier—our children are on avg shorter than healthy children

Consequences-height-cognitive development gradient

Greater the height, greater the cognitive development (of course corrected for genetic potential for height not that because Chinese are short they are less smart then tall Caribbeans)

• taller Indian children are considerably better readers than shorter ones (height proxy for nutrition which affects cognitive development)
• absolute reading ability has not increased over time i.e we have not made much progress in addressing the nutrition and education challenge

Clearly much more needs to be done to improve the nutrition situation in India.

The Dismal State of Maternal Health

As we have already discussed first 1000 days of life (nine month in womb plus 2 years) are most critical for a child’s development. They depend critically on maternal health (esp 9 months in the womb)

70% of infant mortality (children who die before reaching their 1st birthday) is due to neonatal mortality(dying before 1 month). A leading cause of this is low birth weight which is clearly due to poor maternal health and nutrition.

Consider this data-

1. 42.2% of Indian women are underweight at the beginning of pregnancy
2. 50% of pregnant ladies are anemic(low hemoglobin in blood) <data from An Uncertain Glory>
3. Women from richer households in India start pregnancy heavier,suggesting that resources are at least part of the reason for low pre-pregnancy weight <poor #less to spend on nutritious food #low pre pregnancy weight>

No surprises then that women in India gain only about 7 kgs during pregnancy, substantially less than the 12.5- 18 kg gain that the WHO recommends for underweight women.

Very very important sociological insights

Use these observations in paper 1 (society) and essay. They will certainly add value to your answers.

1. reason for poor maternal health is that social norms accord young women low status in joint households. <When compared across the same ages, till about age 35, fraction of underweight women exceeds that of men by at least 5 percentage points. > within-household nutritional differentials are stark
2. lower status of younger daughter-inlaws in families. <children of younger brothers in joint family households are significantly more likely to be born underweight than children of their older brother> Chacha’s children more likely to be born low birth weight than Tau’s<Tijori ki Key Badi bahu ke haath mein>
3. Indian firstborn sons are found to have a height advantage over African firstborn sons, and the height disadvantage appears first in second-born children, increasing for subsequent births<preference for healthy male heir>

Improving Maternal Health in India

Clearly much more needs to be done to improve maternal health.

Govt response-. The National Food Security Act of 2013 legislated a universal cash entitlement for pregnant women of at least 6,000 rupees.

But it will only be successful if families convert these payments into more, higher-quality food and more rest for pregnant women and to make sure it happens, the cash transfer could be paired with education about how much weight a woman should gain during pregnancy and why weight gain during pregnancy is important. <cash transfer plus health education>

You can follow the whole women empowerment story, click here

Universal v/s conditional cash transfers

Should cash transfer be universal i.e given to every pregnant women regardless of what she does with that money or conditional on women performing certain tasks such as visit hospital regularly, getting delivered in hospital, vaccinating her child etc as in Indira Gandhi Matritva Sahiyog Yojana (IGMSY)?

Conditional cash transfer seems better but it entails high administrative costs, delays and often lead to significant exclusion. Hence survey suggests the cash transfer should be given in a single, lump-sum payment early in pregnancy to avoid delays, reduce administrative costs, and ensure that it is possible for the household to spend the money on better food during pregnancy.

Case for going universal and problems with conditional cash transfer

With careful design and significant investment of state capacity, maternal health could be significantly improved during pregnancy.

The problem of open defecation

Facts-open defecation in India is much more common than in even much poorer countries <61% in rural India v/s 37 % Nepal, 32% rural Sub Saharan Africa, just 1.8% B’Desh>

Only lack of toilets or income constraints is not the reason, but there are sociological reasons

Fact- many people in rural India who live in households that contain working latrines that are in use by other household members nevertheless defecate in the open.

Research suggests that rural Indian households reject the types of latrines promoted by the WHO and the Indian government partly because their pits needed to be emptied every few years and empty the latrine pit is associated with the strong notion of purity and pollution <history of untouchability- work of disposing of human faeces is associated with severe forms of social exclusion and oppression>

Consequences- disease, diarrhoea, environmental enteropathy (reduced absorption of food) resulting in less amount of net nutrition available to kids as we discussed above.

Building toilets and ensuring people defecate in the open is an example of public good as even those who don’t defecate in the open get sick due to germs from people who defecate in the open.

Addressing open defecation

Govt. response- swatch Bharat Abhiyan

• In the last year alone, the government built over 80 lakh toilets
• UN’s Sustainable Development Goals commit to ending open defecation worldwide by 2030

Historically, open defecation in India has declined by about 1 % per year  <about 50 years before India becomes open defecation free>. We need to more than triple the rate of reduction to achieve SDG. For that, it is important to understand barriers to toilet adoption in rural India and promote latrine use <as we just learnt, it;s much of a sociological, behavioral problem>

Influencing social norms to make investment yield better return

A big challenge is deeply entrenched norms and facilitating behavioural change. One can build clinics in villages or transfer money to pregnant mothers or build latrines, but how does one bring out the right usage of all this physical capital ?

Govt has a progressive role to play in changing norms, and thus the importance of high pitch campaigns such as Swatch Bharat Abhiyans.

The government has recognised the importance of influencing social norms in a wide variety of sectors—

• persuading the rich to give up subsidies they do not need (give up lpg subsidy campaign)
• reducing social prejudices against girls (selfie with daughter)
• educating people about the health externalities of defecating in the open (swatch bharat)
• and encouraging citizens to keep public spaces clean (swatch Bharat)

Way forward-

• Invest more resources in understanding the behavioral patterns and how to change them
• Create a Nudge unit within government for behavior change communication as other countries have done
  

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You might want to read- Blog from CD published on The Better India

7 Rights Every Pregnant Woman in India Should Know About (govt schemes for pregnant women in short, imp for exam)

Open all the hyperlinks. Learn, understand and revise

Ask all your doubts in the comment section below or in doubts clearing forum . All your suggestions, criticism and feedback are most welcome.

If you like what you read, show your support to Civilsdaily and give us a hi 5 at the Android Play – Click here.

If you haven’t read first three chapters, read them here first,  Chapter two, Chapter three

India lives in villages and agriculture is the soul of Indian economy- Mahatma Gandhi

“Most of the world’s poor people earn their living from agriculture, so if we knew the economics of agriculture, we would know much of the economics of being poor.”- Theodore Schultz, Nobel laureate

As per NSS data avg annual income of the median farmer net of production costs from cultivation is less than Rs 20,000 (avg per cpaita income at current prices is about 98000 per annum in India)

Post independence agricultural success

• Chronic food shortages of 1960s (recall PL 480 programme) have given way to  grain self-sufficiency (not nutrition self sufficiency) despite a two-and-a-half fold increase in population.
• In 1966-67, Indian wheat and milk production were just about 1/3 of US output.  Contrast it with recent figures with wheat output being 60% higher than America’s, while milk output being 50% higher. (Result of green and white revolution)

This seems like a remarkable success. Then, what’s the problem with Indian agriculture?

• Indian agriculture has become cereal-centric (wheat and rice production to the neglect of pulses and oil seed production even though demand for protein based items is rising)
• It is regionally biased (Punjab, Haryana, western UP cornering all agri subsidies) and input-intensive, consuming generous amounts of land, water, and fertiliser
• Input intensive cultivation means there is sharp decline in cultivable land available per capita as also much lower levels of water per capita
• Challenge of climate change – erratic monsoon, more frequent flood and droughts
• Challenge of income- As we mentioned above avg income of farmer from agriculture is just 20000 per annum.

Let’s discuss some major issues with agriculture

1. Productivity/ Yield-  low productivity esp. in pulses is the central challenge facing Indian agriculture.

Consider the case of wheat and rice-

As already stated, Indian agriculture has become cereal centric and input intensive and these two crops are grown on most fertile tracts with irrigation facilities and corner bulk of agri support available to all crops across country. Yet, if we compare average yield of wheat and rice in India with China, we find that

1. avg yields of wheat is 39% below China and in case of rice 46% below that of China’s.
2. In wheat save for Punjab and Haryana, most states have yield lower than that of B’desh
3. In paddy even Punjab trails behind yield level of China while other states trail behind even B’desh.

Now if we compare productivity in pulses of which India is topmost producer, consumer as well as importer, yield gaps are even more stark.

1. On an avg, countries like Brazil, Nigeria, and Myanmar have higher yields
2. even the key pulse producing state of M.P. has 60% yield of China’s

Take home message from above analysis-

• Yield gap varies among states in India and we could make rapid gains in productivity through convergence within India
• For instance, in pulses, if all states were to attain even Bihar’s level of productivity, pulses production would increase by an estimated 41% on aggregate and we would be self sufficient in pulses

Why is pulses productivity so low (land related reasons)

• Most of the land dedicated to growing pulses in each state is unirrigated
• National output of pulses comes predominantly from un-irrigated land

Issue of Intensive use of water (problem of Indian agriculture becoming highly input intensive)

• Although water is one of India’s most scarce natural resources, We use 2 to 4 times more water to produce a unit of major food crop than does China and Brazil.
• We have invested in flood irrigation method (canal and tube wells) which is highly inefficient way of using water
• Also despite being water scarce, we are virtually exporting water by exporting water guzzling crops such as paddy, sugarcane, cotton also meat (not exactly crop)
• India now exports about 1 per cent of total available water every year (demand of 13m people)

Reason for inefficient use of water-subsidies on power and water for agriculture.

Result– water tables are declining at a rate of 0.3 meters per year

Solution-  shift to sprinkler and drip irrigation and rainwater harvesting.

• Leverage MGNREGA labour to build rainwater harvesting structures.
• accord “infrastructure lending” status to these new technologies (infra lending status decreases cost of borrowing to invest in these technologies)

Govt. response– Convergence of various schemes under PM krishi Sinchai Yojana which will help in convergence of investments in irrigation, from water source to distribution and end-use i.e. at individual farm level.

What is drip irrigation?

• A type of micro irrigation method in which perforated pipes are placed either above or slightly below ground and drip water on the roots and stems of plants, directing water more precisely to crops that need it
• It reduces consumption of fertiliser (through fertigation ) and water lost to evaporation, and higher yields than traditional flood irrigation <Fertigation is the process of introducing fertiliser directly into the crop’s irrigation system.>

Problem in adoption of drip irrigation- high initial cost of purchase and the skill required for maintenance.

Solution- the increase in yields and reduction in costs of power and fertiliser use can help farmers recover the fixed cost quickly. Hence, provision for credit to farmers to adopt this technology.

But there are teething troubles in agri finance as mentioned in last year’s economic survey box-

Problem of agri finance-

1. 40% of agri finance still by informal sector
2. 26% by usurious moneylenders
3. Share of long-term finance i.e. capital loans in overall credit going down over the years (70% in 1991 to 40% in 2011)
4. Share of small loans decreasing (less than 2lakh rupee loan from 78% of total in 2000 to 48 % in 2011 and 10 lakh and above from 8% in 2000 to 28%in 2011) March rush (jan to march quarter) in loan disbursal i.e. loan in lean season to comply with PSL
5. More and more agri loans going to urban and metropolitan areas

Implication of all this is that lending to agriculture is grossly misallocated # largely to ;arge farmers # not being used for capital formation # worst of all may not even be going into agriculture.

Issue of Minimum support Price (MSP) and Procurement being cereal centric and regionally biased

• while the government announces MSP for 23 crops, effective MSP-linked procurement occurs mainly for wheat, rice and cotton and indirectly for sugarcane via sugar mills
• Even in these crops majority of procurement is from Punjab, Haryana, Western UP.
• Poor farmers aof Rajasthan and Jharkhand are not even aware of any such MSP policy

Result– Regional disparity, excess stock of wheat and pulses and import and volatility in prices of pulses.

Solution-reorienting agriculture price policies, such that MSPs are matched by public procurement efforts towards crops that better reflect the country’s natural resource scarcities i.e. provide higher MSP for those crops which we import such as pulses and oil seeds and at the same time procure thise crops so that MSP policy is effective on the ground.

One way we discussed in chapter two was to not only taking economic but social and environmental costs and benefit into account while deciding MSP. Copy pasting from chapter two

• Eg. Costs of producing cereals in Punjab and Haryana; declining water table, soil quality degradation, post harvest burning of stalks causing pollution, rich farmers getting benefits
• v/s benefits from pulses; nitrogen fixation, lower import dependency etc.

For cereals a system of Price Deficiency payment can be instituted

Under this system if the price in an APMC mandi fell below the MSP then the farmer would be entitled to a maximum of, say, 50% of the difference between the MSP and the market price. This subsidy could be paid to the farmer via Direct Benefits Transfer (DBT)

For eg. If say MSP for wheat is 100 rs per kg. In present scenario, govt would procure it at 100 no matter if market demand is very low and prices some 10 rs per kg. Farmer has no incentive to switch to other crops to reflect market demand.

But in price deficiency payment, he will receive only 10 + (1/2*100-10) = 10 + 45 = 55 rs. It protects farmers while signalling him to produce crops reflecting market demand.

Issue of Agri Research and extension 

Agricultural extension is the application of scientific research and new knowledge to agricultural practices through farmer education. Basically educating farmers about the latest technologies being developed in the labs i.e. lab to land linkage.

While Indian Council of Agricultural Research (ICAR) with agriculture research universities played a key role in the Green revolution. Of late agriculture research has been plagued by severe under investment and neglect.

Three key weaknesses

1. Agri education is weak in states due to (i) resource crunch, (ii) difficulty in attracting talented faculty, (iii) limited linkages and collaborations with international counterparts, (iv) weakening of the lab-to-land connect; and, (v) lack of innovation
2. Low investment in public agricultural research in India. As share of agriculture GDP, it is even less than that of Bangladesh and Indonesia
3. Majority (63.5 per cent) of scientists have low to very low level of productivity

Solution

• There is need of instituting performance indicators in universities.
• Improve investment as a proportion of agri GDP
• securing participation from the private sector
• instituting a system in which the winner is offered a proportionately large enough award for innovating desirable agricultural traits (such as improving pules productivity considerably) but the intellectual property rights of the innovation are transferred to the government
• Leverage mobile phones to provide timely information to farmers
• Leverage the potential of drones (UAVs) to provide crucial information on crop health, irrigation problems, soil variation and even pest and fungal infestations that are not apparent at eye level to farmers
• Improve regulatory process to address concerns against GM crops while adapting high yielding technologies

Agriculture market segmentation

Last year’s economic survey mentions, effectively, India has not one, not 29 but thousands of agricultural markets.

Why are so many markets bad?

Whole capitalistic economy is dependent on trade, competition and specialisation and so many markets prevent that thus reduces overall welfare because it prevents gains through competition, efficient resource allocation, specialization in sub sectors (everyone has to produce everything as they can’t trade with others resulting in jack of all trades master of none) and fewer intermediaries. 

• If there were one common market, prices would be same from Kashmir to Kanyakumari and Dwarka to Puri (don’t add transport and storage cost please).
• In USA which has a common market, maximum price variation is in case of peanuts with highest prices being 1.75 times that of lowest prices. Remarkably it is lower than India’s minimum price variation crop Tur dal.
• It creates particular problem for perishables such as fruits, vegetables, onions, hence sudden and sharp spike in prices in one area while being sold at throwaway prices in some other area

Solution-

• Pass GST bill
• Create common national agriculture market
• Create better physical infrastructure
• Improved price dissemination campaign
• Remove laws that force farmers to sell to local monopolies i.e APMC act

What you have to read for yourself

1. All the figures which are basically curves
2. Open all the hyperlinks. Learn, understand and revise
3. Read chapter eight A National Market for Agricultural Commodities- Some Issues and the Way Forward  from last year’s economic survey to understand concepts behind need for common agri market

Ask all your doubts in the comment section below or in doubts clearing forum . All your suggestions, criticism and feedback are most welcome.

If you like what you read, show your support to Civilsdaily and give us a hi 5 at the Android Play – Click here.

If you haven’t read chapter one, read that here first

We follow the standard pattern delineated in chapter one i.e. ‘quotable quotes’, statistics, major themes and recommended reading. Click on the hyperlinks in green to read and revise the topic hyperlinked.

Let’s get started

• A market economy requires unrestricted entry of new firms, new ideas, and new technologies so that the forces of competition can guide capital and labour resources to their most productive and dynamic uses
• But it also requires exit so that resources are forced or enticed away from inefficient and unsustainable uses
• Joseph Schumpeter expounded the concept of “creative destruction,” the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating new ones”

Structural impediments to India’s progress-

Problems of entry i.e. “licence-quota-permit Raj”

It has been largely taken care of by-

• liberalization(delicensing, end of permit quota system) , privatization (Divestment and end of public sector monopoly), Globalization (FDI and reduced tariff) reforms of 1991
• New initiative of across the board FDI liberalization and Start up-Stand up programme aim to further liberalize the entry.

But exit (chakrvyuah) remains the major challenge-

What is this problem of exit and what’s it’s magnitude?

• Inefficient and unsustainable firms are not allowed to wind down their operations and exit from the market
• In a normal economy, old firms would be the ones that were efficient, only then could they survive for that long and hence should be much bigger in size than new firms
• But in India avg 40 year old firm is just 1.5 times larger than a new firm (8 times in US
• Worst part is that a decade back they were 2.5 times larger i.e. inefficient firms are not allowed to exit and they remain small

What are the costs of impeded exit?

#1. Fiscal cost

• Of course, inefficient firms are supported by explicit (bailouts) or implicit (free power, reduced tariff, interest subvention etc) government subsidies
• High subsidies # high borrowings # high fiscal deficit # high debt # high interest cost.
• Add to this the tax revenue forgone, if efficient firms were allowed to take their place i.e. Double whammy of low tax and high subsidies

#2. Economic cost-

• Market economy is supposed to allocate resources/ factors of production (capital and labour) in the most efficient way towards most profitable ventures
• Lack of exit leads to misallocation of resources with enormous costs for a capital starved country such as India
• Overhang of stressed assets on corporate and bank balance sheets reflect same problem (remember twin balance sheet challenges, 4Rs solution discussed in part one) of  difficulty of apportioning costs of past mistakes

#3. Political costs

1. Benefits of impeded exit follows to rich (firms are owned by richie rich naa) # govt charged as pro rich # No political constituency for reform measures (recall debate on land ordinance)
2. No action against willful defaulters # erosion of legitimacy of regulatory institutions such as RBI

Let’s take an example of fertilizer subsidies

• Fiscal cost- .8% of GDP, much of which leaks abroad or to non-agricultural uses, or goes to inefficient producers, or to firms given the exclusive privilege to import.
• But precisely for these reasons it has proved politically impossible to close the inefficient firms or eliminate the canalisation of imports. Rich farmers have internalised the benefits and prevent reforms

What causes an exit problem?

3 Is

#1. Interests – Power of vested interests which is aggravated by certain imbalances or asymmetry

• Concentrated producer interests (a few losers stand to lose by lot) v/s diffused consumer interests (individual benefit small but aggregate benefit large)
• Concentrated interests have more voice, backed by financial power and often democratic political systems tend to give disproportional influence to them (vocal minority v/s silent majority)
• In the case of administrative schemes, vested interests often create a market of their own, planning their actions to benefit from it: put differently, this is a case of supply creating its own demand
• Bureaucratic inertia perpetuates persistence
• 50 percent of schemes are 25 years old. extra vigilance is necessary to ensure that schemes remain relevant and useful over time. And vigilance should probably increase in proportion to the longevity. (for these reasons only concept of ZERO based budgeting was introduced)

Q. List down advantages/ disadvantages of zero based budgeting.

#2. Institutions– Paradoxical situation of both weak and strong institutions delaying exit

Weak institutions –

• Inability to punish willful defaulters (legitimacy of institutions itself is questioned)
• Judiciary- Tareekh pe Tareekh (time and cost overrun)

• Eg. Debt recovery tribunal- share of settled cases is small and declining (4 lakh crore locked up)

Strong institutions so called referee or vigilance institutions– CBI, CVC, CAG, Judiciary combined with the asymmetric incentives for bureaucrats that favours abundant caution and hence the status quo.

Incentives are stacked against decisions to precipitate exit for fear of being seen as favouring corporate interests and hence susceptible to scrutiny, encouraging ever-greening of loans, postponing exit

#3. Ideas/ ideology

• Very difficult to phase out entitlements especially in a country with sizable poverty and inequality and one that is a democracy
• The objective is often laudable but once the policies and programs have been set in place, they are very difficult to reverse
• For instance, minimum support prices (MSPs) were envisioned as an insurance mechanism for farmers, but have become price floors instead, favouring some crops in some regions at the expense of other

How to address the problem

#1. Avoid exit through liberal entry: promote competition via private sector entry rather than change ownership through privatization. Eg. BSNL, MTNL were not privatized but liberal entry to private telcos

Advantage- It bypasses opposition from managers as well as labour interests.

#2. Direct policy action- Frame better laws, align incentives with the objectives

Govt response– a new bankruptcy law (solves weak institution problem), amendment to prevention of corruption act (solves strong referee institution problem), reforms in PPP (Kelkar Committee Report)

#3. Technology and the JAM solution:  Direct Benefit Transfer (DBT) for targeting and protecting the poor while removing distortions

• Brings down human discretion and the layers of intermediaries
• Breaks the old shackles and old ways of doing business

#4. Transparency: Transparently reflect economic as well as social, environmental and health costs and benefits

• Eg. Costs of producing cereals in Punjab and Haryana; declining water table, soil quality degradation, post harvest burning of stalks causing pollution, rich farmers getting benefits
• v/s benefits from pulses; nitrogen fixation, lower import dependency etc.

#5. Exit as an opportunity- It’s not the business of govt to be in business. For eg. loss making Air India

• Opposition from existing managers or employees’ interests;  solution- earmark resources earned from privatization for compensation and retraining;
• credibly ensure that reservation policies will be maintained in the privatized enterprise as well
• convert part of land into land bank and develop industrial clusters or in dense urban areas nurture start ups

A few more points about strong referee institution problems

1. Prevention of corruption act (PCA) definition of corruption does not include words like ‘corruptly’ or ‘wrongfully’ i.e. no requirement of mens rea or guilty intent hence even a benefit conferred inadvertently is sufficient to be prosecuted
2. For example, suppose an honest public servant makes, in good faith, an error of judgment and undervalues an asset which is being disinvested. Obviously that undervaluation causes a pecuniary gain to the buyer of the asset and is not in public interest, he is in way benefited but can still be prosecuted.
3. Misaligned incentive structure– external monitoring in the public sector tends to be skewed towards bad decisions that were taken rather than good decisions that were not taken (i.e. opportunities that were missed).
4. This promotes a culture where avoidance of mistakes is more important than the pursuit of opportunities

Result –

1. The reluctance of government to accept responsibility for its own delays in projects
2. The penchant for departments to appeal even fair and reasonable arbitration awards or lower court judgments
3. The tendency to raise tax disputes based on audit objections even if the tax authority disagrees with the auditor
4. The reluctance of civil servants to sell land or divest public enterprises

Solution:

1. Amendment to prevention of Corruption act (prs bill summary) to prevent prosecution for mere administrative errors,  differentiating cases of graft from those of genuine errors of decision-making 
2. Providing investigative agencies with tools, skills and training to do a proper investigation of modern day financial crime and corruption so that culprits do not go scot free either
3. Reexamine the cost of elaborate but largely ineffective and counterproductive vigilance machinery

What you have to read for yourself

1. All the boxes from the chapter plus bankruptcy box from statistical appendix
2. Open all the hyperlinks. Learn, understand and revise.

Ask all your doubts in the comment section below or in doubts clearing forum . all your suggestions, criticism and feedback are most welcome.

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