End of fertilizer price decontrol?

It was with great fanfare that the Government of India launched the Nutrient Based Subsidy (NBS) regime for fertilizers in April 1, 2010. It effectively dismantled the administrative control over fertilizer prices. The subsidy was to be fixed, based on the nutrient content of each fertilizer, and then transferred as a back-end subsidy to the manufacturing companies. It gave companies full freedom to fix Maximum Retail Prices (MRPs), though there was an informal understanding to keep price hikes within 'acceptable' limits.

It went off relatively well in its first year, raising hopes of further reforms in the subsidy regime. However, following the steep increases in global petroleum prices in recent months, the wheels seem to be coming off the NBS regime. The manufacturers have been left with no option but to increase the MRP to cover for the increased import prices. As I have blogged earlier, in response the government has been forced into revising the subsidy for 2011-12 three times already.

Faced with continuing rise in fuel prices, the Government has issued directions to the fertilizer companies to restrict the MRP increases to a band. The Businessline points to a recent circular issued by the Department of Fertilisers asking firms to limit the increase in the MRP of di-ammonium phosphate (DAP) to Rs 600 a tonne for the kharif season ahead. It writes,

"Since the MRP, prior to April 1, averaged Rs 10,750 a tonne, a Rs 600 rise works out to Rs 11,350 a tonne. To this, if the 1.03 per cent excise-cum-education cess imposed in the 2011-12 Union Budget is added — this is recoverable from farmers — the new admissible MRP would be roughly Rs 11,470. Against this, companies like Coromandel International, Indian Farmers Fertiliser Cooperative and Zuari Industries have already declared MRPs of Rs 11,700 to Rs 12,000 a tonne, exclusive of State-level and local levies. It remains to be seen if they will now have to roll back their MRPs to the May 5 circular-prescribed levels."

The NBS regime for fertilizers is a test case for cash transfers with PDS. It highlights the challenges in subsidy administration posed by price volatility. However, unlike the fragmented food grains markets, fertilizer market is more integrated. Therefore it is possible to develop an index, also linked to global crude prices, that is a reasonable reflection of fertilizer prices. The subsidy payable to manufacturers or distributors could be calibrated with respect to this index, so as to avoid the repeated ad-hoc revisions. This does create a slight fiscal uncertainty, though the variation is not likely to be so much as to imbalance government finances.

Cash transfers and negative income tax credits

Cash transfers are the flavour of the season in India. The two commonly discussed cash transfer strategies are direct cash transfers to replace subsidies (as in case of food grains, kerosene, fertilizers, cooking gas etc) and conditional cash transfers to incentivize social outcomes (immunizing, sending children to school, maintaining nutritional standards etc).

In both cases, it is proposed that the cash can be transferred using the Aadhaar identity number to the beneficiary's Aadhaar-linked savings bank account. Though this will not completely resolve the problem of beneficiary selection, the issues of pilferage (by ghost and duplicate beneficiaries) and administration of the transfers will be satisfactorily addressed.

Apart from the two aforementioned types of cash transfers, there is a view, still marginal, that advocates direct payment of cash to all those below the poverty line. Such a universal minimum income guarantee, it is argued, should replace all subsidies and, if delivered through biometrically validated Aadhaar-linked accounts, will simplify program administration, minimize leakages, and limit incentive distortions.

I am not interested in this post to get into the relative merits of the three approaches to cash transfer. Needless to say, there are some very formidable challenges with a universal minimum income guarantee cash transfer. However, if this is adopted, the most effective strategy to implement it would be to package it as a negative income tax (NIT) scheme.

An NIT is reimbursed to the income tax assessee whose income falls below the basic minimum income level for which no one pays income tax. Just as tax payers pay tax at a percentage of their positive taxable income, NIT assessees can be reimbursed, into their Aadhaar-linked accounts, at a percentage of their income deficit (or shortfall from the basic minimum level at which tax kicks-in, the negative taxable income).

Milton Friedman had first proposed the NIT in the late sixties to replace all other welfare programs for the poor. A variant of this, the earned income tax credit (EITC), was introduced in the US in the seventies for the working poor.

The NIT has several benefits in the Indian context. Apart from the numerous benefits arising from dispensing with all other subsidies, the NIT, by making every individual file his income tax returns, would be big step in legitimizing all income streams. Though there will be the risk of people under-reporting incomes, it will open up a large part of the massive parallel economy in India.

The formidable challenge, as mentioned, will be to get people to report their incomes with reasonable degree of accuracy. Rigorous analysis of the massive database so created would itself provide ample information that can further uncover the parallel economy.

In any case, this would be a definite improvement over a direct minimum income transfer where cash would be transferred without any pre-conditions to all the identified beneficiaries. But with NIT, the government would be benchmarking all transfers to the reported incomes of the individual.

Phasing the cash transfer roll-out

I have an op-ed in Mint today that calls for small pilots to test the cash transfer implementation strategy for each product before the program is fully rolled out.

Who are the eligible beneficiaries?

In my previous post, I had drawn attention to the debate about whether the Aadhaar identity would help more effective targeting of welfare beneficiaries. I had argued that Aadhar-based identification would not help screen out those beneficiaries who do not meet the eligibility requirements.

In this context, one of the comments pointed to the psychological deterrent effect of any Aadhaar-based identity in screening out the ineligible. This works on the presumption that since Aadhaar localizes the identity and makes it easy to trace individuals, the possibility of being noticed when drawing benefits would deter the ineligible from accessing those benefits.

I am not sure about the effectiveness of such deterrent for two reasons. First, the margins between the eligible and ineligible are never cut-and-dry. For example, it is impossible to accurately avoid inclusion errors (ineligible getting included) when identifying people below or above the poverty line based on the standard income parameter. What should be the cut-off income? How do we quantify that income? Second, given the widespread poverty in the country, the numbers of people who straddle the blurred boundaries of eligibility are considerable.

In other words, a large number of people face the ambiguity about whether they are eligible or not to receive certain welfare benefits. In the circumstances, the deterrent effect gets considerably diluted. Where is the need to fear when many of your neighbours belong to the same category? In any case, given the difficulty with income quantification, how can anybody establish that you are not income poor (especially when the major share of incomes of those under scrutiny generally comes from the informal sector)?

This challenge will remain with or without Aadhaar and raises the question of what is the most appropriate method to identify welfare beneficiaries. In this context, I am reminded of George Akerlof's famous paper that advocates the use of "tagging" - which tags (identifies) people and then makes specific transfers (or concessions) to them - in taxation. Tagging eliminates the ambiguity arising from eligibility parameters (like income) and enables easier differentiation of the eligible from the ineligible.

What are the most effective tags to identify poor people eligible to receive welfare benefits? The commonest tags are height, weight, looks, gender, age, educational qualifications etc. These are all, for obvious reasons, unsuited for identification of the income poor.

Among the more effective likely tags could be the nature and/or size of ones house. For example, a person living in a temporary or semi-permamnent house could be treated as income poor. Alternatively, the carpet area of the house, discounting for locations, could be used as tags for income levels. Either way, it becomes possible to verify and mark out a person who claims benefits despite failing the eligibility norm. Though administration of house-type based tags too raises concerns, it does look a more promising approach to screen beneficiaries than the current practice of identification based on incomes.

It is possible there are more effective tags, especially for certain subsidized products. In any case, irrespective of whether Aadhaar is used or not, the problem of beneficiary identification, with a reasonable degree of accuracy, has to be satisfactorily resolved.

Pitfalls in cash transfer implementation

The decision by the Union Government to replace the current subsidy regime in fertilizers, cooking gas and kerosene with a system of cash transfers in a phased manner has triggered off an intense debate about cash transfers. This post will summarize the most relevant and common objections to cash transfers and critically examine each of them.

1. It does not resolve the targeting problem

The biggest criticism of Aadhaar is that it leaves the critical issue of beneficiary identification, or targeting, unresolved. The Aadhaar identification merely validates whether the particular individual has come to receive his welfare benefit. It does not say anything about whether the individual is, in the first place, eligible to receive the benefit itself. The means testing of the beneficiary for his or her eligibility is essentially an administrative process.

There are four possible sources of leakages in any welfare program – beneficiary impersonation, ghost, duplicate, and ineligible beneficiaries. Aadhaar-based identification can easily eliminate the first three possibilities. It ensures that benefits are transferred only to the registered beneficiaries. However, ineligible beneficiaries cannot be immediately addressed with Aadhaar. The concern about failure to ensure targeting is therefore only partially correct.

Aadhaar-linked processes are a definite and significant improvement on the prevailing system of beneficiary identification and benefit disbursement. Its effectiveness will improve incrementally as Aadhaar is adopted by a critical mass of user departments so that databases can be shared to screen out the ineligible. In any case, Aadhaar cannot be a substitute for the administrative failure in keeping the beneficiary selection process honest.

It also provides governments an excellent second-best tool to effectively target benefits on petroleum products like cooking gas and fertilizers that are currently universally subsidized. Any such change in regime will be a qualitative and substantial improvement on the current universal subsidy regime.

2. Cash transfers cannot factor in price volatility

The most serious concern about cash transfers, one that deserves the strongest consideration, is on the issue of price volatility. Critics point to the possibility of sharp and sudden price fluctuations, especially for food grains, and argue that this would adversely affect the consumer’s purchasing power. They argue that unless subsidy amounts are calibrated real-time to in response to local market price, a virtually impossible task given the diverse and fragmented nature of rural markets, the cash transfers will fail to achieve its objective.

It is undeniable that prices of commodities, especially food-grains, fluctuate sharply across regions (even within districts, between the head quarters and rural interiors) and over even small time-periods. I have blogged about this here and here. To the extent that the ultimate objective is food or fuel security, or making available these commodities at affordable prices, price volatility poses serious problems.

The new nutrient-based fertilizer subsidy regime overcomes the problem of price volatility by providing a large enough subsidy to act as a buffer against reasonably large manufacturing cost increases. The subsidy transferred to the manufacturers, which is fixed once a year, is deliberately kept high so as to discourage manufacturers from indulging in any market manipulation. It is also hoped that with this subsidy, even if costs increase, the subsidy will cover the increased costs and keep fertilizer prices affordable. However, it has to be admitted that this approach may not be practical for products like food grains and other products.

In the circumstances, at least in the initial phases, it may be more appropriate if cash transfers for products like food grains are restricted to areas where the volatility is least. Urban markets experience less price volatility and they are also more closely integrated into each other. Therefore, an arrangement where the subsidy amount is indexed to the relevant inflation measure is likely to address most of the concerns on price volatility. It has to be admitted that this strategy does not address local price shocks and sudden spikes which cannot be accurately captured on a pan-Indian inflation index.

3. The cash transferred will be frittered away on wasteful expenditures

One of the long-held opposition to cash transfers revolves around the premise that recipients are likely to fritter away their cash on wasteful expenditures. This is all the more so in rural areas, where men are more likely to manage household finances. The widespread self-control problems that bedevil human beings, as highlighted by research in behavioral psychology, adds credence to this claim.

Consider the case of a beneficiary who receives cash transfers on fertilizers and cooking gas into his account, besides NREGA wages and other welfare transfers. There is the possibility that these multiple and often lumpy inflows into a single account would be diverted for other purposes, especially on wasteful expenditures, thereby defeating the purpose of such transfers.

Such concerns can be effectively addressed through vouchers, smart cards, and structured savings bank accounts. The retailers can be reimbursed their subsidy on production of the vouchers for the subsidized product received from the beneficiaries. Debit cards with purchases restricted to only the prescribed commodities can also be used to administer cash transfers. Transfers to the account of the woman family member can also help address such concerns to some extent.

Finally, there are multi-tier savings bank accounts. Insights from recent research in behavioral economics show that use-directed sub-accounts within the main account, designed to take into consideration people’s "mental accounting choices", may be more effective at optimal management of multiple inflows. Accordingly, savings accounts, with say, food or fertilizer sub-accounts, can combat people’s behavioral urges to spend their cash transfer incomes on other expenditures.

In any case, there are doubts on the assumption itself. A study of unconditional cash transfer schemes in 15 Eastern and Southern African countries by S Devereux, J Marshall, J MacAskill and L Pelham indicates that the fungibility of cash transfers does not necessarily undermine the intended outcomes. They also found that recipients used the freedom of choice provided by unconditional cash transfers in a wide range of ways that directly or indirectly benefited children, from purchase of food, groceries, health and education services to investments in farming or small enterprise.

4. It does not address the issue of consumer choice

Another serious objection comes from those pointing to the limited consumer choice in most Indian markets. Since cash transfers are meaningful only when citizens have choice, what use is this cash when people have little or no choice with schools or hospitals? It is a reality that many parts of the country and millions of people have no access to hospital facilities. Further, such presentation of choices, far from creating competition among service provides, only adds to the rent-seeking opportunities. It amplifies the power of the entrenched sub-optimal interests.

Similarly, in most parts of rural India there are typically just one or two retailers for any product. The resultant lack of competition renders any claims of choice disingenuous. If the exclusive government outlets, say ration shops, are closed down, the possibility of price gouging (atleast on certain occasions) by the local kirana shop owner cannot be ruled out.

This concern loses its relevance outside the rural context. Even the smaller cities offer enough choice with retailers, schools and hospitals. Urban residents, who enjoy such choices, can therefore benefit from cash transfers. In any case, given the widespread prevalence of predatory practices like hoarding among retailers even in the smaller towns, such policies will have to be complemented with strong administrative actions to curb these practices.

5. It is a smokescreen to roll-back Government

The strongest critics from the left view a "roll-back the government" agenda behind the cash transfer movement. They see cash transfers as the first step in a systematic campaign to divert attention from more fundamental issues. They express the fear that the focus on cash transfers would slowly displace critical basic welfare issues like investments in primary education and health care, food and fuel security, and so on.

They portray cash transfers as a convenient excuse for governments to abdicate on their responsibilities, "We have done our side of the bargain. We provided you cash, now you go and buy whatever you want". Governments, they argue, will transfer cash to students, patients, and farmers, and leave investments in schools, hospitals, and irrigation to the vagaries of market forces. Similarly, cash transfer in place of food grains, run the risk of seriously imperiling food security. Such ideological arguments are never easy to refute. It may be more effective to tackle them on similar ideological grounds, though its success is not assured.

In conclusion, the concerns of price volatility and choice are not easily refuted. They also remain formidable obstacles to widespread adoption of cash transfers. However, urban markets, which are less susceptible to random and local price shocks and may offer adequate choice, are best placed to receive cash transfers.

Accordingly, it is preferable that the first phase of cash transfers be implemented in towns and cities and for products with less price volatility and choice problems. Food grains distributed through PDS are vulnerable to sharp price fluctuations. The concerns of food security raised by skeptics are not easily refutable. Besides, any failures arising from cash transfers in food grains could become a rallying point for opponents calling for aborting the cash transfer scheme. Cooking gas and fertilizers, and less so kerosene, with their centralized distribution network, are less vulnerable to these concerns.

It is undeniable that urban areas are more suited for cash transfers in all these products. However, this dual subsidy regime, wherein city residents get cash transfers whereas villagers continue to receive subsidies through the conventional channels, may generate its set of problems.

This will be all the more so for food grains and kerosene, and especially during periods of price volatility. In this context, it is important that subsidy benefits are disbursed to consumers in all areas through an Aadhaar-linked system, irrespective of whether they receive cash or not.

Fixing the free power problem

I have an op-ed in today's Mint on a possible strategy to address the challenge of free-power.