How the government will keep its entitlement commitments

You won’t like any of them

No one really knows how much the Food Security Bill (or Act, if it becomes law) will cost the exchequer. Given the way the legislation is framed, it is impossible to make an accurate assessment of its costs. That doesn’t mean we are short of proponents who argue that it should be (or, worse, normatively must be) affordable. We also have a few opponents who argue that it’s more expensive that what the proponents suggest. We’re talking about numbers whose order of magnitude is in the range of single-digit percentages of GDP.

The scheme is open-ended: there’s no expiry date, no sunset clause. It covers around two-thirds of the population—even those who are not really needy. This means that the outlays will have to increase as the population grows.

Obviously, finding the money to keep this scheme going year after year will be a big problem. There’s worse news though—this programme is over and above other open-ended spending commitments like the NREGA, fuel and fertiliser subsidies which are in the vicinity of 2%-3% of GDP. These are the explicit subsidies. We will not even attempt to calculate the implicit subsidies and opportunity costs in this post.

Many of these schemes work such that the subsidy load will increase when growth slows down. In other words, at such times, subsidies as a fraction of GDP will increase—tightening the government’s budget constraints and reducing its fiscal space.

The nature of these schemes is such that governments will be scared to cut them during times of distress, forget ending them altogether. So how will the Indian government finance the gargantuan entitlement economy and what might be the consequences?

First, through new and higher taxes. This has already happened. Didn’t you notice the ‘education cess’? Didn’t you notice the higher marginal taxes on high income earners? Expect more of the ‘Good Cause Cesses/Surcharges’, a fiscal sleight of hand to raise new taxes by citing a plausible good cause. (See this post on education cess for more). As the economic and fiscal situation gets worse, expect higher tax rates lower down the income pyramid. Corporate profits are also an easy target—so they too will be taxed in increasingly creative and extortionary ways.

The consequence of higher taxes are lower investments and higher tax evasion. Lower investment means lower growth. Higher taxes when you are already in a low growth phase is a recipe to stay in the low growth phase longer than otherwise.

The second way for the government to raise resources is through borrowing. It can borrow money abroad (and incur foreign debt) and borrow money from the domestic market. The former puts the Indian government at the mercy of its foreign lenders to the extent of its borrowings. If you do not recall the days of the 1960s-80s, when India was mired in foreign debt, ask someone who does.

The Indian government can borrow from Indian citizens and corporates through the bond market and other instruments (a new -Vikas Patra can be invented quite easily). While it transfers money into the government’s budget, it crowds out the private sector. Interest rates will rise because of the large government demand for funds, making it harder for entrepreneurs and businesses to raise funds to expand their economic activity. This too puts the brakes on economic growth. Higher interest rates during an economic slowdown will prolong it.

The third way for the government to raise resources is to get the Reserve Bank of India to print more money. This has the effect of increasing inflation and depreciating the value of the rupee vis-a-vis other currencies. Higher inflation makes people poorer. It makes poorer people even more poorer (because they do not own assets like real estate, shares or foreign exchange that can weather inflation). A drop in the value of the rupee will make it tougher to service foreign debt, both for the government and for private firms. If the rise in exports on the account of a cheaper currency does not outpace the higher cost of imports, the current account deficit will grow. It could even result in a balance of payments crisis, like the one seen in 1991.

The fourth way is what is termed an “austerity drive”—for the government to cut expenses. Because politics will not allow cutting back on salaries, pensions, subsidies and entitlements, the government will cut two things: office expenses and capital expenditure. So you’ll probably get to see ministers photographed coming to work on bicycles and civil servants working without air-conditioning. Other than schadenfreude, these measures achieve nothing substantial. Cutting down on capital expenditure—roads, power plants, defence equipment—does create fiscal space, but at the cost of future growth.

Where does this leave us? Well, at the edge of a vicious cycle of low growth, high inflation, low investment, higher unemployment, higher taxes, greater evasion and higher out-migration of talented individuals and firms. We’ve been there before. It’s unconscionable that we are being taken there again.

The only way to avoid this vicious cycle is to suspend entitlements and rekindle growth. It is unlikely that growth can be rekindled without sustained pro-growth measures: greater liberalisation, simpler taxation and coherent economic governance. The Delhi Straitjacket must be dismantled.

Related: INI9 Conversation with V Anantha Nageswaran on the falling Indian Rupee.

Garibi Hatao Hatao

The old, failed and corrupt political economy of poverty alleviation fights attempts at reform

Jean Dreze, member of the influential, unaccountable and extra-constitutional National Advisory Council, has launched a pre-emptive attack against conditional cash transfers in the pages of today’s Indian Express. It provides an excellent example of how rank paternalism and contempt for the poor Indian’s right to live a free life guides the UPA government’s mindset. This mindset, of course, is covered in the language of “development economics”. In reality it is bad economics and bad for development in addition to being morally repugnant.

Before we look at Mr Dreze’s arguments, let’s look at this conclusion:

The most common argument for cash transfers is that cash makes it possible to satisfy a variety of needs (not just food), and that people are best judges of their own priorities. Fair enough. But if people are best judges of their own interest, why not ask them whether they prefer food or cash? In my limited experience, poor people tend to prefer food, with a gradual shift from food-preference to cash-preference among better-off households…I am more inclined to listen to them than to the learned champions of cash transfers. [IE]

The arrogance in the last sentence must come from sitting close to the Congress party president (another NAC member recently wanted to impose how many dishes could be served at wedding dinners). Mr Dreze, unsurprisingly, does not believe the people are the best judges of their own interests, for he uses the conditional “if”.

Even so, doesn’t he have a point when he says “why not ask them whether they prefer food or cash?” Not quite, because the question is a bit of sophistry. Basic economics will tell you that because cash is most fungible, if you give them cash, the question itself is redundant. If they prefer food they’ll buy food. If they prefer arrack they’ll buy arrack. Neither Jean Dreze nor the National Advisory Council, nor indeed the Government of India has any business dictating what an Indian ought to do with his or her income. Only ‘development economists’ of the dubious sort can think that development is possible when hundreds of millions of adult citizens have the right to vote and procreate but not to decide what to do with their money.

Just because the government gives this money doesn’t mean it can override the individual’s freedom to choose. Neither the government, nor the taxpayer whose money is transferred can deprive the recipient of her freedom.

Let’s consider Mr Dreze’s policy arguments. He first argues that conditional cash transfers won’t work in India (as they did in Latin America) because public services are “missing to a large extent”. This is bizarre, for giving Indians the money to procure services like healthcare and education from private operators allows them to escape having to depend on the government. Just because conditional cash transfers complement public provision in Latin America doesn’t mean they have to do so in India too. There’s no reason—other than socialist ones—why India shouldn’t go in for privately provided, but publicly financed, services. [See this post on the critics of the UID]

Next, he argues that targeting the scheme properly is a problem in India. And in so doing, he expects us to believe that conditional transfers in kind (for instance, food entitlements) can be better targeted than cash. In reality, targeting will remain a problem, not least because of the ‘political economies of development’ which require poverty to remain a problem. A poverty line, even if arbitrarily drawn, helps show the extent of the challenge. But once you target policies around a poverty line you run into all ‘targeting problems’ (see the case of Karnataka’s BPL cards). The entitlement economy also breeds competitive intolerance and political violence.

On these feeble legs Mr Dreze erects his defence of the Public Distribution System (PDS), independent India’s largest and longest running ‘scam’:

First, (food entitlements under PDS) are inflation-proof, unlike cash transfers that can be eroded by local price increases, even if they are indexed to the general price level.

Food entitlements may be “inflation-proof” for the recipient, but not for the government, which still needs to pay for it. It also creates incentives for government to interfere in the pricing of food: from underpaying farmers, to blocking exports, to entering into non-competitive import arrangements. Moreover, Mr Dreze fails to account for the true economic cost of the PDS—procurement, storage, distribution, wastage, pilferage and the associated shadiness that characterises it from bottom to top. Once you see the PDS as mostly inefficient and usually corrupt, you are unlikely to think throwing more money through it is a clever thing to do.

A government that really cares about inflation hurting the poor will be careful about the consequences of its policies. On the other hand, the UPA government listened to Mr Dreze.

Second, food tends to be consumed more wisely and sparingly; cash, on the other hand, can easily be misused.

The contempt for individual freedom apart, there is a practical reason why Mr Dreze is wrong: you can’t save, lend or invest food. Food entitlements will at best lead to hundreds of millions of well-fed, but poor people. To use Atanu Dey’s phrase food entitlements are a pro-poor scheme. They will keep people poor.

Third, food is shared equitably within the family, while cash can easily be cornered by selfish individuals.

Why, hasn’t Mr Dreze heard of families who treat their boy and girl children differently? Can’t food be bartered for arrack or exchanged for cash? Indeed, food or cash, there is nothing to prevent selfish individuals from hurting their families. It is conceit to believe that a government that lacks the competence to deliver drinking water to its citizens can somehow change human behaviour. Social ills need to be addressed, but unless the government is parsimonious in ambitions, outcomes will suffer.

Then again, the irony of disparaging cash is surely lost on Mr Dreze, champion of a scheme to provide, err, cash for work. NREGA is a conditional cash transfer, isn’t it?

Fourth, the PDS network has a much wider reach than the banking system. In remote areas, where the need for social assistance is the greatest, banking facilities are simply not ready for a system of cash transfers (as it is, they are unable to cope with NREGA wage payments).

This is an argument for getting the banking system pervasively into rural areas. Indeed, implementing conditional cash transfers provides banks with an incentive to set up more outlets in rural areas. Liberalising the financial sector to enable greater financial inclusion is necessary in any case, and implementing cash transfers might provide enough of an anchor tenant effect to get it going.

Last but not least, cash transfers are likely to bring in their trail predatory commercial interests and exploitative elements, eager to sell alcohol, branded products, fake insurance policies or other items that would contribute very little to people’s nutrition or well-being.

There is nothing wrong in buying or selling alcohol and branded products. Selling fake insurance policies is illegal. Conflating the two is a manifestation of an ideological prism that abhors free markets and free people. Indians might be poor but they are aspiring for the comforts, fashions and fallacies of modernity. The government has no mandate to prevent his and condemn to have-nots into shall-not-haves.

Mr Dreze’s pre-emptive salvo seeks to defend against the dismantling of the edifice of India’s old, failed and corrupt political economy of poverty alleviation. Ideologues confuse socialism for development. The vested interests that collect rent from the PDS, government hospitals, schools and suchlike are fighting to retain their spoils. Both have little interest in making Indians prosperous.

How the UPA government’s policies caused inflation

Gargantuan spending without addressing underlying supply bottlenecks

Inflation is like fever — it is not the disease itself but a symptom of an underlying disease. The right approach is to treat the underlying disease and not focus on treating the symptoms.

Supply bottlenecks are the underlying problem
Inflation is the direct result of the UPA government’s failure to put in place the necessary policies that could sustain the growth spurt that started during the NDA’s term. When an economy grows at 8% year on year all classes of people — poor, middle-class, rural and urban — will demand more goods & services. Yet, the UPA government has failed to ensure that the economy can produce and efficiently distribute goods & services. This is the core cause of inflation.

The anaemic growth in infrastructure industries is an indicator of the policy failures that have led to inflation. Better infrastructure can moderate price rises by better connecting buyers and sellers. Despite the economy growing at 8%, the infrastructure industries growth has been only 6.7% under the UPA government. In fact this has further fallen to 5% in mid-2010. The shortfall in power supply has worsened from 8.5% in 1992 to 12% in 2008-09. Worse, capacity addition in thermal power is a mere 4.4% of the target.

NREGA has contributed to price rises in many areas because the UPA government has failed to make rural markets competitive. In a village with a few shops, any rise in income of the villagers will cause shopkeepers to increase their prices. If rural areas are better connected to each other with good roads, electricity and cheap transport, villagers can purchase goods in adjacent villages if the goods are cheaper there. Despite the claims by the promoters of NREGA it is unclear if NREGA has benefited the rural poor. The UPA government has shown much less enthusiasm to complete the Golden Quadrilateral programme and extend it to rural areas.

The UPA government has failed to enable farmers to participate in India’s growth. The failure to dismantle barriers to agricultural marketing and failure to integrate India into a single market for agricultural goods not only contribute to food price inflation but undermine the welfare of farmers. (Farmers receive only 50 paisa for a kilo of tomatoes while consumers pay Rs 20).

It is a matter of basic economics that when demand rises faster than supply, prices will rise. By neglecting this basic reality, the UPA government has created the conditions for inflation

Regarding fuel prices
The UPA frittered away the chance to complete the process of fiscal consolidation started by the NDA government, otherwise credit rating agencies like Moody’s would have upgraded India’s sovereign credit rating a long time ago, rather than in 2010.

The removal of fuel price subsidies was done without adequately preparing the nation for the same. The UPA has not revealed that it intends to rectify the fundamental problems in the petroleum sector because of the patchwork of pricing policies. Furthermore, despite it being clear for the last few years that energy prices are rising globally, the UPA government failed to create the framework for a massive improvement in public transportation.

The removal of petrol subsidy and rise in prices does not directly affect the poor — mostly they use buses and trains. Those who use two-wheelers are affected. However, despite presiding over a healthy economy for over 8 years, there is no sign of the UPA government evolving a integrated public transport policy. Instead there is a continuation of the licence-permit raj that leads to the harassment of auto-rickshaws and other private bus operators, and increasing inconvenience for ordinary people.

The fuel pricing policy has damaged our public sector and private sector oil & gas companies. Reliance had to close down 2000 petrol stations because prices are non-remunerative — this is a major waste of capital. While the UPA government is damaging our oil & gas companies in this way, the Chinese government is throwing its weight behind their state-owned companies to corner energy resources around the globe.

UPA’s fascination with pet projects is diverting attention from the necessary ones. For instance, instead of thinking of only building a pipeline to buy natural gas from Iran, and paying money to the Pakistani government to safeguard our lifeline, we should have invested in building LNG terminal & pipelines along our coastline. Investing in ports, refineries and pipelines in India would not only increase the income of Indians but also improve our energy security. We can still buy the gas from Iran without having to depend on Pakistan.

(This note was prepared and privately circulated in July 2010. It is published here as it is still relevant, unfortunately.)

Killed by bad policy

A thousand Lalit Mehtas will risk their lives fighting corruption. And how entirely avoidable this could have been.

There is an outcry over the murder of Lalit Mehta, an upright public-minded citizen, who was allegedly killed while attempting to expose the corruption in the National Rural Employment Guarantee Scheme (NREGS) in Palamau, Jharkhand. The public attention should help focus attention on the crime and bring the guilty to justice.

The murder provides a convenient excuse for proponents of the dubious scheme to reiterate their argument that the NREGS is being undermined by corruption. Prime Minister Manmohan Singh and Jean Drèze, the scheme’s chief proponent, have already done it. It is easy for Dr Drèze to blame the intermediaries and district officials for Mr Mehta’s brutal killing. But those who designed the system—and that includes Dr Drèze—can’t escape their share of the blame.

Any fool can design a scheme that would work if only there were no dishonest people in the world. As The Acorn has argued, the way the NREGS is designed creates huge new incentives for corruption. The proponents claim that the controls they had put in to check corruption would somehow work better than the controls that had been put in place to check corruption in the past. It should be clear to everyone by now that those controls don’t work. They only put good people like Mr Mehta in harm’s way.

Let’s remember now that among the UPA government’s acts of monumental irresponsibility ranks the extension of the NREGS to all districts in India, despite knowing that it is not quite working as touted. There are hundreds of Palamaus out there and thousands of Mr Mehtas will face threats to life and limb. These would have been avoidable with some clear thinking, competent policy design and responsible leadership.

In fact bad policy design only compounds a more fundamental flaw: bad policy vision. As Rohit Pradhan notes, the NREGS is designed to keep people in villages. And as Atanu Dey writes, it is also a scheme that is designed to keep them poor.

Villagers won’t be suckered by propaganda

…but you* might

Ravikiran Rao wonders why the UPA government is advertising the benefits of the national employment guarantee programme, on NDTV?

Let’s set aside the spreading the love explanation for a moment. The question why the government is using an English language channel, targeting the urban middle class, when the ads ostensibly are meant for landless villagers, has a simple answer.

Because that is exactly what you would do if you want the urban middle class voter to believe that you are doing something for the landless villager. Because its proponents have been crying foul that you, gentle readers, have been subjected to a propaganda campaign against this gargantuan spending programme. [The best way to justify a propaganda campaign is to claim that it is necessary to counter an existing one]

* With due apologies to rural readers

How the rural employment guarantee might cause inflation

If rural markets are not competitive, then prices will rise with incomes

After a spate of recent reports confirmed that what manyincluding The Acorn—understood was inevitable, Jean Drèze has risen again to defend the national rural employment guarantee scheme. This time, by dubbing criticisms as propaganda. His strategy is classic: to take a seemingly neutral position by pointing out there is propaganda from both pro- and anti-NREGS sides, and drawing an equivalence between the two. It’s from Schopenhauer. The word propaganda, like socialism, “does not have a definite meaning, and can mean different things at different times”. So let it be.

But you would expect a professor of economics to be more exact in his economics. He writes

By way of illustration, prominent media attention was given a few months ago to a so-called “study by the India Development Foundation,” allegedly showing that the NREGA caused inflation. This is an outlandish claim, and I leave it to the reader to guess why this particular item of government expenditure was singled out as being responsible for inflation, as opposed to, say, the defence budget, which is almost 10 times as expensive. Further enquiry revealed that this “study” did not exist; it was just a speculative remark made at a panel discussion by a member of this Foundation. Nevertheless, this hot air was promptly pumped into the propaganda balloon. [The Hindu]

Now let us grant that the media indeed turned a remark into a report. But is Prof Drèze right about NREGS being less responsible for inflation than say, the defence budget?

Let’s look at the microeconomics of the NREGS. The money that the government puts into the pockets of the NREGS recipient translates into a higher demand for food, household goods and other such items. This is called an “income effect”. The solid blue line in the adjoining chart shows the original demand curve for these goods in, say, a rural district. Since NREGS recipients convert a part of their income into consumption, their individual demand for these goods increases, causing the demand curve to move upwards. This is shown by the dotted blue line.

NREGS and Inflation

What Prof Drèze fails to take into account is the shape of the supply curve (shown in red). How much the price rises depends on how steep it is. In the adjoining chart, you will notice that the price level goes up significantly after incomes increase. In fact the steeper the supply curve is, the higher will the price rise, and the incremental consumption will be smaller. In other words, if the curve is steep, then people will be consuming the same quantity of goods as before, only paying more money for it. In such circumstances the money that the NREGS spends is not ending up with the intended recipients, but in the pockets of suppliers.

And why might supply curves be steep? Well, because the markets are not competitive. Perhaps because there are only a handful of shops selling these goods and the shopkeepers are colluding to keep prices high. They are likely to do this when they know that there is NREGS in the air.

So contrary to what Prof Drèze writes, it is not at all “outlandish” to claim that NREGS causes price levels in rural areas to rise. There is a good chance that a good fraction of the money that does not get siphoned off by officials ends up fattening the profit margins of rural shopkeepers and traders. [It follows that a better way to help the rural poor is to make the supply curve flatter. It’s done with better infrastructure, irrigation and information]

Defence expenditure too causes inflation. But not in the same direct, localised way as NREGS (besides, the fraction that is used to import military goods doesn’t contribute to domestic inflation). But the comparison is bogus. Increases in defence expenditure are not justified on account of improving the lot of the “rural poor”, but rather, recognised as a necessary evil. The NREGS, on the other hand, is solely justified on that basis. To the extent that it raises prices without increasing consumption, the scheme is an “unnecessary evil”.

Update: Ravikiran Rao comments on Drèze’s article over at The Examined Life