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Fertiliser Subsidy

 Arvind Panagariya

  WE SPEND more than 0.7 per cent of India’s GDP on fertiliser subsidies. This is almost twice the entire amount we spend on higher education. In absolute terms, the subsidy amounted to a whopping Rs 13,200 crore in 1999-2000. There is little economic justification for placing this huge burden on the Indian taxpayer. Not surprisingly, even the Prime Minister’s Economic Advisory Council advocates an end to the subsidy in a report available on his website.

 The bulk of the fertiliser subsidy rewards the gross inefficiency of our urea manufacturers. According to the second report of the Expenditure Reforms Commission, issued on September 20, 2000, production costs of urea vary from Rs 4,800 per tonne for the most efficient plant to Rs 15,175 per tonne for the least efficient one. In today’s highly competitive environment in which paper-thin margins in costs are sufficient to drive firms out of business in most parts of the world, we sustain plants with production costs three times as much as the most efficient one.

 Since 1977, we have maintained the so-called Retention Price Scheme under which the government buys fertiliser from each plant at a price equal to the average production cost plus a post-tax return of 12 per cent on net worth. The government then sells the fertiliser to farmers at subsidised prices that are unrelated to production costs.

 This cost-plus pricing has robbed the industry of all incentives to improve efficiency. Manufacturers know that any reduction in cost will lead to an equivalent reduction in the price. Thus, for example, ignoring the cheaper availability of Naphtha from abroad, they buy it from high-cost domestic sources.

 To understand who benefits from the subsidy and how much, we must compare the prices paid by farmers and those received by manufacturers with the opportunity cost of obtaining urea from abroad. Though this is a somewhat complicated exercise due to large fluctuations in the world price of urea, it can be accomplished by defining a benchmark price based on the average of the prices recently observed.

 Thus, between January 1998 and February 2001, the price of urea varied from $70 to $140 per tonne. To give the industry maximum benefit of doubt, let us follow the recent ERC report, which generously set the long run benchmark import price of urea at $150 per tonne.  At the current exchange rate of Rs 46 per dollar, this is equivalent to Rs 6,900 per tonne. Add to it, as per the generous ERC suggestion once again, Rs 1,100 per tonne in handling, transport and dealership margins. This yields a delivered import price of Rs 8,000 — far below the prices paid to the majority of urea plants under the RPS.

 Next, turn to farmers. The government sells urea to them at Rs 4,600 per tonne. This being substantially lower than the benchmark import price of Rs 8000, farmers also benefit significantly from the subsidy.

 The subsidy to manufacturers has been defended on the ground that we must be self-sufficient in fertiliser. The subsidy to farmers has been defended on the ground that it helps boost the output of foodgrains. And the subsidy to marginal farmers has been additionally defended as a poverty-reduction measure.

 Frankly, continued preoccupation of our policy makers with self-sufficiency in fertiliser, central even to the recent ERC recommendations, is baffling. What is the rationale for it when we are far from self-sufficient even in arms production? And if such a goal is justified for fertiliser, why is it not applicable to tractors, harvesters and other agricultural machinery, all of them necessary for foodgrains production?

 As for subsidy to farmers, even if one accepts the questionable objective of maintaining a certain level of foodgrains production, the right instrument is the support price. Rather than rely on it, ironically, we have often done exactly the opposite, subjecting the farmer to a levy that deprives him of his rightful market price and offsets the subsidy he receives on fertiliser.

 In turn, in the name of procuring foodgrains at low prices for the consumer, we have subsidised yet another behemoth and monument to inefficiency — the Food Corporation of India.

 As for safeguarding the interests of small and marginal farmers, the right instrument is an income transfer. It is not clear why such transfers have to be made in the form of fertiliser.  Surely, it is at least as efficient to give them the subsidy in terms of food they consume (as we already do to some extent), allowing them to sell what they produce at the highest price available.

 If we are serious about freeing the taxpayer of the huge burden of the urea subsidy, we must first give up our obsession with self-sufficiency in fertiliser. Once this is accomplished, four key steps must be taken.

 First, urea imports must be decanalised with the import duty set at 30 per cent initially. The opening of imports is necessary to generate competitive pressure on the domestic industry.

 At the same time, the import duty addresses the concern that India has market power in the world urea market. The duty will also generate revenues thereby adding to the treasury rather than draining it.

 Second, all subsidies to fertiliser manufacturers must go. Regardless of the feedstock they use — natural gas, naphtha or fuel oil — manufacturers must compete in the open market. The ERC recommendation to continue subsidising plants that do not use natural gas is untenable.

 Third, subsidies on the fertiliser use must go as well. If larger food production is the objective, higher support prices are the answer. It makes no sense to subsidise a specific input such as urea to boost foodgrains production.

 Finally, the interests of small and marginal farmers should be protected through income transfers. Giving them fertiliser at subsidised prices, as recommended by the ERC, makes sense only if this is administratively the easiest way to make the transfer. It is not clear why that should be so.

 Economic Times, February 28, 2001