Welfare cost of subsidies

SUBSIDIES: Subsidies are of different types: transfers of budgetary resources, tax holidays, tax concessions, supplying goods or services below cost and policies that create transfers through the market mechanism.

Subsidies are popular means of providing relief by governments to categories of persons (e.g. farmers), private agents and public enterprises, enabling them to either purchase or sell a good or a service at a cost below the market price.

The welfare cost of subsidies is multi-faceted. They lead to governments incurring a budgetary burden, which has to be met through either increased taxing of the population or increasing the government's indebtedness or covering the cost by cutting fiscal expenditure, frequently by reducing expenditure on public investment.

Thus, subsidies often involve a serious opportunity, cost of growth and development with the reallocation of resources from productive public investment to current expenditure. Furthermore, lower prices, mostly below the cost of production paid by economic agents on goods and services could lead to over exploitation and misallocation of resources.

Utilities such as water, electricity and petroleum in many countries are subject to subsidies and those resources are being over exploited. Such over exploitation could lead to a worldwide shortage of resources.

In Sri Lanka, subsidies are widespread. Annual subsidies for fuel and fertiliser amount to Rs. 26 billion and Rs. 6.8 billion, respectively.

These subsidies amounted to 1.4 per cent of GDP in 2005. which could be compaired with the total public spending on health in 2005. (Rs. 44.8 billion) and the cost of the Norochcholai power project (Rs. 47.9 billion). It is almost equal to the total estimated cost of the Southern Highway (Rs. 33.9 billion). This is several times higher than the allocation (Rs. 0.35 billion) made for the new Uva Wellassa University in 2005.

The annual cost of subsidies could be utilised to construct about 1,300 schools or about 160 base hospitals per year. In addition to these, a wide range of corporate tax holidays and tax concession exists leading to a loss of fiscal revenue.

The key issues in managing subsidies are the size, incidence and distortions in allocation. The adverse implications of subsidies could be minimised by their reduction through provision of subsidies only to the needy through proper targeting.

Though the need for reducing subsidies has been recognised, intervention by various pressure groups and insufficient consensus on reforming subsidies, often does not allow the implementation of such policies.

Rationalisation of subsidies can remove economic distortions, thereby improving efficiency and growth, reduce the budgetary burden and significantly enhance much needed public investment. Central Bank Annual Report 2005.