Putting incentives under the microscope

Written by YRK Reddy | Updated: Nov 12 2005, 06:00am hrs
The benefits that government bestows on tiny, small and medium enterprises, the informal sector, the farmers, women, the aged and the deprived are all subsidies. An economic concession in favour of an MNC, a big league corporate or a well-connected businessman is termed as an incentive. Similarly, what sub-Saharan Africa gets is subsidy and aid, but the hidden concessions to the developed world or its industry are incentives. This is no different from attributing a modest wear to the meagre income of a clerk, as against modesty or fashion when it is on a wealthy individual. Is there a rational and equitable distinction that economists and policy-makers can make between subsidy and incentives, apart from the social, economic and development status of various beneficiaries

Subsidies have been much debated in economics and public policy. They are also better defined. They are deemed as prices which are below the marginal costs or market prices. One definition is that subsidies are measures that keep prices for consumers below market level or keep prices for producers above market level, or that reduce costs for consumers or producers by giving direct or indirect support.

Subsidies are often achieved by active intervention of the government, but can sometimes arise due to unattended externalities. They distort prices and induce inefficiencies of many varieties. They also induce wealthy people to free-ride, as in the case of water or village transport. The artificial prices give wrong signals; they do not get properly reflected in budgets; they impose disincentives on organisations that have to bear the brunt of government actions and many more such. Naturally, there is much denigration of subsidies, except among welfare economists, who may want to define, measure and assess the positive impacts closely and contextually.

There is much less debate on incentives, which in any case gives a positive connotation universally. It is also less of an economic concept than a behavioural one. It is all about changing motivation and behaviour to fulfill contracts or expectations which would not happen otherwise. They are normally deemed as monetary and, hence, stock options, performance payments, incentives in infrastructure contracts, bonus-malus in insurance, tax breaks, special allotments, etc., are structured in this light. The important assumption is that those offering the incentive have a clear understanding of the implicit contract and its benefits. In the absence of such analysis, they become runaway incentives that achieve little.

Subsidies have a negative connotation and are intensely scrutinised
Unlike incentives, where it is assumed that costs and benefits are understood
Policymakers must do far more to understand and justify incentives
Take the case of an international company wanting to set up an automobile unit in a state. The government may want to give large tracts of land at prices set by it, which may be only part of the true cost. The government may also give long years of exemption from local taxes, subsidised power or water and also undertake to beef local infrastructure. All this for political reasons, for fear of the investor going to another state which is very much within India.

Understandably, a smart investor would play one state against the other and get away with benefits that remain a wish for ordinary entrepreneurs. Private airports are being set up after acquiring land from small farmers at a fraction of the pre-escalated costs, while the wealthy actually buy land all around in anticipation of the escalation.

The financial districts, special zones, electronic, IT, bio-tech or knowledge parks built on acquired land are opened to companies case-by-case and suffer from contractual incompleteness as to the benefits to the state. But after the new rights to information, there is much fodder for social activists that could soon put both the recipients as well as the governments to much embarrassment.

While the entire world and multilateral organisations are stepping up support for the SME sector, as it hosts massive employment at small per-employee investment, policy makers appear to favour others for giving special incentives. It is not surprising that many technocrats and mid-corporates feel ignored. They are in the mass category that deserves only standard subsidies, not class to benefit from customised incentives. It is, indeed, high time for policy makers to closely study incentive structures, evaluate their impact and devise more transparent, equitable and economically justifiable policies. Otherwise, the incentives could easily be termed perverse subsidies in the garb of incentives.