Over-Drilling: Local Externalities and the Social Cost of Electricity Subsidies in South India

Borewells for groundwater extraction have proliferated across India, encouraged by massive electricity subsidies. Because the discharges from borewells operating near one another are mutually attenuated, farmers interact strategically with potentially many neighbors in deciding whether and when to drill. An analysis of survey data from two districts in southern India establishes both the importance of this well interference externality and its influence on drilling decisions. This paper then estimates a structural model of well-drilling as a dynamic discrete investment game played across a network of adjacent plots. Using this model, the paper compares the current regime of free (but rationed) electricity against an annual tax on all functioning borewells that fully defrays electricity costs. The findings show that the counterfactual policy, by reining in over-drilling, reduces deadweight loss by US$170 (in present value terms) per acre of land with groundwater potential, or by around 3 percent of its market value. The paper also finds that taxing only newly drilled borewells at a rate 23 percent higher than annual electricity costs (to address the negative externality) is nearly welfare-maximizing yet avoids a capital levy on existing well owners.