Fuel and Food Subsidies: Issues and Reform Options

MENA Chief Economist Office Breakfast SeminarFebruary 23rd, 2012

David CoadyFiscal Affairs Department

International Monetary Fund

The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy.

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Background

Recent volatility in food and fuel prices has highlighted the fiscal risks inherent in price subsidy programs

Although historically food subsidies have been more of a fiscal risk, more recently this mantle has been acquired by fuel subsidies

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A bit of Déjà Vu

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1/ Deflated by U.S. CPI

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Format of presentation

Recent policy responses to price volatility

The case for subsidy reform

Developing a subsidy reform strategy

Presentation will focus more on fuel than food, but issues and options are common

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Responses to fuel price increases between end-2008 and end-2011

Gasoline Diesel Kerosene

All countries:Advanced 133 124 …Developing 36 50 17Emerging 85 71 0

Total 164 162 44Passthrough less than 1 116 99 40Passthrough less than 0.75 99 85 36Passthrough less than 0.5 79 68 32

Passthrough (in percent)

Number of countries

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Responses to fuel price increases between end-2008 and end-2011

Gasoline Diesel Kerosene

All countries: 51 70 14Africa 30 45 17Asia and Pacific 45 71 …Europe 130 158 …Middle East and Central Asia 21 26 2Western Hemisphere 66 61 …

By oil trade:Import 116 99 40Export 79 68 32

Passthrough (in percent)

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Less then full-pass through led to lower tax rates (subsidies) in many countries

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…..and the fiscal cost has been substantial (% GDP)

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Some passthrough,

2008-2010

AFR 2.3 3.6 3.2

Taxes in 2008 2.3 3.6 3.2

AP D 0.3 1.5 0.9

Subsidy in 2008 0.3 1.8 1.1

Taxes in 2008 0.3 1.5 0.9

MCD 1.8 3.2 2.9

Subsidy in 2008 4.0 4.0 3.8

Taxes in 2008 2.9 2.9 2.4

WHD 0.8 1.9 1.3

Subsidy in 2008 2.4 3.4 3.4

Taxes in 2008 0.8 1.9 1.2

2011

Source: IMF staff estimates.

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Most of the benefit accrues to higher-income groups

Bottom 2 3 4 Top All households

Total Impact 7.1 11.4 16.2 22.5 42.8 100.0Total Direct Impact 7.1 10.7 14.0 19.9 47.6 100.0

Gasoline 3.0 5.7 9.7 19.4 61.3 100.0Kerosene 19.0 19.7 20.6 20.1 20.6 100.0LPG 3.8 7.6 12.6 20.8 53.8 100.0

Indirect Impact 7.3 11.7 16.3 22.6 42.0 100.0Source: Arze del Granado and Coady (2010)

Consumption QuintilesDistribution of Fuel Subsidies Across Income Groups

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Subsidies are inefficient

Low prices provide insufficient incentives to reduce consumption and worsen terms of trade impact

Absence of demand and supply responses increases volatility of world prices

Low prices can result in smuggling abroad, higher fiscal costs, and domestic supply shortages

High fiscal cost crowds-out high priority public investments in education, health, and infrastructure

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Developing a reform strategy I

Successful strategy needs to prepare population for reforms Identify clearly the size of the fiscal cost of

subsidies Link cost to crowding out of key public

investments which are crucial for growth and development (best way to protect most of population from high prices is through growth)

Highlight the high share of benefits going to higher groups and identify better ways of protecting poor

Identify inefficiencies of subsidies (smuggling, shortages, energy inefficiency)

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Developing a reform strategy II

Reform strategy needs to be set out in advance Identify key public investments that will benefit

from reallocation of budgetary savings Identify well-targeted programs that will be

expanded/created to protect the most vulnerable social groups

Prepare strategy for improving energy efficiency of most energy-intensive internationally traded industries (cement, fertilizer, metal products....)

This may involve appropriate monetary and exchange rate policies, investment incentives, and credit access, etc

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Developing a reform strategy III Sequenced and gradual reform approach may

be warranted if large price increases required (and fiscal conditions allow)

Instant adjustment of subsidies that mostly benefit the rich (higher quality foods, gasoline, jet kerosene and LPG?)

More gradual adjustment of other products to allow industry to adjust (e.g., diesel and LPG?)

Delay increase in fuels most important to poor (e.g., lower quality foods, kerosene)

But there is a limit to sequencing since large price differentials can cause market disruption (adulteration)

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Developing a reform strategy IV Develop strategy for reform of social safety net

Limit subsidies to products most important for lower income groups (low quality foods, kerosene)

Limit quantities of subsidized products Limit eligibility for subsidized products to lower income

groups (differential subsidy rates, means or proxy-means testing)

With improved targeting, consider switching from price subsidies to price-indexed cash transfers

However, subsidies and cash transfers address the symptoms but not the causes of persistent poverty

Consider developing conditional cash transfer programs

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Example of fuel subsidy reform:Indonesia, 2005-2008

Repeated increases in subsidies (reaching 5 percent GDP in 2005) necessitated large price increases

Prices more than doubled in 2005 (March, October) Prices increased by around 30 percent in May 2008

Implemented range of mitigating measures Introduced large temporary cash transfer program covering

one-third of households building on existing social safety net programs (both reforms)

Reallocated some budgetary savings to existing education, health, and infrastructure programs benefitting broader population

Initiated program to reduce kerosene use by increasing LPG use

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Developing a reform strategy V Addressing underlying causes of subsidies

requires new approach to pricing and not just ad hoc price adjustments

In Indonesia, subsidies kept recurring so political cost was achieved with only a short-term fiscal gain

First-best option is to liberalize fuel pricing and markets

However, adoption of an automatic pricing mechanism can serve as an interim approach while capacity to regulate liberalized market is developed

Turkey moved from an automatic pricing mechanism between 1998-2004 to liberalized regime in 2005, and from low to very high fuel taxation

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Example of fuel subsidy reform: Jordan, 2005-2008

Initiated gradual subsidy reform in mid 2005 Supported by range of targeted mitigating

measures, including investments in targeted transfers

Eventually decided to do instantaneous adjustment in February 2008 Fuel prices increased by between 33-66 percent Adopted an automatic pricing mechanism that

adjusts prices monthly in line with international prices

Mechanism implemented by a committee composed of representatives from ministries and refinery

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Jordan addressed the causes

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Automatic Price AdjustmentDiesel Prices in Jordan and International Prices

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Developing a reform strategy VII

Fragility of automatic pricing mechanisms often reflects reluctance to pass through large international price increases to domestic prices, especially if turn out to be temporary

However, a “wait and see” policy can result in escalating subsidies if international prices continue to increase eventually requiring large domestic price adjustments or entrenched subsidies

Incorporating a smoothing rule in the automatic pricing mechanism can help to avoid large price increases while protecting budget against subsidies recurring over the medium term, e.g.,

Pricing based on moving average of past international prices

Imposing a cap on maximum price adjustment allowed, e.g., +/- 3 percent of existing price

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Example of smoothing ruleJa

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International Price (right axis)Full Pass Through6-month moving average

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Summary of Main Messages

Price subsidies are inefficient, inequitable, and fiscally costly

Reform strategies can be strengthened through Information campaign informing public of

shortcomings of subsidies Clear program reallocating some budgetary savings to

crucial public investments (education, health, infrastructure) or even tax reform

Development of well-targeted safety net measures to protect most vulnerable households

Adoption of an automatic pricing mechanism (possibly with smoothing rule) until capacity for regulating liberalized market is developed

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Links to referenced and other work

IMF Board Papers http://www.imf.org/external/np/pp/eng/2008/063008.pdf http://www.imf.org/external/np/pp/eng/2008/091908.pdf http://www.imf.org/external/np/pp/eng/2008/090808a.pdf

Coady and others (2010) http://www.imf.org/external/pubs/cat/longres.cfm?sk=23584.0

Arze del Granado and Coady (2010) http://www.imf.org/external/pubs/cat/longres.cfm?sk=24184.0

World Bank Guidance on Policy Responses http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTSOCIALPROTECTION/EXTSAF

ETYNETSANDTRANSFERS/0,,contentMDK:21835036~pagePK:148956~piPK:216618~theSitePK:282761,00.html

Designing and evaluating social safety nets (Grosh and others, 2008; Coady, 2004)

http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTSOCIALPROTECTION/EXTSAFETYNETSANDTRANSFERS/0,,contentMDK:21925478~menuPK:282766~pagePK:148956~piPK:216618~theSitePK:282761,00.html

http://www.ifpri.org/publication/designing-and-evaluating-social-safety-nets-0