The Magnitude and Distribution of Fuel Subsidies

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The Magnitude and Distribution of Fuel Subsidies

• David Coady
• PSIA Group
• Fiscal Affairs Department
• International Monetary Fund

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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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Structure of Presentation

• Background to PSIA on fuel subsidies
• Objective of the PSIA studies
• Methodology, data, impacts (five steps)
• Mitigating measures plus pro-poor and pro-growth
  expenditures
• Policy messages from PSIA

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Background I Market Structure

• Most developing countries control the domestic
  pricing and distribution of petroleum products
• Recent FAD survey found that from 48 countries
• 15 had fully liberalized systems
• 8 had functioning automatic pricing formulae (8
  suspended recently)
• 21 had ad hoc pricing

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Background II Prices and Subsidies(World prices
have increased substantially since 2002)
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Major Events and Real Price of U. S. Oil Imports,
19702006
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Background II Prices and Subsidies

• Controlled prices have resulted in rising budget
  subsidies in many countries ( 2005 GDP,
  estimated)
• Yemen, 9.2 Jordan, 5.8 Indonesia, 4.2 Bolivia,
  0.8
• Subsidy rates typically higher for kerosene and
  diesel as well as in exporting countries
• Countries often respond by decreasing taxation,
  so-called tax expenditures (especially kerosene
  and diesel)
• e.g. Bangladesh, India, Sri Lanka, Kenya, Zambia
• Implicit subsidies also often substantial and
  take form of quasi-fiscal deficit financed by
  debt (GDP2005, estimated)
• Azerbaijan, 13.9 (2.8ex) Egypt, 4.1 Ecuador,
  3.6 Bolivia, 5.2

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Explicit Subsidies (GDP)
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Implicit Subsidies (GDP)
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Pricing Regime (Selected Countries)
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Background III Reform Agenda

• Fuel subsidies seen as undesirable because
• High fiscal cost with consequences elsewhere in
  budget (Indonesia/Yemen subsidies exceeded
  combined health and education budgets)
• Inefficient leads to over-consumption
• Governments still reluctant to increase domestic
  prices in line with world prices
• Concerns about impact on poor and politically
  unpopular
• PSIA can inform choice of appropriate policy
  response (so far Angola, Bangladesh, Bolivia,
  Ethiopia, Gabon, Ghana, Honduras, Jordan,
  Madagascar, Mali, Moldova, Sri Lanka, Sudan)

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Objective of PSIA

• To identify the magnitude and financing of
  consumer subsidies
• To evaluate the aggregate and distributional
  incidence of their withdrawal on household real
  incomes
• To identify appropriate mitigation measures to
  offset adverse impact on poorest households
• To identify higher priority public expenditures
  (more pro-poor and pro-growth)

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Methodology and Data

• Higher domestic prices affect consumers through
  two channels
• Direct effect from increase in price of fuels
  consumed by households
• Indirect effect from increase in prices of goods
  and services that use fuel as inputs
• Indirect effect often substantial since over 50
  percent of total consumption of fuel is as
  intermediate product

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Step I Identify magnitude and financing

• This requires a reference price for each product
  and required price increases
• For most countries, border (cif,fob) price
  (plus,minus) domestic trade and transport margins
• Often existing or desired tax levels included in
  reference price to allow for tax expenditures
• Average price increase ranged from 34-68 percent
  (mostly including taxes)

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Magnitude and Financing of Subsidies

• Domestic refinery that imports product
• Import at P(m), produce at P(c)
• Subsidized domestic price is P(s)
• Produces Q(c), imports Q(s)-Q(c)
• Total consumer subsidy (ABC)Q(s)P(m)-P(s)
• Where shows up depends on price to producer. If
  taxes, P(p), P(s)
• Explicit import subsidy(BC)
• Loss in profits(AD)E
• Tax revenue(DE)
• Net fiscal position
• On budget (DE)-(BC)
• Off budget -(ADE)

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Cameroon More Transparent Formula
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Sri Lanka Eliminating subsidies required
gas (12), diesel (20), kerosene (58), average
(23)
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Step II Calculate direct effect

• Need household survey with information on
  different fuel expenditures
• For each household, calculate budget shares as
  expenditure on fuel divided by total household
  consumption
• Multiply required price increases by budget share
  to get approx. real income impact
• Look at distribution of percentage real income
  effect across income groups (regressive vs.
  progressive)

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Example of fuel consumption patterns in Sri Lanka
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Magnitude of direct effect

• Fuel budget shares varied from 2-4.3 percent
  (3.1-6.6 percent including electricity)
• Therefore, a 50 percent increase in average price
  implies a 1-2.1 percent (1.6-3.3 percent)
  decrease in real incomes
• Fuel budget shares for lowest welfare quintile
  varied from 2-6 percent (2.7-7.1 percent)
• Therefore, a 50 percent increase in average price
  implies a 1-3 percent (1.4-3.6 percent) decrease
  in real incomes
• Direct effect found to be either neutral of
  regressive
• Reflects importance of kerosene, which is
  typically relatively heavily subsidized

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Step III Calculate indirect effect

• An input-output table and a simple model can be
  used to calculate the increase in prices for
  other goods and services from higher fuel costs
• Aggregate household consumption data to get
  budget shares for input-output sectors
• Multiply budget shares by percentage price
  increases to get percentage real income effect
• Aggregate to get total indirect effect and look
  at distribution across different income groups
• Add to direct effect to get total impact of fuel
  price increase on household real incomes and
  distribution

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Example from Ghana
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Magnitude of indirect effect

• Indirect effect at least as large as direct
  effect and approximately neutral incidence
• A 50 percent average increase associated with a 3
  percent decrease in real incomes
• Most of indirect effect comes through higher food
  and transport costs

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Magnitude of total effect

• Total effect ranged from 2-8.5 percent
• A 50 percent increase associated on average with
  a 4.6 percent decrease in real incomes
• Distribution typically regressive reflecting role
  of higher kerosene price increases

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Step IV Evaluate targeting efficiency

• Calculate the share of the total subsidy (or,
  equivalently, the burden of subsidy removal)
  accruing to each income group
• Can do this separately for each product as well
  as the direct, indirect and total effects
• Individual product shares useful later when
  comparing alternative approaches to protecting
  the real incomes of low-income households

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Fuel subsidies are badly targeted

• A relatively high share of total fuel subsidies
  go to higher income groups
• Share of bottom two quintiles varied from 15-25
  percent (so 75-85 percent of subsidy benefit
  accrues to top three quintiles)
• So costs 4-6.7 units of income for every 1 unit
  transferred to bottom two quintiles
• Even direct (mainly kerosene) subsidy is badly
  targeted
• Between 70-80 percent leaks to top three
  quintiles so costs 3.3-5 units of income for
  every unit transferred to bottom two quintiles

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Step V Identify mitigating measures

• Although badly targeted, withdrawal of fuel
  subsidies can have substantial adverse effect on
  poor (c2-9)
• Can consider a number of alternatives and
  simulate using household-level data (budgetary
  cost minimized by better targeted
  transfers/expenditures)
• Gradual withdrawal of specific fuel subsidies
  (kerosene, LPG) to minimize revenue-poverty
  trade-off
• Using some of budgetary savings to finance
  targeted public expenditures (education, health,
  roads, transport, electricity)
• Restructure electricity tariff schedules to
  reduces cost for poor
• Use savings to finance existing/reformed/new
  social safety net for poorest households

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Example from Ghana
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Example from Sri Lanka

• Kerosene subsidies
• Use of electricity lifeline rates
• Potential benefits from restructuring tariff
  schedule
• Use of existing Samurdhi transfer program
• Highlight performance level of existing program
• Emphasize gains from reforming design and
  implementation

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Even kerosene subsidies involves substantial
leakage to the non-poor
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Share of Gasoline Burden (Cameroon)
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Share of LPG Burden (Cameroon)
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Alternatively could subsidize electricity.......
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......but these appear badly structured.....
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.....and involve very substantial leakage to
non-poor
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The Samurdhi program reduces leakage
substantially.........
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....and potentially provides a more
cost-effective approach to social protection
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Bottom 2nd Quintile 3rd Quintile 4th Quintile Top All
Kerosene Subsidy
Coverage 0.777 0.689 0.687 0.618 0.449 0.644
Coverage Share 0.211 0.204 0.212 0.201 0.173 1.000
Avg effect 0.017 0.011 0.009 0.007 0.003 0.010
Amount share 0.211 0.199 0.198 0.215 0.177 1.000

Samurdhi Food Stamps
Coverage 0.634 0.512 0.454 0.328 0.125 0.410
Coverage Share 0.276 0.237 0.227 0.179 0.081 1.000
Avg Effect 0.023 0.013 0.010 0.006 0.001 0.011
Amount Share 0.287 0.241 0.233 0.173 0.065 1.000

Proxy Means Food Stamps
Coverage 0.825 0.566 0.395 0.204 0.033 0.405
Coverage Share 0.391 0.281 0.203 0.105 0.020 1.000
Avg Effect 0.033 0.016 0.009 0.004 0.000 0.012
Amount Share 0.391 0.281 0.203 0.105 0.020 1.000
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Mitigating Measures Ghana

• Introduced formula in January 2003 with 90
  percent price increase.
• But formula abandoned and subsidies of 2.2
  GDP2004
• February 2005 introduced new formula and set up
  National Petroleum Authority (broad stakeholder
  group) to depoliticize implementation.
• Prices increased in March/June/August/October
  2005 and initial moves to liberalizing markets
  (import tendering)
• Announced range of mitigating expenditures
  (financed by mitigating levy in formula)
• Removal of fees for primary and junior secondary
  school
• Increased investments in mass urban transport
• Expansion of rural electrification scheme

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Mitigating Measures Jordan

• In 2004 subsidy of 3.2 percent GDP, projected at
  8.5 percent for 2005
• A 68 percent increase in prices (including taxes)
  needed to eliminate subsidies
• Price increases would lead to 4.4 percent
  reduction in real incomes (5.4 for bottom
  quintile)
• In July 2005 increased prices by over 25,
  reducing subsidies to 3 annual basis
• Introduced range of mitigating measures
• Raised minimum wage and increased salaries for
  low-paid state employees
• Maintained lifeline electricity tariff
• Provided one-time bonus to government employees
  and pensioners earning less than JD400/month
• Will increase when targeting is improved
• LPG, diesel, kerosene prices expected to reach
  import parity by March 2007 and intend to
  liberalize thereafter

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Mitigating Measures Indonesia

• Ad hoc system froze prices between 2002 and
  February 2005, when subsidies grew to
• gasoline (58), diesel (60) and kerosene (88)
• Prices increased by 29 in March 2005 and planned
  increase of 30 in October
• Announced 114 increase in October resulting in
  subsidies
• gasoline (20), diesel (23), kerosene (67)
• Subsidies projected to be 3.2 GDP2005 and 1.8
  in 2006
• Introduced unprecedented cash transfer program
  delivered through Post Office
• Coverage of 15.5 million poor families (60million
  persons)
• Each family to receive Rp.300,000 every 3 months
  (around US30/mth)
• Annual cost estimated at RS.20 trillion
• Additional incentive package also introduced

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Policy messages from PSIA

• Fuel subsidies are often substantial fiscal
  drain, crowd-out priority expenditures and badly
  targeted
• So should be able to identify alternative uses
  that are more pro-poor and pro-growth
• Alternative approaches to social protection can
  provide same or better protection at
  substantially lower fiscal cost
• Higher priority public expenditures (nutrition,
  health, education, infrastructure) e.g. based
  on PRSP
• Access to effective system for targeting
  expenditures can be a crucial component for
  promoting efficiency-enhancing structural reforms

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Policy messages from PSIA

• Important to announce reforms as part of a
  package budgetary savings to finance better
  targeted, higher priority expenditures that
  benefit low- and middle-income households
• Gradual reduction of better targeted fuel
  subsidies should be seen only as short term
  measure are developed since revenue-poverty trade
  off is large and efficiency cost from inter-fuel
  substitution large