When prices wobble subsidies’ balance

Petroleum product subsidies have again started to rise with the slow recover of international prices. This note reviews recent developments in terms of subsidy levels and argues that it is necessary to reform the policy framework for setting petroleum product prices in order to reduce the fiscal burden of these subsidies and to address the market change

In 2003, global consumer subsidies for petroleum products totaled nearly $60 billion. They are projected to reach almost $250 billion at the end of 2010. Tax-inclusive subsidies, reflecting suboptimal taxation, are estimated to be much larger—$740 billion in 2010, or 1 % of global GDP. The G-20 countries account for over 70% of tax-inclusive subsidies, with emerging G-20 countries accounting for a sizable share. Halving tax-inclusive subsidies could reduce projected fiscal deficits by one-sixth in subsidizing countries and could reduce greenhouse emissions by around 15% over the long run. Subsidy reform strategies should contain measures to mitigate the impact of higher prices on the poorest groups.

Petroleum product subsidies have increased in recent years and many countries did not fully pass through the sharp increases of international petroleum products prices that occurred in 2007 and early 2008, resulting in a marked increase in subsidies. After declining of oil prices during the second half of 2008, subsidies have again started to rise, renewing concerns about the fiscal costs. These concerns have been reinforced by the need in many countries to formulate an exit strategy from the recent crisis-related accumulation of public debt. The international community has also targeted the reform of fossil fuel subsidies as part of efforts to confront global warming, with the September 2009 G-20 Pittsburgh communiqué calling for a gradual get rid of these subsidies.

Subsidy reform scenarios
A-Targeting mitigating measures
Compensating the poor for eliminating subsidies requires a system to deliver compensation to the needy. Because it may not be feasible to quickly put in place efficient safety nets based on targeted cash transfers, a gradual reform strategy may initially be needed. This could include the following steps:

1- Temporarily maintaining universal subsidies on commodities that are more important in the budgets of the poor: for instance, kerosene subsidies are relatively better targeted. However, there is a limit to how much can be achieved through lower kerosene prices without severe disruption of petroleum product markets (for example, redirection of kerosene from the household sector to the transport sector for mixing with diesel, or cross-border smuggling).

2- Introducing a package of short-term measures to mitigate the adverse impact of price increases on the poor: this includes existing programs that can be expanded quickly, possibly with some improvements in targeting effectiveness (for instance, basic food supplies, education and health user fees, subsidized mass urban transport, cash transfers to vulnerable groups, subsidies for consumption of water and electricity below a specified threshold).

3- Identifying high-priority public expenditures: They can include education and health expenditures as well as infrastructure expenditures such as roads and electrification schemes.

4- Improving the design of safety net programs over time: This includes “targeting by using socioeconomic and demographic characteristics”, such as the elderly, children, or the unemployed (categorical targeting), or those living in specific areas (geographic targeting); and also linking subsidies or cash benefits to a self-targeting work or school requirement.

5- The appropriate reform depends on several factors: the political and administrative capacity of the country and its fiscal and macroeconomic situation (for example, risks to growth and inflation).

B-Promoting transparency
Petroleum subsidies should be recorded transparently in government accounts. Where these have fiscal consequences, they should be incorporated into the budget on a gross basis and explicitly identified. Off-budget subsidies should be identified and recorded in separate accounts; this may require improvements in the budget classification system. Arrangements whereby oil companies provide subsidies to consumers without explicit budget support should be clearly described and evaluated in budget documents (IMF, 2007). Transparency is also important for oil-exporting countries, for whom the opportunity cost of subsidies is the revenue forgone by not charging international prices domestically (oil producers that have recorded subsidies explicitly in the budget include Indonesia, Iran, Malaysia, Sudan, and Yemen).
Even subsidies, with no fiscal costs, should be measured and analyzed and reported in budget documents. Some subsidies do not affect government finances. A ban on exports of a particular good reduces the domestic price. This leads to a price subsidy for domestic consumers financed by producers. By contrast, an import tariff raises the price received by domestic producers, resulting in a producer subsidy financed by consumers.
Also, some countries have implemented specific subsidy reporting systems designed to help raise public awareness. Germany has published Biannual Subsidy Reports for many years. Switzerland has implemented an online subsidy database, in which individual subsidies are recorded.

C-Overcoming vested interests
Public information campaigns can help overcome vested interests. Public information should aim particularly at informing the potential beneficiaries (consumers and taxpayers) about the drawbacks of existing subsidies and the benefits of reform. When relevant, governments should also highlight that subsidies promote smuggling, shortages, black market activities, and corruption. Regarding the drawbacks of subsidies, in 2005 the government of Ghana used the finding of a Poverty and Social Impact Analysis that petroleum subsidies go predominantly to high-income groups to convince the public of the need to raise petroleum prices.

D-Addressing spillover effects
Cross-border spillovers of petroleum subsidies can operate in many ways. Subsidies alter trade patterns and divert benefits from their intended recipients. Low domestic petroleum prices provide incentives for smuggling, which benefits consumers in other countries. Subsidies for intermediate inputs may also be passed through to the prices of exported goods. Another important cross-border effect relates to environmental spillovers, including from global warming. Finally, lack of pass-through of international prices to domestic prices can have effects on global demand; lower domestic prices increase demand, which can further raise international prices.
Because of these international spillovers, removing petroleum subsidies can benefit from multilateral cooperation. When externalities are global, as with climate change, benefits of (potentially costly) unilateral action are limited. If other countries fail to take similar action, the gains are limited; if other countries do act, it can be in a country’s perceived interest not to join in (the free-rider problem). Therefore, international cooperation in the area of subsidy policies is desirable.

E-Reforming price-setting mechanisms
Government direct control of domestic petroleum prices has often been an obstacle to subsidy reform. Even if these prices are initially set or adjusted to eliminate subsidies, these can reemerge if prices are not adjusted to reflect market conditions. Reform of the pricing mechanism is thus essential in reforming petroleum subsidies.
The first-best solution is to liberalize petroleum prices, which helps depoliticize petro

leum product pricing. In regulated
environments, people tend to see domestic prices as under the government’s control and therefore to blame the government for price increases. There is evidence that liberalized regimes tend to be more politically robust than automatic pricing formulas. However, liberalizing prices requires preparation. For example, some refineries have been established under concession conventions, which would make it difficult to liberalize the market before the concessions expire.
Also, If markets are imperfect or if governments are concerned about excessive price volatility, they can implement an automatic pricing mechanism that adjusts prices regularly in light of changes in international prices. Often, the pricing formulas are designed to smooth the pass-through of international prices to domestic prices. Smoothing mechanisms include moving averages, price adjustment ceilings and/or triggers, and price bands. Countries that have implemented formula-based mechanisms (in some cases temporarily) include Bolivia, Chile, Republic of Congo, Dominica, Ghana, Gabon, Pakistan, Peru, South Africa, and Sri Lanka. However, such pricing formulas have often been suspended in the face of opposition to price adjustments. It is likely that the factors that promote subsidy reform more generally also promote the elasticity of pricing mechanisms.
Giving the example of the Middle East and North Africa, in Morocco, Tunisia, Egypt, Jordan, and Syria— North Africa and Middle East’s oil importing countries—budget deficits are on the rise, as are demands for employment, health, education, and social protection. Nonetheless, the governments of these countries continue to allocate a high share of government expenditure to consumption subsidies, crowding out investment in other significant public services. Fuel subsidies, which account for the majority of consumption subsidies in Egypt, Morocco, and Syria, benefit the rich more than the poor. With oil prices rising and the OIC’s fiscal space having narrowed since the last price hike, the burden of these fuel subsidies on government budgets is growing more acute. Jordan, Syria, and, to some extent, Tunisia have cut down on them, but Egypt and Morocco continue to avoid reforms. Reforming the fuel subsidy system is inevitable, however, as fiscal room for them is no longer sufficient. By postponing action, policy makers are wasting valuable fiscal resources, engaging in regressive policies, and worsening their economic prospects.
Reforms in Jordan and Syria

Jordan, Syria, and, to some extent, Tunisia are ahead in their efforts to reform fuel subsidies:
• Jordan: An IMF study in 2005, which found that the poorest 20% of the country’s population received less than 10% of total fuel subsidies, while the richest 20% received more than 40%, helped the country make the case for phasing out fuel subsidies by 2008. Since then, Jordan has implemented an automatic price adjustment mechanism to pass world oil prices on to consumers.
• Syria: In 2008, the country increased the domestic market prices of most petroleum products, saving 7% of GDP in implicit subsidies. In parallel, the government issued coupons to each household for up to 1,000 liters of diesel at one-third of the market price. In 2009, targeted cash transfers, for which approximately half of Syrian households are eligible, replaced the coupons.
• Tunisia: In January of 2009, the country launched a new fuel pricing mechanism that partially reflects the movement of international oil prices in the domestic market.
In both Jordan and Syria, policy makers also adopted measures to mitigate the impact of higher fuel prices on low-income households. Jordan increased the minimum wage and salaries for low-paid state employees. Government employees and pensioners earning less than $560 per month received a one-time bonus. In Syria, the government raised public sector wages.
Egypt and Morocco need a stand
Policy makers in Egypt and Morocco need to shift scarce fiscal resources from fuel subsidies to public investment and sectors with high social payoffs, such as health and education. While they agree on the need to replace universal fuel subsidies with cost-effective, targeted approaches. However, policy makers should learn from the successful removal of fuel subsidies in other countries, like Jordan and Syria, and plan the phase-out around three pillars:
• Building Public Support: First, policy makers need to highlight the shortcomings of fuel subsidies, their excessive budgetary cost, and their variation of distribution, which hurts the poor.
• Gradual Implementation: Second, they need to gradually, but steadily reduce the fuel subsidies. This is particularly critical in Egypt, where the gap between the subsidized and market price is so far big.
• Mitigate the Impact on the Poor: Finally, policy makers have to set credible commitments to ease the impact on the poor. Egypt can commit to increasing the minimum wage in both the government and the private sector. Over four million Egyptians work for the government and 1.3 million work in the public sector, yet the minimum monthly salary for public sector workers is around $620. Egypt spends as much money on consumption subsidies as on remunerations of civil servants. Extending health insurance to the poor is another relevant policy alternative. Less than 20% of the poor in Morocco are insured, while in Egypt ambitious governmental plan will cover 80%, which never exists in North Africa, and some Middle East countries.

The following table illustrates the trend of gasoline and diesel prices of 40 country in local currency and US$:
The above table shows that fuel prices in most countries are moving up and down, while in Egypt, prices never goes up or down, which represent a heavy burden on petroleum sector budget. Petroleum Sector is solely responsible for subsidizing petroleum products without any support from the government. But started finally to declare the painful subsidies figures which reached to 12 billion US$ during the current fiscal year and will increase yearly by 7% approx. Gradual cut down of subsidies is inevitable and cannot continue forever.

Gasoline and diesel prices per liter in local currency

Country Gasoline Diesel Valid date
Local price Price in US$ Local price Price in US$
China 6, 46   ,95 6,23  ,92 04/2010
Egypt 1.75   ,31 1,10  ,19 05/2008
Greece 1,50 1,95 1,40 1,82 06/2010
India 57,51 1,30 49,41 1,12 07/2010
Iran 4000  ,40 2500   ,25 06/2009
Iraq 400  ,34 400  ,34 06/2009
Jordan ,80 1,13 ,73 1,03 09/2009
Morocco 10,65 1,19 7,65  ,85 04/2010
Nigeria 70   ,46 N.A N.A 12/2009
Russia 21,65   ,80 19,43  ,72 01/2010
South Africa 7,30  ,72 8,27   ,81 11/2008
Syria 40  ,86 25   ,54 09/2009
Tunisia 1,27  ,99 ,91   ,71 09/2009
Canada 1,01 1,01 1,27 1,27 06/2010
France 1,42 1,84 1,12 1,45 12/2009
Germany 1, 46 1,90 1,24 1,61 06/2010
Italy 1,46 1,90 1,20 1,56 07/2010
Japan 135 1,59 102   ,86 06/2009
UK 1,13 1,76 1,07 1,66 06/2010
US   ,73   ,73 1,60 1,60 09/2010

By Mostafa Mabrouk, Vice Chairman Assistant for Economic Affairs, Ganope


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