Evaluating the Fiscal and Social Cost of Fuel Subsidies

1. Evaluating the Fiscal and Social Cost of Fuel Subsidies Poverty and Social Impact Analysis (PSIA) Group Fiscal Affairs Department March 2006

2. Structure of Presentation • Background to PSIA on fuel subsidies • Objective of the PSIA studies • Methodology and data (five steps) • Examples of policy responses • Policy messages from PSIA

3. Background I: Market Structure • Most developing countries control the domestic pricing and distribution of petroleum products • Recent FAD survey found that from 48 countries • 16 had fully liberalized systems • 9 had functioning automatic pricing formulae (+8 suspended recently) • 23 had ad hoc pricing • Liberalized in Kenya, Tanzania, Uganda • Automatic in Ghana, Senegal, South Africa

4. Background II: Prices and Subsidies • World prices have increased >100% since 2000 • Controlled prices have resulted in rising budget subsidies in many countries (% 2005 GDP, projd.) • Yemen, 9.2; Jordan, 6.6; Indonesia, 3.2; 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, projd.) • Azerbaijan, 9.9 (2.8ex); Egypt, 4.1; Ecuador, 3.6; Bolivia, 2.3

5. Crude oil prices,1970-2005 ($/bbl)

6. Background III: Reform Agenda • Fuel subsidies seen as undesirable because • High fiscal cost with consequences elsewhere in budget (Indonesia: 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: Bolivia, Ghana, Jordan, Mali, Sri Lanka...expected to increase!...Angola, Bangladesh, Cameroon, Ethiopia, Gabon, Honduras, Madagascar, Nicaragua, Nigeria)

7. Objective of PSIA • To evaluate the social and fiscal cost 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

8. 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

9. Step I: Identify extent and “location” 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”

10. Fiscal and social cost 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 = (A+B+C)=Q(s)[P(m)-P(s)] • Where shows up depends on price to producer. If taxes, P(p), P(s) • Explicit import subsidy=(B+C) • Loss in profits=(A+D)+E • Tax revenue=(D+E) • Net fiscal position • On budget: (D+E)-(B+C) • Off budget: -(A+D+E)

11. Example from Ghana

12. 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)

13. Example from Ghana

14. 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

15. Example from Ghana

16. Example from Ghana

17. 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

18. Example from Ghana

20. Step V: Identify mitigating measures • Can consider a number of alternatives and simulate using household-level data • 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

21. Example from Ghana

22. Example from Sri Lanka • Subsidy Coverage, Level, and Targeting • Simulated Effect of Price Increases with Compensating Measures • Real Income Impact of Electricity Tariff Subsidies • Real Income Effects of Alternative Tariff Structures

27. 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

28. 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

29. 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 US$30/mth) • Annual cost estimated at RS.20 trillion • Additional “incentive package” also introduced

30. Policy messages from PSIA • Fuel subsidies are often substantial fiscal drain and badly targeted • So should be able to identify alternative approaches to social protection that provide same or better protection at substantially lower fiscal cost • Access to effective system for targeting expenditures can be a crucial component for promoting efficiency-enhancing structural reforms • Important to announce reforms as part of a package where budgetary savings will be used to finance an effective safety net as well as expand social and infrastructure 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 • PSIA provides very useful approach for highlighting shortcomings of fuel subsidies and providing insights into alternative approaches for protecting the poor and reallocating expenditures