Saving the subsidy reform program
Ever since it took over the reigns of government in August, President Rouhani’s administration has been grappling with the challenge of closing the huge gap in the government budget that it has inherited from its predecessor, reportedly at about 800 trillion rials (about $33 billion) or more than one third of planned expenditures. This is no small challenge given the fact that half of the year is over and much of the expenditures have already taken place or been committed. So, to reduce the deficit the government has little choice but to raise revenue. Luckily, inflation started to slow down just before Rouhani took over and has stayed below the 20% annual rate for the last three months, down from twice that rate in previous months. The bad news is that the most praiseworthy of the Ahmadinejad programs, the subsidy reform, is in deep deficit. The program has other problems besides its revenue gap, but it is on life support and the chord will be cut unless this problem is taken care of. Good solutions are there, all involving further adjustment in prices, but to implement them the government needs to show courage. The idea that has been floating for some time to cut the payments to richer consumers is appealing but not practical.
The government wants to delay the implementation of the so-called Phase 2 of the program, which calls for modest price increases of less than 40%. Perhaps it is buying time for some good news on the sanctions front. But delay in the worst option and abandoning the reform is no option at all. The longer we wait the more painful would be the necessary price adjustment.Why subsidy reform?
The program that was launched 2.5 years ago served several important goals: to raise the price of energy to global levels to prevent waste of energy (reducing waste of time behind the wheel in urban traffic, a bonus) ; to prevent further environmental destruction (save the air that city people breathe and the rapidly disappearing groundwater); and to replace highly regressive subsidies (most of them were and still are going to the rich) with a cash transfer scheme.
In addition to these benefits, the elimination of energy subsidies will contribute to solving Iran’s more serious employment problem. Higher energy prices would increase the value of labor and human capital relative to energy and physical capital by putting Iran’s production structure on a more rational basis. Cheap energy encourages producers to use more physical capital at the expense of labor and human capital. They employ fewer workers per unit of output, which means you can have economic growth without job creation, something Iran experienced since 2006 when the economy grew at more than 6% while jobs growth was practically nil. Human capital also gets a short shrift in an economy with cheap energy. Producers learn to compete, both in export markets and domestically with imports, using the advantage offered by subsidized energy rather than the nation’s supply of skilled workers. When producers start looking for workers with global skills, more people will seek them, rather than chase useless diplomas.
These benefits come with a substantial cost, of course, but those are one-time and unavoidable. Postponing the adjustment in energy prices makes it only more painful. Iranians have borne much of these costs once, in 2011, when prices rose multiple times. Inflation spiked and the economy went into shock. They do not need to go through that again.
Much of the opposition to the reform came from the middle class that never liked the Ahmadinejad government to begin with, and there was also much confusion about its actual impact. The reform’s shock was closely followed by a supply shock and a foreign exchange crisis due to international sanctions. The program’s financing gap made it an immediate culprit for the high inflation that hit the country a year ago. More research will clear up some of this confusion and dispel some of the more outlandish claims against it (such as this one, which claimed more than half a million agricultural workers have quit their jobs because of the cash subsidy, presumably too rich to work). But the program cannot wait for research results.Fixing the program’s deficit
The program’s deficit was first announced by the new economy minster, Ali Tayyebnia, to be about 100 trillion rials (TR) annually, which is only 1/8th of the deficit and 5% of all expenditures. Yesterday, he was quoted (link in Persian) as painting a much bleaker picture — revenues of 15 trillion TR per months against cash transfers of 35 TR. We have to wait to get the final story on this one, but whatever the size of the gap, it needs to be fixed by increasing the price of energy while keeping the amount of cash transfer per person constant.
One proposal that was seriously debated in the majles, and was wisely rejected by the government yesterday, is to stop the cash payments to the top three deciles of the income distribution. This would largely fix the financing gap of the program and would also improve its equity. This would be a win-win solution if the government could identify the 25 million Iranians who do not deserve a cash transfer. After all, they are already collecting subsidies in energy (yes, they are back in doing that), university education, bank loans, government contracts and jobs, and more. Without a reliable reporting system for earnings and taxes, trying to identify families above a certain level of income is socially disruptive and not worth the cost. The Ahmadinejad government tried to do that in 2010 and failed. There is no reason to think that this time will be different.
There are solutions that are easier to implement and promote efficient use of energy at the time. The top 30% richest Iranians probably consume about half the gasoline in Iran, which would roughly amount to 30 million liters per day. If they would pay half as much as their Turkish neighbors for gasoline, my rough calculations shows that the government could raise another 10 TR per month, which would cover the annual gap of 100 TR first noted by the economy minster. With similar increases in prices of natural gas, electricity, and water for bigger consumers and in richer neighborhoods, enough money could be raised to close even the larger reported gap. These people can be identified by the type of car they drive and where they live.
Another scheme that also takes advantage of geography and is much easier to implement if for gas stations in different neighborhoods to charge different prices. There is no reason on earth why someone in Niavaran, one of the richest neighborhoods in Tehran, should pay the same for gasoline as someone in Saravan in Sistan and Baluchestan. With the ratio of land prices in the two places in the hundreds, this makes absolutely no sense. Gasoline prices in Manhattan are one and a half times those in my small university town in Virginia because it costs that much more to deliver the product to cars in Manhattan than in Blacksburg.
Besides revenue shortfall, the reform has other problems that need fixing, such as making the cash payments conditional on children’s school attendance, putting part of the money in matching funds for community development, and the like, but those are ideas for another post.