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 deficitThe 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.
Tyranny of numbers 
Thank you for your reply. Yes now that makes sense.
But still the logic behind some parts of your article is not very clear to me. Your suggestion about setting discriminating prices (among gas stations, car makes, etc.) basically entails setting prices by the government and not the market. This could be an acceptable short-run solution. But this could also be followed by all sorts of price setting complications: people driving all the way to cheaper gas stations (which could even raise the total gas consumption), a black market for smart fuel cards coming to existence (since richer people will have an incentive to by cards of those with cheaper cars) and the net result might be little or no reduction in fuel consumption/subsidies, not to mention the corruption that could follow.
So my question is, why not advocating a free market mechanism for the supply side of the fuel which would lead to some natural price discrimination and, if the government wants to raise some revenue from richer people, charge it as some kind of non-linear consumption tax? Even if freeing up the market at once is not possible, encouraging the government to take steps toward that ideal might better pay off in the long run.
Dear Djavad,
About your recent article in Donya-e-Eqtesad where you suggest voluntary giving up of their subsidy stipends by richer households as a way to reduce budget deficit, I am wondering how could that actually reduce the deficit, since you are not decreasing the costs but solely spending the same amount of money on different expenditure. That is, instead of paying out cash to wealthy households, by your proposal, the government spend the same money building schools, etc. So other than improving “social capital” I don’t see how this can help reducing budget deficit.
That is a very good question, and thanks for spotting the possible
omission. I certainly had made it clear in the english version that I
wrote first the donations of subsidy money should substitute for
government expenditures intended for those purposes — education and
health infrastructure. Perhaps it got left out in the translation. For
those who did not see the post, here is the link:
http://www.donya-e-eqtesad.com/news/765815/
Ultimately, this is not the biggest part of the deficit, because it is
about 5% of the total expenditures and diminishing at the speed of 20-30%
per year. So it is not a problem in the longer run, whereas freezing of
energy prices is.
May I make two practical observations that hopefully have nothing to do with any conspiracy theories?.
First: From personal experience, I can confirm that all cement producers in Iran would prefer to use natural gas, piped to their plants, over heavy fuel oil (HFO) which is sold F.O.T. and has to be hauled to the plant and needs costly warming to transfer into huge storage tanks. Natural gas is desirable even at a premium of 20% over heavy fuel oil of the same BTU content. Yet the new Rouhani team of economic minded technocrats, continue to sell natural gas delivered to all industrial plants at a 70% discount relative to BTU equivalent of heavy fuel oil! Why so? When already HFO is the cheapest selling extract of oil derived fuels like petrol and diesel. Just correcting this discrepancy, without increasing any other fuel price would bring in Rls 300,000,000,000,000.- additional revenues without increasing prices at petrol stations. In many rural areas poor people are today using diesel to warm their houses, which is more expensive than the suggested correction price for natural piped gas. I suggest you ask Mr. Zangane for a plausible reason or I would have to come up with my favorite conspiracy theory that could point out to the involvement of many cabinet associates in the petrochemical industry, where products from gas are sold in hard currency.
Second: Since you rightly state that richer people are the real beneficiary of dirt cheap energy prices, why bother to find out where they live or even who they are; just increase energy prices, collect the revenues, set 30% aside and divide the rest equally among the population. Surely the lower income people would gain, we richer creatures are not the types to set fire to pump stations, and besides the hole in the budget would more than be fixed by the saved 30%. Q.E.D. Or, there is a hole in my simple minded reasoning?
Why not doing a similar thing with cash transfers? Why is it so impossible to identify the people who live in certain neighborhoods and just ask for their IDs (Melli cards) and then cut their cash transfers? Making a database may take some time, but it should be doable?
There is a strong geographic dimension to income but in most well-off areas there are also people who are poor –unemployed, retired, and divorced– so denying payments based on location will be very unfair. However, asking people to pay more for gasoline bought in a rich neighborhood or if they own a late model car above a certain value or for high grade gasoline is much less unfair.
My idea (be it practical or not) was mainly that in wealthy neighborhoods they could go door to door for houses which seem above a certain value, and ask for the ID (melli card) of the owner of the house and then make a database based on that cut their cash transfer. They seem to be able do this with satellite dishes, so I thought perhaps with half the effort that they put on that, perhaps they can make something useful. A similar thing can be done on the streets with high-end cars; they used to do it for checking alcohol, again with half the effort on something actually useful they should be able to make a database.
So you’re saying the Rouhani administration should effect targeted higher prices and a higher cost of living upon their own political base of support: the upper-middle and upper class of Iran. Yes, you’re right, that would require quite a bit of courage.
Courage, indeed. But that is what good governance is all about, delivering something good at a price. I think the people, especially Rouhani’s political base, are tired of populist promises that are not deliverable in the end. If he presented his case the right way and asked them to help him close the gap in a program that he supports, they would understand. In any case, the cost to them is relatively small.
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The so called ‘upper middle class’ in Iran is tied directly or indirectly to the extensive bureaucracy and their relative access to indirect subsidies, hung around for people ‘tall’ enough to pick. The cover being rejection of liberal economics and the heresy of ‘ the invisible hand’. Ulyanovsky has been the invisible hand guiding the subsidy-mongers.
According to Felix Imonti of oilprice.com, a similar situation resulted in a ‘national’ uprising by 6 million bureaucrats and their families, resulting in a military coup in Egypt, and a gift of 15 billion dollars to the generals by KSA to re-establish the old order. See “Egypt for Sale.”
Oh, another Russian-spun oil conspiracy theory. The world looks crazy enough to me without their theories.