Tyranny of numbers

Reform of energy subsidies

Posted in General, Inequality, Poverty by Djavad on October 22, 2009

At long last and after decades of talking about doing something about the subsidies, there is a bill before Iran’s majlis to target (but not remove) subsidies.  I could not locate the bill itself but my impression is that it only addresses energy subsidies and not other subsidies such as food and medicine.  So far only 5 of the bill’s 14 articles have been passed, but the government already has the mandate to raise prices on energy products over the next five years.  The bill has been criticized from both the Right and the Left, which leads me to think it must be a move in the right direction. Opponents of the bill criticize it for its potential to increase inflation and poverty, and proponents think it can end waste while reducing poverty.   Inflation is not a necessary outcome but it should be taken for granted that it will rise as energy prices are adjusted upward.  Much depends on the speed of the adjustment and the extent to which the Central Bank accommodates the price increases.  The bill allows the government to raise prices to generate revenues of $10-20 billion (for roundness, in this post I use $1=10,000 rials) per year.   It limits the total revenues raised instead of individual price increases. So, there is room for gradualism that could ease its inflationary impact. 

The subsidy reform has the potential to reduce poverty because about half of the revenue it raises is to be distributed back to the poorer half of the population.  An average family of five can expect roughly $1000-$2000 per year, which is a significant sum  given that families below the median spends on average about $4000 per year ($3800 in 2007).  The cash-back part of the bill explains the striking fact that a measure to remove subsidies, a policy that is more often associated with the so-called neo-liberal thinking, has received strong support from the Ahmadinejad government, which is not known for its pro-market stance, but has been opposed by more liberal politicians.   Both sides seem to focus on the redistribution part of the bill because it can win hearts and minds for whoever is in charge of the redistribution, but who knows how the price increase will go down politically.

Greater equity and poverty reduction are only potential benefits, not certain by any means.  The devils are in the details, which I will explain after reviewing a bit of history. 

General subsidies have been a big part of the welfare state in post-revolution Iran.  They grew out of the rationing system during the war and the government’s committment to the poor, and over time increased in volume, especially for energy products as world energy prices increased while consumer prices in Iran stayed low.  The results have been both good and bad.  Food and medicine subsidies have played an important role in increasing child nutrition, lowering child mortality, both of which contributed  to lower fertility (and hence the modernization of the average Iranian family).  The important role of subsidies in these transformations becomes evident when we note that they started in the mid 1980s when the economy was still in a very bad shape –that is, they are not the consequence of economic growth as in other countries.   

The worst part about general subsidies is waste.  Iranians throw too much food away, take too many pills, and pollute with inefficient use of energy.  Energy subsidies have become especially large in the last decade as oil prices skyrocketed.  I remember that about 18 years ago when I gave a talk on energy subsidies at Iran’s Institute for International Energy Studies, people were amused to hear that someone was worrying about energy subsidies in oil rich Iran.  I estimated energy subsidies about $5 billion for 1993, when food and medicine subsidies were $3.2 billion.  (That study was published by the Oxford Energy Institute and a version appeared in an edited book.)  The latter has not changed much while energy subsidies have grown to $50 billion! Add to that the realization that energy subsidies go mostly to those above the median income and cause pollution and you get a consensus to do something about them, which is why both Khatami and Ahmadinejad governments agreed on this one issue. 

General subsidies for food and medicine are not the best way to raise the living standards of the poor but they are effective in raising their nutrition and health.  They target needs rather than the needy.   They are favored when identifying the needy is difficult and intrahousehold allocations of expenditures favor the adults males in the family.  Economists often advocate cash assistance in place of general subsidies, but if you do not know who the poor are general subsidies is the only way to reach the poor.  Even when you can identify the poor (by where they live, for example), money given to the head of a poor family may not be spent on child nutrition and education.  This was an important finding in the development literature a couple of decades ago, that money from foreign aid given to men was more likely to go to adult male goods (such as beer and tobacco) than to milk, children clothing, health, and education, which are considered female-type goods. 

The targeting of needs does not really apply to energy subsidies, which makes the case for their removal much less complicated.  For households, natural gas and gasoline are the two most important items and in both cases a greater share of the subsidy goes to the upper half of the population.  Gasoline sells in Iran at about 40 cents a gallon, compared to $2 in the US, and natural gas is delivered to homes at about 1.4 cents per cubic meter compared to 14 cents in the US.  Price adjustments will be huge and can have a large impact both on overall consumption and on the distribution of income.  Politically, raising prices without a cash back mechanism is unthinkable.

But paying back cash to deserving individuals is much easier said than done.  There are two distinct questions: Which families should get cash back and who inside those families should actually receive it.  The latter is a question of how household resources are allocated between family members (intrahousehold allocations), a question on which there is little research for Iran, but, as I mentioned earlier, is serious in many developing countries.  Without the facts, it is hard to know the extent of the problem we face if all the cash is given to the head of the household.  But you don’t need rocket science research to know that if the head of the households (often a male) is an addict the money is likely to go to drugs unless it is controlled by his spouse.

The targeting of the needy is a more serious problem.  It appears that the government intends to use the information it collected last year using a very crude survey instrument. About 60% of the households returned a filled questionnaire, but no one knows how accurate is the information in them.  The Statistical Center of Iran is heavily involved with identifying the low income families, a task that runs counter to its mandate to guard the confidentiality of all individual information it collects.  Its involvement has negative ramifications for future reporting of income and wealth through its numerous surveys.  In the upcoming census of 1390 (fall 2011), when SCI interviewers will ask about ownership of assets —homes, cars, and appliances– they are less likely to get a straight answer.  The government plans to also use the information available from other agencies, such as Behzisti and Komiteh Emdad, to identify those below median income.  But in the end, there is likely to be lots of bad feelings about giving money back to the wrong people.  For those who believe they are right around the median, there will be endless tension and maneuvering to hide their assets and income, not to mention disincentives to earn or accumulate less with the hope of qualifying for the cash back program.

This is a good time for Iran to think about introducing a legally binding annual reporting of incomes for all individuals with income, similar to what the Internal Revenue Service does in the US.  Over time, the earning history of a person provides a much better indication of its economic status than answers to one questionnaire. 

The bottom line is that none of these problems are reason enough to keep energy prices in Iran at one-tenth of their world levels and for Iran to engage in massive waste of energy.  The effort to reduce energy consumption in a way that equity does not suffer needs everyone’s support.  I only wish that the specifics of the bill could benefit from greater expertise than is currently applied to the immensely complex issues the bill raises.

Advertisements

14 Responses

Subscribe to comments with RSS.

  1. a said, on November 2, 2009 at 1:44 pm

    Hi,

    As always I enjoyed reading your article. Thank you. By the, I saw a translation of your article here:

    http://alef.ir/1388/content/view/56277/

  2. مرتضی said, on November 2, 2009 at 8:53 am

    بسیار جالب بود…ممنون

  3. یاسر said, on November 1, 2009 at 6:50 am

    Thank you fro some new ideas, which I was not familiar with them before, like “intrahousehold allocation” issue.

    I think a big difference between Iran and some other developing countries is the fact that these subsidies are from natural resources, not tax revenues. The bill gives control of half of the revenues to the government, directly. It means a bigger government, a larger proportion of oil in government budget, and a regime more away from democratization.

    I think if we conduct revenues of the bill to a spread social security system, like income maintenance and health-care system, then the government budget benefits from the bill revenues without these bad effects.

    • Djavad said, on November 2, 2009 at 1:29 pm

      You have a good point that redistribution increases government power. You suggestion that the revenue should go the general budget and then be used for social welfare also has merit on this ground, but from a practical political economy point of view, the cash back program is better. People will not believe that the government will actually reutnr the money to them in indirect ways, so they will oppose the price increases and we will lose a historic opportunity to deal with the thorny issue of energy subsidies.

      • یاسر said, on November 3, 2009 at 12:49 pm

        My suggestion about method of expanding social security system in this regard, is improving income maintenance for first two income deciles, and settlement of the premium of medical care insurance for all households. I think this would not bring a significant difference for households, relative to a direct cash policy. The important point here is that from political point of view, any change in direct cash policy is not applicable. I anticipate that the political battles in future would be around, who will charge household accounts more?
        About the method of dealing with energy subsidies, I think there must be more consideration and it is not true that all kinds of price increase would be helpful. For example, imagine that the government changes current situation of gasoline prices (=1000Rials for ration and 4000 Rials for free sale) by a 100% increase in price, to a 2000 Rials for each liter, without any limitation. The consequence would be: 1) a shock to the market and change in relative prices, which would have a pressure on households and leads to their unsatisfactory, 2) we are far away from international prices and within 2-3 years, we would be in our first place due to rate of inflation, 3) there would not be any movement toward a free market in supply of energy. At the end, the economy gains nothing and the public mind won’t be ready for another shock. If one reviews the history of gasoline prices in last two decades, finds what I am speaking about. The point about this bill is that the most important motive for the government is its budget defect, not what we all believe about the importance of relative prices in resource allocation, or goodness of market. (For getting the point, I refer to the causes of 80% increase in gasoline price, in 1378).
        My suggestion here is keeping rations and its price, with declaring a free market out of the ration. it means that every one can enter to the market and import and sale gasoline, with a standard tax rate. In this manner, we would experience a free market for gasoline, without a significant shock to the economy (the magnitude of gasoline market out of rations (that with price of 4000 Rials per liter) is about 2% of the whole). Gradually, the government can reduce and eliminate rations in a five or more year period. This policy is applicable for other kinds of energy.

  4. Amir F said, on October 30, 2009 at 12:58 pm

    “Food and medicine subsidies have played an important role in increasing child nutrition, lowering child mortality, both of which contributed to lower fertility (and hence the modernization of the average Iranian family).”

    I guess this part requires more explication since at first it comes to mind that lower costs for raising a child and lower infant mortality rates would contribute to a higher fertility.

    • Max Ajl said, on October 30, 2009 at 8:12 pm

      People have less children when they don’t need to have multiple children simply to ensure that one or two survive to adulthood.

    • Djavad said, on November 2, 2009 at 1:32 pm

      You are right that lower cost of food lowers the cost of children, but lower mortaility means fewer births to get to the same desired family size, so on balance it should reduce fertility. Lower mortality also increases the return on investment in children, which again favors smaller families.

  5. امیررضا said, on October 30, 2009 at 11:08 am

    Dear Dr. Salehi,

    Thank you for your great article. Unfortunately, I think the problem is that not so many people in Iran can read and understand such material as you have written. Both intellectual and popular atmosphere in Iran is plagued with mostly superficial analyses and the need for more profound analyses such as yours is easily felt.

    That’s why I’d like to ask you if you would let me (and maybe some of my friends) to translate your article and arrange for its publication in an economic newspaper of high circulation (such as Donya-e-Eghtesad). Of course, the translation would be reviewed and approved by you before being published.

    Thanks for your notice.

    • dsalehi said, on October 30, 2009 at 12:19 pm

      Thanks for your interest and kind words. Yes, by all means, you can translate and distribute the content of this blog. It is a public source, so it is ok for the material to be reprinted as long as the source–the blog–is mentioned.

  6. More Iranian Fantasies | Jewbonics said, on October 29, 2009 at 3:24 pm

    […] it was fascinating to read Djavad Salehi-Isfahani's account of the Ahmadinejad government's move towards economic populism, particularly subsidy reform. […]

  7. masoud said, on October 29, 2009 at 1:42 am

    Dr. Salehi,

    Assuming that the poor can be identified through the means you mention, wouldn’t a coupon system using smart card technology, something like Iran’s current implementation of the gas subsidy, be more effective in targeting ‘needs’ as opposed to ‘the needful’ as you put it?

    This would seem to combine the best aspects of the cash handout proposal and the current system, allowing the government to allocate specific ammounts of money per family and consumer good, and adjust these targeted subsidies as conditions warrant. If these subisdy levels are defined as continuous function of the household income these benefits would decrease gradually as a family becomes more prosperous, mitigating the ‘margin’ effect you talk about.

    I doubt this proposal would be popular, as it would be too similar to the war years, or that the government would want to be burdened with having to constantly make such politicized decisions, but it is a system that could be experimented with and phased in gradually and expanded if it proves effective.

    I think most Western economists would be instictively hostile to such an idea, one of the main reasons being the corruption and black markets this kind of system tends to generate. This may be mitigated to a large extent by modern day technology, but what are the other objections?

    Masoud

    • Djavad said, on November 2, 2009 at 1:35 pm

      I like the smart card for gasoline. It is a great example of using technology to deal with undersirable effects of market allocations. Using them in bakeries is probably more complicated because of the diversity of supply. Still, a good point and worth thinking about!

      • masoud said, on November 4, 2009 at 12:59 am

        I’ve thought about this too, but doesn’t the Government already subsidise bread and other foodstuffs to a significant extent? Adding smartcards into the may require some additional infrastructure to be installed, but could only help track where money already being spent goes.

        Masoud


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: