Tyranny of numbers

Iran’s subsidy reform survives crucial hurdle

Posted in Inequality, Macroeconomy, Poverty, Subsidy reform by Djavad on May 21, 2012

What is described as the second phase of Iran’s Targeted Subsidy Program appears to be on its way to implementation after the parliament approved to increase the size of the program to 660 trillion rials (about $54 billion using the official exchange rate), denying the government its request for a much larger program (1,350 trillion or $100 billion).  The compromise allows the government to increase prices of subsidized goods and at the same time raise the monthly payment of cash to families by an as yet undetermined amount.  Some reports suggested that the current cash rebate of 450,000 rials per person per month could increase by as much as one third for the remainder of this year, which ends on March 20, 2013.  The timing of the second phase is unknown but there is no doubt that it will happen.  Getting the parliament to authorize the second phase means that the subsidy reform program has passed a crucial test, all the more because the economy is under stress from the effects of past inflation, sanctions, and general macroeconomic mismanagement.  The critics who wanted to stop the program on its tracks have had a field day in pinning various failures onto the reform program.  For the time being they seem content with having slashed its extravagant proposed budget.

The chief failures that the program’s critics point to are high inflation and decline in household welfare.  Let me take these criticisms in turn.

Inflation
Inflation has been high but not all of it is because of the subsidy reform.  A few months after the implementation of the program, the inflation rate jumped from about 10% to an annualized rate of 30%, but it started to moderate last fall when a sharp devaluation gave inflation a fresh boost.  The devaluation was in large part the result of accumulated past inflation, which had caused the rial to appreciate by at least 50% in the last few years  (see my earlier post).

But inflation is also the reason why the second phase of the program is so important.  The Consumer Price Index has increased by about 30% since December 2010, so unless the government wants to resume subsidizing energy it should adjust energy prices upward by about 30%.  In fact, since some inflation has become endemic in Iran, for in the near term energy prices should be increased periodically.  And, as the political skirmishes over the second phase have demonstrated, this is going to be very costly, so the wise thing to do is to amend the subsidy reform law to rule out future subsidies for energy products altogether.  Rather than fix energy prices in rials, the original law should have required the government to keep energy prices at their opportunity cost, which most of the time is simply the world price.  It is never too late to tie the hand of future governments from taking the easy way out by letting people have their cheap energy, as they have done for the past 30 years.  To stop using the nation’s wealth to pollute the environment and subsidize the rich is good economic and social policy.

In the absence of periodic adjustments, each passing year results in lower real energy prices, a larger distortion that needs correcting, a more skeptical public to convince, and weaker political resolve to do so.  Iran is familiar with the politics of gradual increases in energy prices: recall the ill-fated attempts at gradual increases during the previous Rafsanjani and Khatami administrations.

A related argument for postponing price adjustments is that we should wait for a better time to subject the economy to higher energy prices.  There are two fallacies in this argument. First, it assumes that better times are around the corner, something no one can bet on at this time.  Waiting for the right time to adjust prices is likely to wait for a long time.  Second, this argument implicitly assumes that the best way to fight inflation or recession is to subsidize energy prices.  There is no economic argument that I am aware of that recommends this approach.

Most people forget that Iran got into a mess of economic distortions using cheap energy to fight inflation.  During national emergencies, such as during the war with Iraq, it may make sense to subsidize basic commodities, but it should be with the realization that sometime later when subsidies are removed, higher inflation will return.  There is no sch thing as free lunch.

Decline in household welfare
The idea that subsidy reform has put pressure on households in general is at odds with the logic of simple arithmetic.  A regressive subsidy was replaced with uniform payments to all citizens.  The government raised the prices of bread and energy products by several fold and paid the money it collected plus $1 billion of its own money each month.  How can everyone lose at the same time?  The government lost, and households as a whole gained, so the real dispute is about who among households gained and who lost.

Before the reforms, about 30% of the gasoline subsidy went to individuals in the top 10% of incomes (see my earlier post here), and for every $1 of this subsidy that benefited the lowest decile, $10 went to those in the top decile.  Except for the bread subsidy, in the past the rich have received the lion’s share of government subsidies every year.

This simple arithmetic logic is now supported by evidence.  Iran’s Central Bank and the Statistical Center have recently estimated that after the reforms income inequality has reached a “historic low.”  My own analysis of the 1389 survey corroborates their claims.  Using the survey data from the last quarter os 1389 (first quarter of 2011, when subsidy money started to flow to families) I find that income inequality measured by the Gini coefficient was 2 percentage points lower with the cash rebate than without  it — 0.40 instead of 0.42.  Since the gains were higher at the lower end of the income distribution, if we use a measure of inequality that is more sensitive to changes at the lower end of the distribution, the decline in inequality should be more pronounced.  The General Entropy index with a coefficient of minus 1, GE(-1), is such an measure.  For households surveyed in the last quarter of 1389, when about 63% of households reported having received cash rebates, GE(-1) is estimated at 0.405.  If we subtract the cash rebate from their incomes, GE(-1) increases to 0.472.

Likewise, the reform program has had a significant positive impact on poverty reduction:  Comparing the poverty rates for the last quarter of 1389 with and without the cash rebate, my estimates show that the percentage of the population in poverty is lower by 5 percentage points in rural areas and 1.5 percentage points in urban areas.  (The poverty lines I use for these calculations are about 16,000 rials per person per day in rural areas and 25,500 rials in urban areas, but the estimated size of the impact is not very sensitive to the choice of these particular poverty lines.)

The cash disbursement part of the program has been a huge success, not only in improving the welfare of the country’s poorest citizens, but also in avoiding riots and strikes that have brought down similar programs in other developing countries, most recently in Bolivia and Nigeria.  Whether it will continue to benefit the poor depends on the behavior wages and prices; whether the real incomes of the poor from other sources can keep up in these weak economic conditions.  For the answer to this question, we must wait of the results of the 1390 survey and beyond.

I do not expect the impact to have increased in 2011 nor for the second phase to do more.  Although one would have to wait for new survey data for 2011 to be released, I suspect that the amount of real transfer will not increase.  General inflation will eat partly into these gains, and the government may stop running the program with a large deficit.

If the government spends the entire 66 trillion rials during the 9 months that remain of the current Iranian year, it could hand out as much as 120000 rials ($10) extra per person per month, an increase of about 25% in the monthly cash rebate, which may turn out to be less than the rate of inflation, and therefore result in lower real compensation.  Still, for people below the median income who this year will spend less than 2 million rials per month, the higher cash payment will help pay for upwards of 28% of their expenditures, which is nothing to sneer at.  People in the higher brackets will not gain anything, but then they have least to complain about since they benefit more from the national wealth in other ways.

President Ahmadinejad is running out of time to tweak the subsidy program in a way to increase its positive redistirbutive impact, but he has not stopped trying.  After the failure of the initial mechanism to make the cash rebates conditional on income, recently a “request” has gone to certain people in the form of an SMS message asking them to voluntarily give up their cash rebates.  No one seems to know exactly how these people were selected, but something is to be said for a polite request instead of just cutting off money without a warning.

In less than a year from now Iran’s presidential campaign will be underway.  Political platforms will be defined in part with respect to the Targeted Subsidy Program.  It would be interesting to watch what presidential hopefuls will promise to do with it.  Populists will promise to stop it, while those who treat the poor as sophisticated voters might promise to increase the impact of the subsidy money on their welfare.  For example, they might promise to build better health, education, and sports facilities in their neighborhoods or use it to create jobs rather than send cash.  If the recent vote in the parliament in favor of the second phase is any guide as to the general popularity of the program, the debate from now on should be about how to spend the money saved from energy subsidies more effectively, not if we should go back to the old ways of wasting energy and subsidizing the rich.  Such a debate over economic policy would be a hopeful outcome, of course, because it would mean that in the coming months grand political issues do not swamp modest economic debates.

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  1. […] [71] Iran: The Rial Saga, Jahangir Amuzegar, Middle East Economic Survey, 6 August 2012http://www.mees.com/en/articles/5584-iran-the-rial-saga ;https://djavad.wordpress.com/2012/05/21/irans-subsidy-reform-survives-crucial-hurdle/#more-1623 […]

  2. محمد said, on October 10, 2012 at 4:39 am

    Dr. Hamid H. said:
    “But personally I think parliament should not have slowed the implementation of subsidies. I think it would have been better if they had gone with Ahmadinejad’s plan for a faster removal of subsidies which are really holding back Iran’s economic potential. But anyways, at least they did not kill it completely as so often happens in developing countries. I also must admit, I have little faith that the next Iranian president will go ahead with these grand plans which is going to be an unfortunate thing. ”

    But as Dr. Salehi said “Populists will promise to stop it”, they are doing their best to to this.
    With increase in the price of dollar, and political attacks to Dr. Ahmadi-Nejad’s management, and finally with decision of Majlis to stop the second phase of the reform, everything is going to be stopped. They may even want to restore the good-old-days.

    So, we are going to see that unfortunate thing.

    • Djavad said, on October 11, 2012 at 6:32 am

      I agree with you. The hard gained benefits of the subsidy reform will be lost because inflation will be higher this year. But priorities of the government have changed and fighting inflation is its most important goal. So I understand why they do not consider raising energy prices as an option

  3. دکتر علیرضا مختار said, on June 11, 2012 at 7:30 am

    Hi Javad, a clever article. I also read its translation in Farsi in yesterday’s “Donyaye Eghtesad” daily in Iran. One missing point in my opinion is considering inflation originated from production processes which rely on energy consumption and result in necessary products to be sold in higher than before price.
    Kind Regards,
    Alireza

    • Djavad said, on June 11, 2012 at 9:29 am

      Dear Dr. Mokhtar,
      Thank you for your comment and alerting me to the Persian translation of this post in Donyayey Eghtesad. I was not aware that it had be republished, but I welcome the wider audience.

      About inflation, you are right that much of it stems from the cost push effect of the subsidy reform program. This is inevitable as delayed inflation catches up with consumers anytime the government lets go of fixed prices. The good thing is that it is a one shot affair, and with time and with proper macroeconomic management its effect will subside. Unfortunately, we can’t rely on the management part as much as we can on time.

  4. Dr. Hamid H said, on May 31, 2012 at 3:21 pm

    A wonderful read. But personally I think parliament should not have slowed the implementation of subsidies. I think it would have been better if they had gone with Ahmadinejad’s plan for a faster removal of subsidies which are really holding back Iran’s economic potential. But anyways, at least they did not kill it completely as so often happens in developing countries. I also must admit, I have little faith that the next Iranian president will go ahead with these grand plans which is going to be an unfortunate thing.

    I have also a question: Why doesn’t Iranian government put some taxes on property and sale and resale market since it appears that most of the capital in Iran is being used to buy, sell, import and speculate on markets such as property and commodities. Would it not be better if Iranian government put some taxes on these activities and instead remove the taxes on production side, therefore directing this capital to manufacturing side? What is stopping Iranian government to do it?

    • Djavad said, on May 31, 2012 at 3:40 pm

      Thank you! Regarding taxes, Iran has one of the lowest tax rates in the Middle East, with the exception of the oil rich countries of the Persian Gulf. There is hardly any sales tax. The opposition to the 3.5% value added tax a couple of years ago shows that in this respect Iranians are like the Tea Party people in the US: they are against taxes on account of government waste and corruption. You are right about the value of property tax, which is quite low in Iran (I think about 0.1 cent to the dollar compared to about 1 cent in the US). But collection may not be widely enforced. Income taxes are even more important because it allows for a more progressive system of revenue collection. I understand less than 10% of all government revenues come from income taxes on individuals.

  5. Iran's Subsidy Reform Survives said, on May 31, 2012 at 12:32 pm

    […] […]

  6. hghandi said, on May 24, 2012 at 12:23 pm

    Yet another interesting read. Thanks for the good analysis of the current subsidy program. I am puzzled by one statement of yours, Dr. Salehi though. Why do you say government lost? Who in the government lost?

    • Djavad said, on May 24, 2012 at 3:13 pm

      Thank you, Hojat. By government losing money I mean running a deficit, collecting less money at the pump than it paid out as cash rebate. This is an important issue also from the point of view of evaluating the impact of the program because the financing of this deficit, which is still wrapped in obscurity, probably caused a good part of the subsequent inflation, the other part being the cost push inflation arising from higher energy prices.

    • Kamal said, on June 8, 2012 at 11:48 am

      Dear hghandi : If you really want an interesting and true analysis of current subsidy program , you may check this link : http://www.mees.com/en/articles/1752-iran-s-subsidy-reform-a-progres-report

  7. Kamal said, on May 23, 2012 at 1:26 am

    You are not living in Iran. And therefore your calculations and theories are not analyzing the dept of truth here in Iran. If people put their hands in their pocket to spend, they feel the real pinch and not economic theories , which you indicate. I’m really sorry for you and your illusions about our real daily life.

    • Djavad said, on May 23, 2012 at 10:12 am

      Kamal: You are right, I do not live in Iran. I do not live in Egypt either, but I know that they are trying to get rid of their subsidies which distributes about $20 billion in an unequal way. In fact, their more sophisticated and well off intellectuals would be very happy to give up their subsidy in a way that would benefit the poor so that poverty would not subvert Egypt’s fledgling democracy. As a matter of fact, most economists who write about developing countries do not live in those countries. That is how the world works these days, I am afraid–you work with data. The point is you do not have to live in Iran to think that regressive energy subsidies do not solve a country’s problems, it adds to them.

      This brings me to a more important issue raised by your comment, which is how does one know if a program is good or bad? I hear often from Iranian friends that Iranian data is so bad that looking out the window or walking the neighborhood gives you a better idea if a program is working or not. Thinking like this is a serious problem for people living in a complex society. This worked well when we lived in small villages and could walk up and down the fields and get a good feel for what the year’s crop was doing or if the new fertilizer was having an effect.

      As more data becomes available to researchers and people come to trust the data and the analysts, they will gradually want analysis of data to complement their intuitive feel. Instead of looking in the neighborhood grocery for the inflation rate, walk the town for the unemployment rate, or check with friends and family about who is going to win the next election, they will look for surveys and good statistical analysis. This is not to say that the data or my analysis in this particular case are free of errors, or that your feelings about the impact of the subsidy reform is not justified because there are losers in this reform. I do understand that inflation is much higher than the last quarter of 1389 which my data refers to. The gains to the poor may be smaller in 1390 or 1391 but I doubt that they will lose on account of ending a regressive subsidy.

      • Kamal said, on May 25, 2012 at 4:51 am

        Nobody can deny economic science. I think politics and economy are interrelated . We should imagine the location of Iran and the economical and political structure domestically and internationally. Of course getting rid of subsidies is a must and logical , but this process should go along opening economy in the mean time to bring confidence and to awake entrepreneurial spirit.Creating jobs and push down inflation in a logical way. In a country like Iran , where Oligopolies and Monopolies ( crony capitalism) extend and growing stronger day by day , how can you erase subsidies ? As an individual entrepreneur or investor in this market you have to fight with networks mentioned above and you are condemned to doom after a while. Its a real and permanent pressure for middle and lower income level of society.
        If the government does not implement subsidy reform scientifically and just wants to get rid of his own budget deficit (and don’t check other parameters carefully) I guess more then half of Iranian people will get really hurt in future. Instead of cutting governmental jobs , Authorities expand their job creation inside government, where productivity doesn’t count and have never been counted before! Like still some parts of Chinese governmental LSE’s etc…
        We are now in a stagflation slump too!!

        K.

      • Djavad said, on May 26, 2012 at 2:30 pm

        One problem at a time…


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