Iran’s subsidy reform survives crucial hurdle
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 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.