Energy Subsidy Reform (ESRx) Module 5 “A Toolkit to Analyze the Distributional Effects of Fuel Subsidy Reform”

Module Learning Objectives Understand how to quantify the distribution of subsidy benefit across different income groups Identify the channels by which subsidy reform affects households’ welfare Assess the direct impact of subsidy reform scenarios on households’ welfare Explain how the price shifting model help in assessing the indirect impact of subsidy reform on households’ welfare Simulate fuel price reform given specific policy objectives, including mitigating the reform impact on the poor

Effects on Household Welfare through Two Channels Direct impact (Yd): Stems from higher prices for fuels directly consumed by households for cooking, heating, lighting, personal transportation, etc. Fuel Price Increases Indirect impact (Yind): Stems from the effects of higher fuel prices on the production costs of other goods and services consumed by households

Concepts and Notations Indicator of Household Welfare: Consumption/expenditure(per capita) Consumption in-kind Income Budget share of product i is it share of household’s spending on that product in their total expenditure:

Estimating the Direct Impact of Higher Fuel Prices Let’s assume that we increase the price Pi of the fuel product i. What would be the direct impact on household’s welfare? (1) For m fuel products (2) Removed Text Box for second equation… “If the price increase concerns a number m of fuel products, the total direct impact is the sum of the direct impact of each fuel product” Would suggest to suggest to write in “Direct Impact”, “Budget share of fuel product i”, and “Increase in the price of fuel i” for the top equation.

For Example… Assume the government implements the following price increases: Gasoline price: 100 percent LPG and Kerosene prices: 50 percent Computation of the direct impact: Gasoline LPG Kerosene Budget share(%) (A) 0.80 1.5 0.50 Price increase (%) (B) 100 50 Direct Impact (%) (=A*B) 0.75 0.25 1.8 The direct impact on a household that spends 0.8 percent of its budget on gasoline, 1.5 percent on LPG, and 0.5 percent on kerosene would be as follows

Estimating the Indirect Impact of Higher Fuel Prices Estimating the Indirect Impact of Higher Fuel Prices The Price Shifting Model Two broad group commodities in the economy: Cost-Push Sectors: Higher input costs are passed on fully to output prices. Assume that there are k commodities in this sector. Controlled Sectors: Output prices are controlled by the government. 2) The indirect impact of the increase in fuel prices on household welfare is: (3) Removed the equation text boxes. Write and explain this on the slide.

An Iterative Process Iterations 1 2 3 ….n… Product A Product A Increase in fuel price Product B Product B Product B Product C Product C Product C We can design this as a full slide image/diagram. See the next slide as an example.

The Input-Output Coefficient Matrix (A) Sector 1 Sector 2 … Sector j ... Sector n Sector i aij aij= the number of units produced by sector i needed to produce one unit of output by sector j

Calculating the Price Increases of Non-Fuel Products The price changes of goods and services consumed by households due to higher fuel prices is given by: (4) Vector of price changes for nonfuel products I: Identity matrix α :Diagonal matrix with cost-push sectors (=1) and controlled sectors (=0) A: Input-Output Matrix Vector of exogenous fuel price changes Vector of price changes for nonfuel products

Calculating the Indirect Impact Once the price changes of non fuel products calculated Plug the estimates in equation 3:

Deriving the Overall Impact as percent of household expenditure = direct impact (Yd)+ indirect impact (Yind) Overall Impact In nominal terms = [direct impact (Yd)+ indirect impact (Yind)] ×household expenditure

The estimated effects should be considered as an upper bound Main Assumptions There is no substitution effect on the consumption and production side Higher input costs are fully passed to output prices in push sectors The only exogenous price changes are in controlled sectors The estimated effects should be considered as an upper bound

Share of each income groups in total consumption of the subsidized product Share of subsidies of quintile Si = Cm,i /Cm where Cm,i = consumption of fuel product m by households in quintile i Cm = consumption of fuel product m by all households

Presenting the Toolkit . Inputs: Household survey data Input-Output matrix Parameters: Cost-push/controlled sectors Deciles/quintiles Reform scenario Output: Magnitude of directs effects Magnitude of indirect effects Distribution of subsidy benefit across income groups Patterns of expenditures Results by deciles or quintiles Results displayed in tables and charts

How to use the Toolkit Illustration with the case of Subsidyland Estimate the impact of the following reform scenario: price increase for kerosene (10%) and diesel (20%) Inputs : Household survey data: about 18,000 of households with data on main expenditure categories (e.g. fuels, food, housing, and transport) Input-Output data with 16 sectors, including fuels, food, transport, services and so on.