The Magnitude and Distribution of Fuel Subsidies David Coady PSIA Group Fiscal Affairs Department International Monetary Fund

The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy

Structure of Presentation Background to PSIA on fuel subsidies Objective of the PSIA studies Methodology, data, impacts (five steps) Mitigating measures plus pro-poor and pro- growth expenditures Policy messages from PSIA

Background I: Market Structure Most developing countries control the domestic pricing and distribution of petroleum products Recent FAD survey found that from 48 countries 15 had fully liberalized systems 8 had functioning automatic pricing formulae (+8 suspended recently) 21 had ad hoc pricing

Background II: Prices and Subsidies (World prices have increased substantially since 2002)

Major Events and Real Price of U. S. Oil Imports, 1970–2006

Background II: Prices and Subsidies Controlled prices have resulted in rising budget subsidies in many countries (% 2005 GDP, estimated) – Yemen, 9.2; Jordan, 5.8; Indonesia, 4.2; Bolivia, 0.8 – Subsidy rates typically higher for kerosene and diesel as well as in exporting countries Countries often respond by decreasing taxation, so- called tax expenditures (especially kerosene and diesel) – e.g. Bangladesh, India, Sri Lanka, Kenya, Zambia Implicit subsidies also often substantial and take form of quasi-fiscal deficit financed by debt (%GDP2005, estimated) – Azerbaijan, 13.9 (2.8ex); Egypt, 4.1; Ecuador, 3.6; Bolivia, 5.2

Explicit Subsidies (%GDP)

Implicit Subsidies (%GDP)

Pricing Regime (Selected Countries)

Background III: Reform Agenda Fuel subsidies seen as undesirable because – High fiscal cost with consequences elsewhere in budget (Indonesia/Yemen: subsidies exceeded combined health and education budgets) – Inefficient: leads to over-consumption Governments still reluctant to increase domestic prices in line with world prices – Concerns about impact on poor and politically unpopular – PSIA can inform choice of appropriate policy response (so far: Angola, Bangladesh, Bolivia, Ethiopia, Gabon, Ghana, Honduras, Jordan, Madagascar, Mali, Moldova, Sri Lanka, Sudan)

Objective of PSIA To identify the magnitude and financing of consumer subsidies To evaluate the aggregate and distributional incidence of their withdrawal on household real incomes To identify appropriate mitigation measures to offset adverse impact on poorest households To identify higher priority public expenditures (more pro-poor and pro-growth)

Methodology and Data Higher domestic prices affect consumers through two channels – Direct effect from increase in price of fuels consumed by households – Indirect effect from increase in prices of goods and services that use fuel as inputs Indirect effect often substantial since over 50 percent of total consumption of fuel is as intermediate product

Step I: Identify magnitude and financing This requires a reference price for each product and required price increases – For most countries, border (cif,fob) price (plus,minus) domestic trade and transport margins – Often existing or desired tax levels included in reference price to allow for “tax expenditures” Average price increase ranged from percent (mostly including taxes)

Magnitude and Financing of Subsidies Domestic refinery that imports product Import at P(m), produce at P(c) Subsidized domestic price is P(s) Produces Q(c), imports Q(s)-Q(c) Total consumer subsidy = (A+B+C)=Q(s)[P(m)-P(s)] Where shows up depends on price to producer. If taxes, P(p), P(s) –Explicit import subsidy=(B+C) –Loss in profits=(A+D)+E –Tax revenue=(D+E) –Net fiscal position On budget: (D+E)-(B+C) Off budget: -(A+D+E)

Cameroon: More Transparent Formula

Sri Lanka: Eliminating subsidies required: gas (12%), diesel (20%), kerosene (58%), average (23%)

Step II: Calculate direct effect Need household survey with information on different fuel expenditures For each household, calculate budget shares as expenditure on fuel divided by total household consumption Multiply required price increases by budget share to get approx. real income impact Look at distribution of percentage real income effect across income groups (regressive vs. progressive)

Example of fuel consumption patterns in Sri Lanka

Magnitude of direct effect Fuel budget shares varied from percent ( percent including electricity) – Therefore, a 50 percent increase in average price implies a percent ( percent) decrease in real incomes Fuel budget shares for lowest welfare quintile varied from 2-6 percent ( percent) – Therefore, a 50 percent increase in average price implies a 1-3 percent ( percent) decrease in real incomes Direct effect found to be either neutral of regressive – Reflects importance of kerosene, which is typically relatively heavily subsidized

Step III: Calculate indirect effect An input-output table and a simple model can be used to calculate the increase in prices for other goods and services from higher fuel costs Aggregate household consumption data to get budget shares for input-output sectors Multiply budget shares by percentage price increases to get percentage real income effect Aggregate to get total indirect effect and look at distribution across different income groups Add to direct effect to get total impact of fuel price increase on household real incomes and distribution

Example from Ghana

Magnitude of indirect effect Indirect effect at least as large as direct effect and approximately neutral incidence A 50 percent average increase associated with a 3 percent decrease in real incomes Most of indirect effect comes through higher food and transport costs

Magnitude of total effect Total effect ranged from percent A 50 percent increase associated on average with a 4.6 percent decrease in real incomes Distribution typically regressive reflecting role of higher kerosene price increases

Step IV: Evaluate targeting efficiency Calculate the share of the total subsidy (or, equivalently, the burden of subsidy removal) accruing to each income group Can do this separately for each product as well as the direct, indirect and total effects Individual product shares useful later when comparing alternative approaches to protecting the real incomes of low-income households

Fuel subsidies are badly targete d A relatively high share of total fuel subsidies go to higher income groups – Share of bottom two quintiles varied from percent (so percent of subsidy benefit accrues to top three quintiles) – So costs units of income for every 1 unit transferred to bottom two quintiles Even direct (mainly kerosene) subsidy is badly targeted – Between percent leaks to top three quintiles so costs units of income for every unit transferred to bottom two quintiles

Step V: Identify mitigating measures Although badly targeted, withdrawal of fuel subsidies can have substantial adverse effect on poor (c2-9%) Can consider a number of alternatives and simulate using household-level data (budgetary cost minimized by better targeted transfers/expenditures) – Gradual withdrawal of specific fuel subsidies (kerosene, LPG) to minimize revenue-poverty trade-off – Using some of budgetary savings to finance targeted public expenditures (education, health, roads, transport, electricity) – Restructure electricity tariff schedules to reduces cost for poor – Use savings to finance existing/reformed/new social safety net for poorest households

Example from Ghana

Example from Sri Lanka Kerosene subsidies Use of electricity lifeline rates – Potential benefits from restructuring tariff schedule Use of existing Samurdhi transfer program – Highlight performance level of existing program – Emphasize gains from reforming design and implementation

Even kerosene subsidies involves substantial leakage to the non-poor

Share of Gasoline Burden (Cameroon)

Share of LPG Burden (Cameroon)

Alternatively could subsidize electricity

......but these appear badly structured.....

.....and involve very substantial leakage to non-poor

The Samurdhi program reduces leakage substantially

....and potentially provides a more cost- effective approach to social protection

Bottom2 nd Quintile 3 rd Quintile 4 th Quintile TopAll Kerosene Subsidy Coverage Coverage Share Avg effect Amount share Samurdhi Food Stamps Coverage Coverage Share Avg Effect Amount Share Proxy Means Food Stamps Coverage Coverage Share Avg Effect Amount Share

Mitigating Measures: Ghana Introduced formula in January 2003 with 90 percent price increase. – But formula abandoned and subsidies of 2.2% GDP2004 February 2005 introduced new formula and set up National Petroleum Authority (broad stakeholder group) to depoliticize implementation. – Prices increased in March/June/August/October 2005 and initial moves to liberalizing markets (import tendering) Announced range of mitigating expenditures (financed by “mitigating levy” in formula) – Removal of fees for primary and junior secondary school – Increased investments in mass urban transport – Expansion of rural electrification scheme

Mitigating Measures: Jordan In 2004 subsidy of 3.2 percent GDP, projected at 8.5 percent for 2005 A 68 percent increase in prices (including taxes) needed to eliminate subsidies Price increases would lead to 4.4 percent reduction in real incomes (5.4% for bottom quintile) In July 2005 increased prices by over 25%, reducing subsidies to 3% annual basis Introduced range of mitigating measures – Raised minimum wage and increased salaries for low-paid state employees – Maintained lifeline electricity tariff – Provided one-time bonus to government employees and pensioners earning less than JD400/month – Will increase when targeting is improved – LPG, diesel, kerosene prices expected to reach import parity by March 2007 and intend to liberalize thereafter

Mitigating Measures: Indonesia Ad hoc system froze prices between 2002 and February 2005, when subsidies grew to – gasoline (58%), diesel (60%) and kerosene (88%) Prices increased by 29% in March 2005 and planned increase of 30% in October Announced 114% increase in October resulting in subsidies – gasoline (20%), diesel (23%), kerosene (67%) – Subsidies projected to be 3.2% GDP2005 and 1.8% in 2006 Introduced unprecedented cash transfer program delivered through Post Office – Coverage of 15.5 million poor families (60million persons) – Each family to receive Rp.300,000 every 3 months (around US$30/mth) – Annual cost estimated at RS.20 trillion – Additional “incentive package” also introduced

Policy messages from PSIA Fuel subsidies are often substantial fiscal drain, crowd- out priority expenditures and badly targeted So should be able to identify alternative uses that are more pro-poor and pro-growth: – Alternative approaches to social protection can provide same or better protection at substantially lower fiscal cost – Higher priority public expenditures (nutrition, health, education, infrastructure) – e.g. based on PRSP – Access to effective system for targeting expenditures can be a crucial component for promoting efficiency-enhancing structural reforms

Policy messages from PSIA Important to announce reforms as part of a package: budgetary savings to finance better targeted, higher priority expenditures that benefit low- and middle-income households Gradual reduction of better targeted fuel subsidies should be seen only as short term measure are developed since revenue-poverty trade off is large and efficiency cost from inter- fuel substitution large