Fuel and Food Subsidies: Issues and Reform Options MENA Chief Economist Office Breakfast Seminar February 23 rd, 2012 David Coady 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.

1 Background Recent volatility in food and fuel prices has highlighted the fiscal risks inherent in price subsidy programs Although historically food subsidies have been more of a fiscal risk, more recently this mantle has been acquired by fuel subsidies

2 A bit of Déjà Vu

3 Format of presentation Recent policy responses to price volatility The case for subsidy reform Developing a subsidy reform strategy Presentation will focus more on fuel than food, but issues and options are common

4 Responses to fuel price increases between end-2008 and end-2011

5

6 Less then full-pass through led to lower tax rates (subsidies) in many countries

7 …..and the fiscal cost has been substantial (% GDP)

8 Most of the benefit accrues to higher-income groups

9 Subsidies are inefficient Low prices provide insufficient incentives to reduce consumption and worsen terms of trade impact Absence of demand and supply responses increases volatility of world prices Low prices can result in smuggling abroad, higher fiscal costs, and domestic supply shortages High fiscal cost crowds-out high priority public investments in education, health, and infrastructure

10 Developing a reform strategy I Successful strategy needs to prepare population for reforms Identify clearly the size of the fiscal cost of subsidies Link cost to crowding out of key public investments which are crucial for growth and development (best way to protect most of population from high prices is through growth) Highlight the high share of benefits going to higher groups and identify better ways of protecting poor Identify inefficiencies of subsidies (smuggling, shortages, energy inefficiency)

11 Developing a reform strategy II Reform strategy needs to be set out in advance Identify key public investments that will benefit from reallocation of budgetary savings Identify well-targeted programs that will be expanded/created to protect the most vulnerable social groups Prepare strategy for improving energy efficiency of most energy-intensive internationally traded industries (cement, fertilizer, metal products....) This may involve appropriate monetary and exchange rate policies, investment incentives, and credit access, etc

12 Developing a reform strategy III Sequenced and gradual reform approach may be warranted if large price increases required (and fiscal conditions allow ) Instant adjustment of subsidies that mostly benefit the rich (higher quality foods, gasoline, jet kerosene and LPG?) More gradual adjustment of other products to allow industry to adjust (e.g., diesel and LPG?) Delay increase in fuels most important to poor (e.g., lower quality foods, kerosene) But there is a limit to sequencing since large price differentials can cause market disruption (adulteration)

13 Developing a reform strategy IV Develop strategy for reform of social safety net Limit subsidies to products most important for lower income groups (low quality foods, kerosene) Limit quantities of subsidized products Limit eligibility for subsidized products to lower income groups (differential subsidy rates, means or proxy-means testing) With improved targeting, consider switching from price subsidies to price-indexed cash transfers However, subsidies and cash transfers address the symptoms but not the causes of persistent poverty Consider developing conditional cash transfer programs

14 Example of fuel subsidy reform: Indonesia, Repeated increases in subsidies (reaching 5 percent GDP in 2005) necessitated large price increases Prices more than doubled in 2005 (March, October) Prices increased by around 30 percent in May 2008 Implemented range of mitigating measures Introduced large temporary cash transfer program covering one- third of households building on existing social safety net programs (both reforms) Reallocated some budgetary savings to existing education, health, and infrastructure programs benefitting broader population Initiated program to reduce kerosene use by increasing LPG use

15 Developing a reform strategy V Addressing underlying causes of subsidies requires new approach to pricing and not just ad hoc price adjustments In Indonesia, subsidies kept recurring so political cost was achieved with only a short-term fiscal gain First-best option is to liberalize fuel pricing and markets However, adoption of an automatic pricing mechanism can serve as an interim approach while capacity to regulate liberalized market is developed Turkey moved from an automatic pricing mechanism between to liberalized regime in 2005, and from low to very high fuel taxation

16 Example of fuel subsidy reform: Jordan, Initiated gradual subsidy reform in mid 2005 Supported by range of targeted mitigating measures, including investments in targeted transfers Eventually decided to do instantaneous adjustment in February 2008 Fuel prices increased by between percent Adopted an automatic pricing mechanism that adjusts prices monthly in line with international prices Mechanism implemented by a committee composed of representatives from ministries and refinery

17 Jordan addressed the causes

18 Developing a reform strategy VII Fragility of automatic pricing mechanisms often reflects reluctance to pass through large international price increases to domestic prices, especially if turn out to be temporary However, a “wait and see” policy can result in escalating subsidies if international prices continue to increase eventually requiring large domestic price adjustments or entrenched subsidies Incorporating a smoothing rule in the automatic pricing mechanism can help to avoid large price increases while protecting budget against subsidies recurring over the medium term, e.g., Pricing based on moving average of past international prices Imposing a cap on maximum price adjustment allowed, e.g., +/- 3 percent of existing price

Example of smoothing rule 19

20 Summary of Main Messages Price subsidies are inefficient, inequitable, and fiscally costly Reform strategies can be strengthened through Information campaign informing public of shortcomings of subsidies Clear program reallocating some budgetary savings to crucial public investments (education, health, infrastructure) or even tax reform Development of well-targeted safety net measures to protect most vulnerable households Adoption of an automatic pricing mechanism (possibly with smoothing rule) until capacity for regulating liberalized market is developed

21 Links to referenced and other work IMF Board Papers Coady and others (2010) Arze del Granado and Coady (2010) World Bank Guidance on Policy Responses SANDTRANSFERS/0,,contentMDK: ~pagePK:148956~piPK:216618~theSitePK:282761,0 0.html SANDTRANSFERS/0,,contentMDK: ~pagePK:148956~piPK:216618~theSitePK:282761,0 0.html Designing and evaluating social safety nets (Grosh and others, 2008; Coady, 2004) SANDTRANSFERS/0,,contentMDK: ~menuPK:282766~pagePK:148956~piPK:216618~th eSitePK:282761,00.html SANDTRANSFERS/0,,contentMDK: ~menuPK:282766~pagePK:148956~piPK:216618~th eSitePK:282761,00.html