Subsidies—Love Them or Hate Them, It’s Better to Target Them

By Masood Ahmed

(Version in عربي)

For decades, countries in the Middle East and North Africa have relied heavily on food and fuel price subsidies as a form of social protection. And, understandably, governments have recently raised subsidies in response to hikes in global commodity prices and regional political developments.

Like many things, there may be a time and a place for using subsidies.But, they need to be better targeted. And, often, there will be better alternatives. Alternatives that do a better job of protecting the poor.

High-cost endeavor

Countries in the region stand out because of their heavy reliance on subsidies. The region accounted for almost two-thirds of petroleum price subsidies worldwide in 2009, according to estimates by the International Energy Agency. Food subsidies are also widespread.

How much these subsidies cost is a bit of a guess, but we estimate it was around $200 billion in 2010—equivalent to almost 8 percent of regional production. About 15 percent of this reflected the cost of food subsidies, and the remainder subsidies on fuels and electricity.

Subsidies may be popular, but they have drawbacks, and not just in terms of the substantial costs. In particular, subsidies:

  • Are not cost-effective or do not target those most in need;
  • Encourage overconsumption and waste, particularly for subsidized energy;
  • May lead to damage to the environment, inefficient investment choices, and competitiveness problems;
  • Can strain public finances and worsen debt levels; and
  • Encourage socially wasteful activities, such as smuggling and black-market dealings.

For example, in the United Arab Emirates and Iran, energy consumption (adjusted for income differences) is more than 50 percent higher than in the United States. In Egypt, price subsidies have reportedly led to the use of bread as animal and fish feed.

Better as stop-gaps

Price subsidies enjoyed by all are typically poorly targeted, so they are not the most cost-effective way to provide social protection. They really should be regarded as stop-gap measures. Take the case of Jordan, where the poorest 40 percent of the population receives less than a quarter of total spending on fuel subsidies.

Attempts to phase out subsidy regimes have often proved challenging. Some subsidy reforms, especially in the 1980s and 1990s, reduced outlays, but attempts were often reversed after meeting resistance (sometimes violent) or rolled back in the face of large commodity price swings.

Some of the reasons why it’s difficult are obvious. Subsidies often create vested interests and, in oil-producing countries, many consider cheap energy an entitlement.

Resistance to subsidy reform may also reflect—in part—broader weaknesses in public services. In many countries, middle-income households are squeezed because they cannot rely on publicly-provided healthcare, schooling, or utilities. Whereas price subsidies are seen as one of few tangible benefits in return for tax payments, removing them is heavily resisted.

But, over the longer term, the objective should be to design and introduce more cost-effective social safety nets and replace price subsidies.

Cash transfers and other forms of income support can be better targeted. Well-designed cash transfer systems can typically result in about 50–75 percent of spending reaching the bottom 40 percent of the population.

And some better targeted measures can be expanded or introduced relatively quickly. Take, for example, school feeding programs, waiving fees for public services for the poor (such as health, education, or public transport), or labor-intensive public works.

Some success stories

Of course, none of this is easy. But, some countries have successfully introduced subsidy reforms.

  • Outside the region, Indonesia more than doubled fuel prices in 2005 and increased fuel product prices by 25–33 percent in 2008. The budgetary savings were used to finance a cash compensation program to 15.5 million poor families.
  • Jordan started reforms in 2005, gradually phased out fuel subsidies and, by February 2008, domestic fuel prices followed international prices via a monthly automatic pricing regime. Although automatic fuel adjustment was temporarily suspended in January of this year due to social pressures, a major factor in the reforms had been measures to ease the adjustment. This included, among others, cash transfers to low-income households and increased allocations to the National Aid Fund (the social assistance body).

Both experiences illustrate the importance of putting in place effective social safety nets as part of price subsidy reforms to reduce the odds of reform reversal in case of sudden shocks.

Need for buy-in

Better targeting subsidies or replacing them with more effective social safety nets is a complex process, both technically and politically. But buy-in from the public is crucial to success.

There are several ways to do this. It’s particularly important to:

  • Develop a comprehensive communication strategy and build political support.
  • Tell the public how much subsidies really cost and who benefits.
  • Compensate those hardest hit, by introducing or strengthening measures to protect the poor, including those that are living slightly above the poverty line.
  • Strengthen public sector governance and accountability. Net savings from subsidy reforms should be transparently allocated to high priority projects.
  • Improve targeting gradually. Narrowing the scope of existing subsidies—say, for products that are most important for the poor—can deliver quick gains. Ultimately, the goal should be to replace price subsidies by price-indexed cash transfers.
  • Automatic pricing mechanisms can help depoliticize price setting.
  • Move regionally, if possible. A broader—even coordinated—regional effort to phase out subsidies and establish better social protection could also help ease resistance.

The key point is that better targeting subsidies is as much about fairness as it is about value for money in public spending.

3 Responses

  1. [...] can create more room in budgets by making costly subsidies more efficient. As we’ve argued, the best way to do this is to reduce generalized [...]

  2. While I agree that subsidies are generally a bad thing, the fact is that removing them does in fact have a major financial impact on the average family, especially in poorer countries.

    Case in point, I’m very surprised that you cite the lifting of fuel subsidies in Jordan as a success. Viewed through the lens of the typical reforms that the IMF advocates, yes it is a success. Viewed from the bottom line of the average Jordanian citizen trying to make ends meet, the move is a catastrophe!

    Barring the upper strata of society, income levels in Jordan are quite modest. The support for the lowest income families in lieu of the subsidies excludes a large portion of the population. Many families have taken a severe financial hit as a result and what this is leading to is the eradication of the Middle East.

    Big business puts costs before compassion. But corporations have shareholders to answer to. Governments have their people to answer to and their role is to ensure the welfare of the people. Unfortunately the IMF encourages a black and white view of the bottom line similar to that of a listed company.

    Has it occurred to you why the people in the Middle East are protesting? Its not because they suddenly felt a strong desire for democracy; its because they can’t feed their families!!! The real world is not a text book case study, so please IMF stop treating it as one.

  3. In Venezuela the current gas (petrol) price is less than US$ 8 cents per gallon (US$ 2 cents per liter) which does not even cover direct distribution costs. If local gasoline consumption expressed in barrels of oil is assumed to be 500.000 barrels of oil per day, and that Venezuela could get 60$ per barrel if it sold its gasoline domestically at international prices, then we could value the real opportunity cost of this subsidy to be US$10.950 million per year.

    Now, for a simple comparison, just consider that the total national budget for education and health for 2011 is US$11.140, if we use the official exchange rates, and of course less if another FX rate is used.

    I have until now with little or no luck been arguing that gasoline subsidies should be officially approved in the budget, and that each receipt handed out to a gasoline consumer when tanking his car should make a clear indication of how much that subsidy represents.

    I would like to see the face of our poor finding out how much is paid to car owners by the government in turn. Of course what I would most like is for that money to be apportioned equally to all citizens and then let them decide what they want to spend it on.

    http://theoilcurse.blogspot.com/

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