Subsidizing Energy Consumption: Why it’s Wrong and What Can Be Done About it

Carlo CottarelliBy Carlo Cottarelli

(Versions in Español中文, Français, 日本語, and Русский)

Let’s face it. Everybody loves cheap energy. Almost all human activities require energy consumption and, if something is so basic, it seems pretty obvious that it should not be denied to anyone and government should make it as cheap as possible to both households and companies, including through subsidies. This can help households avoid paying exorbitant energy bills at the end of the month, something that the poor may not be able to afford even for basic needs like heating and cooking.

Companies may also need energy subsidies to help them stay competitive. Energy subsidies appear even more appropriate, and even the obvious thing to do, in countries that have a large supply of energy, like oil producers. After all, this natural wealth in the form of energy belongs to the people; why shouldn’t it be cheap?

There’s a better way
And yet, energy subsidies (the difference between the price consumers should pay for energy to cover supply costs and the appropriate consumption tax and what they actually pay) are not a very smart thing, as argued in a recent IMF study, “Energy Subsidy Reform: Lessons and Implications.

  • For starters, they are not really a good way of achieving what governments say they want to achieve. When it comes to households’ consumption, subsidies are not really a well-targeted way of supporting the poor. Indeed, our work shows that, because the rich consume much more than the poor, in emerging and low-income countries 43 percent of energy subsidies (before taxation) go to the richest 20 percent of the population. As for subsidizing consumption by companies, this ends up fostering the survival of the inefficient, which certainly cannot be good for growth in the long run.
  • Second, energy subsidies are costly and therefore preempt more useful public spending (for education or infrastructure, for example). This is true even for energy producers as the revenues from, say, selling oil on the international market could be used for more productive purposes than subsidizing energy consumption.
  • And, third, because of subsidies, countries end up consuming too much energy. This is bad for the environment, for example through excessive CO2 emissions, which aggravates climate change.  Our estimates indicate that eliminating energy subsidies would reduce CO2 emissions by 4½ billion tons, a 13 percent reduction.

Here, there, everywhere
How common are energy subsidies? Well, subsidies are pervasive. Let’s start with the “pre-tax” subsidies that arise when prices that consumers pay are below the supply costs of energy. Although relatively few countries have pre-tax subsidies, their magnitude is not trivial: in 2011 they amounted  to some $480 billion, or  0.7 percent of world GDP and 2 percent of public revenues. And they are much more sizable in certain areas of the world: for example, they amounted to 8.6 percent of GDP and 21.8 percent of revenues in the Middle East and North Africa region.

But many more countries fail to tax energy sufficiently. Well, what is meant by “taxing energy sufficiently”? Energy should be taxed like any other product, just to raise revenues. In addition, energy needs to be taxed a bit more because its consumption causes damages to the rest of the population, for example by polluting the environment, which is what economists call “externalities.” Taking these costs into account, and using relatively conservative estimates, our study shows that in 2011 post-tax subsidies amounted  to  $1.9 trillion, or 2.7 percent of world GDP and 8 percent of total government revenues. The offenders here include the advanced economies, where every single one is under-taxing energy—and the Unites States accounting for about one fourth of all post-tax subsidies.

Changing course
Eliminating energy subsidies is not impossible. Our study looks, in particular, at the reform of subsidies in 19 countries, covering a number of cases where governments attempted to reduce pre-tax subsidies. We found that there are six key elements for success:

  • A comprehensive reform plan, which is preferable to ad hoc decisions: clear long-term objectives are needed, such as achieving full price liberalization and improving the quality of service.
  • A far-reaching communications strategy and consultation with stakeholders: people must understand that subsidies involve costs for the economy and society as a whole, not benefits.
  • Protecting the poor: this need not be difficult, at least in terms of resources: with most subsidies benefitting the rich, their elimination allows not only to fully compensate the poor, but also to make resources available for pro-growth, pro-equity public spending.
  • Appropriately phased and sequenced price increases, which allow time for households and governments to adjust their energy consumption. Absent large and immediate fiscal pressures, there is no need to frontload the adjustment, and a gradual pace has proved to be more acceptable as long as it is part of a clear comprehensive strategy.
  • Improving the efficiency of state-owned enterprises to help reduce their fiscal burden.
  • Depoliticizing the setting of energy prices, which is needed to make durable reforms.

One should also look at the tax components of subsidies, which are large in some advanced economies with high public debt. An increase in energy taxation can be a critical component in fiscal consolidation plans that are badly needed in light of recent surges in public debt to historically almost unprecedented levels.

In sum, there’s a sound case for reforming energy subsidies, and a rich background of country experience that provides a roadmap for reform. In this light, renewed efforts at subsidy reform are well justified.

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