## Technical Notes and Manuals 12/03 — Boxes 1–3

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---

### Box 1. The Level and Structure of Fuel Taxes

- Revenue requirements
  - The higher the revenue requirements from indirect taxes, the higher should be the tax rate on all goods and services, including fuels.

- Efficiency objectives
  - Fuel taxation is seen as a relatively efficient source of revenue, due to fuel demand being relatively insensitive to price.
  - The optimum fuel tax is typically thought to be above the average tax on other goods and services.
  - Negative externalities associated with fuel consumption—such as environmental pollution and traffic congestion—reinforce the case for higher fuel taxes.
  - The structure of fuel taxes should minimize distortion in the pattern of consumption across fuel products.
  - Because different fuel products are thought to be very close substitutes, especially over the long run, an efficient structure of fuel taxes should involve little differentiation in tax rates across fuels.
  - The argument for uniformity of fuel taxes is often thought to be relatively strong for diesel and kerosene since these are seen as being especially close substitutes even in the short term—it is common to mix these as transport fuel when kerosene prices are relatively low.

- Income distribution considerations
  - Taxes on fuels for which the poorest households have a higher share in total consumption should be relatively low.
  - Lower taxes on fuels used more by poor households maximize the share of the total budget subsidy accruing to these households and thus minimize the fiscal cost of redistribution.
  - Typically, kerosene (and, in some countries, LPG) is seen as being relatively more important for poor households and gasoline for non-poor households.

- Trade-offs and policy implications
  - There is an inherent trade-off between efficiency and income distribution objectives when setting fuel taxes.
    - Income distribution objectives suggest differentiation across fuel products, with taxes lowest on kerosene and highest on gasoline.
    - Efficiency objectives suggest similar taxes across fuel products since they are close substitutes in consumption.
  - Any distributional gains achieved through differential fuel taxes come at an efficiency cost in terms of a distorted fuel consumption pattern.
  - It is important to explore the possibility of using more efficient direct policy instruments to protect low-income households.

- Implementation mechanisms and price adjustment
  - Governments may adopt formulas to determine desired tax levels and implementation rules to determine when retail prices change and by how much.
  - More rigorous updates to cost components could be undertaken on a 3–5 year cycle based on a detailed market study.
  - A specification of a rule is needed for when retail prices are changed and by how much; e.g., retail prices could be changed monthly to ensure full pass-through of changes in import or distribution costs so as to keep tax levels constant, or to reflect changes in tax policy by the government.
  - A basic principle: differences between changes in import prices and retail prices should be reflected in changes in tax levels and should not affect other components of the price structure.
  - Fluctuations of import prices that are not passed through to retail prices need to be fully reflected in specific taxes or explicit subsidies in the price structure to prevent development of arrears.
  - Although full pass-through of international price movements to retail prices is desirable over the medium term, some smoothing of the adjustment may be desirable in the short term.
    - Full pass-through over the medium term is necessary to achieve fiscal objectives and encourage efficient fuel consumption patterns.
    - Governments may wish to avoid sharp increases in domestic prices if these are deemed temporary; smoothing approaches can be used while ensuring suppliers receive prices reflecting actual import and distribution costs agreed in the formula.
    - Smoothing avoids a “wait-and-see” approach that typically leads to long periods of fixed retail prices and escalating fiscal costs.
  - Reducing the volatility of retail prices is achieved at the expense of increasing fiscal volatility.
  - A range of smoothing mechanisms is available, including price band mechanisms and moving average mechanisms.
    - Price band mechanisms (PB): set a maximum limit on the magnitude of retail price changes. Caps can be set as a proportion of the current retail price or in absolute amounts, but absolute caps can become less effective as international prices increase.
    - Under price caps, at the start of each period (e.g., each month) the retail price according to the full pass-through mechanism is determined based on last month’s average import cost. If the required retail price increase is above the maximum allowed increase (i.e., the cap), then the maximum allowed increase is implemented. If the implied price increase is below this threshold, then the full adjustment is implemented.

### Box 2. The Economics of Fuel Price Smoothing

- Conceptual framework: efficiency trade-offs
  - Objective: reduce short-term price volatility.
  - Two main effects determine net efficiency gains:
    - Risk aversion: If the marginal utility of income decreases with income, risk-averse consumers prefer stable to unstable prices—reducing prices when they are high and increasing them when they are low transfers income from periods of low marginal utility to periods of high marginal utility.
    - Substitution possibilities: Price smoothing suppresses incentives for consumers to substitute away from fuel when prices are high and towards fuel when prices are low, producing an efficiency cost that can be high if close substitutes exist.
  - Analytical condition: the sign of the net gain of price smoothing equals the sign of the expression s(r – 2μ)+ρ where:
    - s is the budget share of the commodity,
    - r is the coefficient of relative risk aversion,
    - μ is the income elasticity of demand,
    - ρ is the compensated price elasticity of demand.
  - Illustrative parameter example for fuel:
    - ρs = 0.1, r = 1, ρ = –0.2, μ = 0.5
    - Result: the expression equals –0.2, i.e., an aggregate efficiency loss from fuel price smoothing.
  - Efficiency loss increases with the marginal cost of public funds:
    - Decreasing volatility of consumer prices is typically achieved by increasing fiscal volatility.
    - The cost depends on how inter-temporal fiscal balance is achieved (debt adjustments, tax changes, or expenditure changes).
    - If balance is achieved via expensive debt, inefficient tax increases, or inefficient expenditure reductions, net welfare gains from price smoothing are lower.
    - Consumers can smooth income (e.g., via net savings); if consumers can do so more efficiently than government, the efficiency loss of public price smoothing is higher.

- Equity considerations and targeting
  - Equity can motivate short-term price smoothing when governments lack efficient social protection instruments.
  - Conditions that justify a role for government smoothing:
    - Poor consumers have relatively high fuel budget shares (including indirect fuel via energy-intensive goods and services).
    - Poor consumers have low fuel price and income elasticities.
    - Poor consumers are constrained in access to income smoothing instruments.
  - Caveat: Universal price smoothing benefits disproportionately accrue to higher income groups, so there is a high return to developing more efficient transfer instruments.

- Smoothing mechanisms described
  - Price bands (PB): impose a maximum monthly percentage change in retail price (e.g., under a 3 percent price band, a 10 percent international increase yields only a 3 percent domestic increase this month, followed by another 3 percent next month if no further international change).
    - Allows gradual catch-up to international price levels.
    - Important to limit declines as well for medium-term fiscal sustainability.
  - Moving average mechanisms (MA): retail price adjustments based on average of past import costs (e.g., average of last three months).
    - Longer averaging periods reduce the magnitude of monthly price changes.
    - Adjusts more effectively to sustained rapid international price increases but is slower to respond to sharp reversals due to reliance on historical prices.
  - Trade-offs:
    - Price bands: quick adjustment to current international prices, simple to explain/implement, but may cause continuously declining tax levels if international prices sustain large increases (may require additional tax adjustment rules).
    - Moving averages: smoother adjustment of import-cost input to formula, slower reaction to directional changes.

- Choice of smoothing mechanism — simulations and comparative performance
  - Evaluated six mechanisms: 2-month, 4-month, and 6-month moving averages (MA2, MA4, MA6); and 3 percent, 5 percent, and 10 percent price bands (PB3, PB5, PB10).
  - Compared to: FTP (full pass-through) and HIST (historical/actual retail price series).
  - Assumptions: constant absolute margins and an initial desired tax level, consistent with mid-2000s country levels.

- Findings on price volatility (Table 2 metrics preserved)
  - Std. deviation of prices:
    - FTP: 3.09
    - HIST: 2.46
    - MA2: 2.97
    - MA4: 2.74
    - MA6: 2.49
    - PB3: 2.03
    - PB5: 2.50
    - PB10: 3.01
  - Avg. monthly price change (sq):
    - FTP: 1.31
    - HIST: 0.14
    - MA2: 0.98
    - MA4: 0.72
    - MA6: 0.58
    - PB3: 0.68
    - PB5: 1.00
    - PB10: 1.25
  - Largest single monthly price increase:
    - FTP: 3.22
    - HIST: 3.72
    - MA2: 2.58
    - MA4: 2.15
    - MA6: 1.24
    - PB3: 0.98
    - PB5: 1.76
    - PB10: 3.14
  - Ranking summary (sum of price volatility rankings): FTP 39; HIST 22; MA2 27; MA4 21; MA6 11; PB3 7; PB5 19; PB10 34.
    - Price volatility rank order: FTP 8, HIST 5, MA2 6, MA4 2, MA6 1, PB3 4, PB5 3, PB10 7.

- Findings on tax volatility (Table 3 metrics preserved)
  - Std. deviation of taxes:
    - FTP: 0.00
    - HIST: 3.54
    - MA2: 0.85
    - MA4: 1.77
    - MA6: 2.38
    - PB3: 2.37
    - PB5: 1.45
    - PB10: 0.39
  - Avg. monthly tax change (sq):
    - FTP: 0.00
    - HIST: 2.69
    - MA2: 1.14
    - MA4: 2.11
    - MA6: 2.65
    - PB3: 1.92
    - PB5: 1.04
    - PB10: 0.17
  - Largest single monthly tax decrease:
    - FTP: 0.00
    - HIST: 3.21
    - MA2: 2.33
    - MA4: 3.84
    - MA6: 3.62
    - PB3: 2.79
    - PB5: 2.93
    - PB10: 1.87
  - Ranking summary (sum of tax volatility rankings): FTP 53; HIST 41; MA2 63; MA4 33; MA6 37; PB3 27; PB5 20; PB10 10.
    - Tax volatility rank order: FTP 1, HIST 7, MA2 3, MA4 6, MA6 8, PB3 5, PB5 4, PB10 2.

- Lowest tax levels under different regimes (Table 5 metrics preserved; three-month moving average tax levels)
  - Lowest 3-month MA tax level:
    - FTP: 8.52
    - HIST: 3.37
    - MA2: 7.30
    - MA4: 5.63
    - MA6: 4.40
    - PB3: 3.99
    - PB5: 6.41
    - PB10: 8.34
  - Avg. of 2 lowest 3-month MA tax levels:
    - FTP: 8.52
    - HIST: 3.54
    - MA2: 7.38
    - MA4: 5.70
    - MA6: 4.70
    - PB3: 4.30
    - PB5: 6.47
    - PB10: 8.34
  - Avg. of 3 lowest 3-month MA tax levels:
    - FTP: 8.52
    - HIST: 3.76
    - MA2: 7.44
    - MA4: 5.79
    - MA6: 5.02
    - PB3: 4.70
    - PB5: 6.56
    - PB10: 5.56
  - Ranking summary (sum of average tax rankings): 32, 48, 14, 18, 21, 11, 19
  - Overall ranking (sum of all rankings): FTP 47; HIST 80; MA2 51; MA4 68; MA6 66; PB3 53; PB5 50; PB10 53.
    - Overall ranking order reported: 1 8 3 7 6 4 2 4 (as presented in tables).

- Synthesis of simulation results
  - Smoothing mechanisms substantially reduce volatility of domestic price changes versus full pass-through.
  - Smoothing avoids full pass-through of temporary sharp international price increases (e.g., mid-2008 example).
  - Smoothing mechanisms produce higher and less volatile tax levels compared to the actual historical approach; tax volatility under smoothing is higher than under full pass-through (where tax is fixed) but always lower than in the actual historical case.
  - Price bands perform best in simulations when balancing price and tax volatility (by simple sum of rankings) and are easier to implement/explain.
  - Additional tax adjustment rules may be desirable to avoid continuous tax erosion under prolonged international price increases (e.g., floor on tax levels based on average of recent months).

- Transition strategy and implementation steps
  - Steps to begin transition to an automatic adjustment mechanism:
    - Identify the price structure (formula) to be used; existing pricing formulas can be adopted short-term, with transparency-focused restructuring. There should be a formula for all government-controlled products.
    - Decide on the target net tax for each fuel product; these can vary across products. If specific taxes are maintained, they could be inflation indexed annually.
    - Specify the reference price, approach to smoothing, and timeline for adjustments. For importers adopting a 5 percent price cap with monthly adjustment, reference price = last month’s import price; monthly adjustment = min(new formula retail price − current retail price, 5 percent), achieved by adjusting the variable tax. A floor on tax levels can be adopted.
    - Specify responsibilities and procedures for announcing and implementing price changes to ensure timely, routine implementation.
    - If desirable, commission a study on cost structures of all government-controlled fuel products and develop guidelines for updating cost components regularly.
  - Determinants of speed of adjustment to target net tax levels:
    - The higher the target net tax relative to current levels, the larger the required price increases.
    - Greater smoothing slows convergence (smaller increases per period).
    - Greater increases in international fuel prices slow convergence.
  - Numeric examples (preserving dates and values exactly from the source):
    - Example starting on September 30, 2012 with a 15 cents per liter gap between existing retail price and target tax-inclusive price:
      - Instant full pass-through and no change in international fuel prices → retail price increases by full 15 cents on October 1, 2012.
      - Under the 3 percent price band → monthly prices increase by approximately 1.83 cents per liter over the next 8 months before reaching the target net tax by May 2013.
      - Under the 10 percent price band → monthly prices each increase by 6.1 cents per liter over the next three months at which time it would reach the target net tax.
    - Increases in international prices would delay the period of convergence.
  - Medium-term refinements:
    - Update margins in the formula based on commissioned study and make regular adjustments.
    - Consider creating an autonomous body responsible for implementing the mechanism to de-politicize pricing (examples: Energy Regulation Commission or similarly structured independent committee).
    - Set out a plan for liberalizing fuel product supply and pricing; under liberalized pricing the formula’s role is regulatory (detect uncompetitive pricing).

- Supporting measures and communications
  - Mitigating impacts on the poor:
    - Evidence: a review finds that, on average, a US$0.25 per liter increase in domestic prices decreases household real incomes by 5 percent, with this impact being similar across all income groups.
    - If an effective social safety net exists, expand budget for these programs to protect the poor while containing fiscal cost.
    - If no effective safety nets exist and fiscal space allows, adopt more gradual reform (e.g., maintain kerosene subsidies short term) and expand existing programs that can be quickly scaled (examples include school meals, reduced education and health user fees, subsidized mass urban transport, cash transfers to vulnerable groups, subsidies for water and electricity consumption below specified thresholds).
    - Alternatively, expand public expenditures that benefit broad population segments (education, health, roads, electrification).
  - Public information campaign to increase support for reforms should highlight:
    - Subsidies impose a high fiscal cost and crowd-out financing for priority public expenditures such as investments in education, health, and physical infrastructure; full extent of subsidies should be transparently recorded in the budget.
    - Subsidies promote cross-border smuggling, shortages, black market activities, and corruption.
    - Higher-income groups capture most benefits from fuel subsidies.
    - Although international prices are outside government control, an automatic pricing formula will protect the population from large retail price increases while protecting the budget from escalating subsidies and high inflation; transparently publishing formula parameters reinforces this perception.
    - Passing-through price increases encourages greater energy efficiency, reducing adverse macroeconomic impacts of international price volatility via smaller external current account deficits and supporting growth and poverty reduction.

### Box 3. Mitigating Measures—Country Experience

- Gabon (March 2007: gasoline and diesel prices increased by 26 percent)
  - Social protection and targeting
    - National Social Guarantee Fund cash payments to the poor were resumed, while conducting a new and improved census of lower income households.
    - Assistance to single mothers via the existing program in the Ministry for the Family was increased.
    - Funding for microcredit program targeting disadvantaged women in rural areas was increased.
    - Households with monthly electricity and water bills of less than the expenditure thresholds for subscribers who already received the social rates were eligible for free electricity and water up to a limited quantity.
    - School enrollment fees were waived for pupils enrolled in public schools and school text books given free of charge to all primary school pupils.
  - Public investment and services
    - PRSP investments related to the expansion of rural health services, electrification, and drinking water supply were accelerated.
    - The mass public transport network in Libreville was expanded (27 buses).

- Ghana (February 2005: domestic fuel prices increased by 50 percent)
  - Education and health
    - Fees for attending primary and junior-secondary school were eliminated.
    - Extra funds were made available for primary health care programs concentrated in the poorest areas through the existing Community Health Compound Scheme.
  - Infrastructure and electrification
    - Investment in the provision of mass urban transport was expanded and expedited.
    - Extra funds were made available to expand a rural electrification scheme.

- Mozambique (2008: fuel prices increased by 38 percent)
  - Social protection expansions
    - Budgetary allocations to a range of social protection programs were increased substantially (Direct Social Support, Social benefits Through Work, Income Generation and Community Development).
    - The level of cash benefits received by beneficiaries of the Food Subsidy Program was increased, with the minimum benefit increasing from 70 MT to 100 MT and the maximum benefit from 140 MT to 300 MT.
    - The number of branches of the National Institute for Social protection was increased from 19 to 30 to facilitate an expansion of the program.

- Indonesia (March and October 2005: more than doubling prices; May 2008: prices of fuel products were increased by 25–33 percent)
  - Cash transfers and targeting
    - A temporary cash transfer program to 19 million poor families, with targeting relying on existing databases, was implemented in 2005 to mitigate the impact of fuel price increases.
    - A similar cash transfer accompanied the fuel price increases in 2008 for a period of seven months.
  - Reallocation and energy substitution
    - Some budgetary savings from reducing subsidies were reallocated to existing education, health and infrastructure programs that benefit low- and middle-income households.
    - The subsidies on kerosene are being reduced in conjunction with a program to increase the use of LPG as an alternative fuel source.

- Jordan (gradual reduction of fuel subsidies starting in 2005, culminating in full price pass-through in February 2008 when fuel prices were increased by 33–76 percent)
  - Payroll and social transfers
    - The minimum wage was increased, and low-paid government employees received higher wage increases than other employees.
    - A one-time bonus was given to low-income government employees and pensioners.
    - Cash transfers were provided to other low-income households whose head is a non-government worker or pensioner.
  - Utilities and safety nets
    - An electricity lifeline tariff was maintained at current low levels—electricity access is almost universal.
    - The government announced a plan to increase funding to the National Aid Fund as part of a program to improve the design and implementation of this national safety net program with World Bank assistance.

- Design, timing, and communication lessons to reinforce public support for pricing reforms
  - Link pricing mechanism adoption to specific public expenditure increases
    - The adoption of the mechanism should be explicitly linked to specific public expenditure increases.
    - Make clear that pricing reforms are necessary to protect planned expenditure increases and finance additional expenditures that benefit the population broadly (e.g., education, health, and public infrastructure) as well as safety net expenditures to protect the most vulnerable.
    - A package of temporary and targeted measures to help internationally traded energy-intensive sectors become more energy efficient may also be warranted (e.g., improved access to credit at competitive rates to finance more energy-efficient investment).
  - Timing considerations
    - If possible, launch the mechanism during a period when inflation is low or international fuel prices are falling to avoid the public associating the mechanism with price inflation and to mitigate the adverse impact on real incomes.
    - Being prepared to more quickly implement the pricing mechanism in the event of a decrease in international prices can emphasize that the formula also passes on price decreases.
    - If current net tax levels are well below target levels, then implementing a price increase well before the adoption of the mechanism will help to avoid large increases subsequent to its adoption and the public perception that the mechanism will only increase fuel prices.
  - Product- and distributional-sensitivity
    - Emphasize gradual adjustment of prices for more socially sensitive commodities (kerosene and diesel) to reinforce public support.
    - Increase taxes or decrease subsidies for less socially sensitive products (such as gasoline) to help finance any short-term fiscal loss from gradual adjustment.

*Source: IMF staff estimates (Technical Notes and Manuals 12/03, 2012).*

### Box 1. The Level and Structure of Fuel Taxes

### Box 1. The Level and Structure of Fuel Taxes

### Revenue requirements
- The higher the revenue requirements from indirect taxes, the higher should be the tax rate on all goods and services, including fuels.

### Efficiency objectives
- Fuel taxation is seen as a relatively efficient source of revenue, due to fuel demand being relatively insensitive to price.
- The optimum fuel tax is typically thought to be above the average tax on other goods and services.
- Negative externalities associated with fuel consumption—such as environmental pollution and traffic congestion—reinforce the case for higher fuel taxes.
- The structure of fuel taxes should minimize distortion in the pattern of consumption across fuel products.
- Because different fuel products are thought to be very close substitutes, especially over the long run, an efficient structure of fuel taxes should involve little differentiation in tax rates across fuels.
- The argument for uniformity of fuel taxes is often thought to be relatively strong for diesel and kerosene since these are seen as being especially close substitutes even in the short term—it is common to mix these as transport fuel when kerosene prices are relatively low.

### Income distribution considerations
- Taxes on fuels for which the poorest households have a higher share in total consumption should be relatively low.
- Lower taxes on fuels used more by poor households maximize the share of the total budget subsidy accruing to these households and thus minimize the fiscal cost of redistribution.
- Typically, kerosene (and, in some countries, LPG) is seen as being relatively more important for poor households and gasoline for non-poor households.

### Trade-offs and policy implications
- There is an inherent trade-off between efficiency and income distribution objectives when setting fuel taxes.
  - Income distribution objectives suggest differentiation across fuel products, with taxes lowest on kerosene and highest on gasoline.
  - Efficiency objectives suggest similar taxes across fuel products since they are close substitutes in consumption.
- Any distributional gains achieved through differential fuel taxes come at an efficiency cost in terms of a distorted fuel consumption pattern.
- It is important to explore the possibility of using more efficient direct policy instruments to protect low-income households.

### Implementation mechanisms and price adjustment
- Governments may adopt formulas to determine desired tax levels and implementation rules to determine when retail prices change and by how much.
- More rigorous updates to cost components could be undertaken on a 3–5 year cycle based on a detailed market study.
- A specification of a rule is needed for when retail prices are changed and by how much; e.g., retail prices could be changed monthly to ensure full pass-through of changes in import or distribution costs so as to keep tax levels constant, or to reflect changes in tax policy by the government.
- A basic principle: differences between changes in import prices and retail prices should be reflected in changes in tax levels and should not affect other components of the price structure.
- Fluctuations of import prices that are not passed through to retail prices need to be fully reflected in specific taxes or explicit subsidies in the price structure to prevent development of arrears.
- Although full pass-through of international price movements to retail prices is desirable over the medium term, some smoothing of the adjustment may be desirable in the short term.
  - Full pass-through over the medium term is necessary to achieve fiscal objectives and encourage efficient fuel consumption patterns.
  - Governments may wish to avoid sharp increases in domestic prices if these are deemed temporary; smoothing approaches can be used while ensuring suppliers receive prices reflecting actual import and distribution costs agreed in the formula.
  - Smoothing avoids a “wait-and-see” approach that typically leads to long periods of fixed retail prices and escalating fiscal costs.
- Reducing the volatility of retail prices is achieved at the expense of increasing fiscal volatility.
- A range of smoothing mechanisms is available, including price band mechanisms and moving average mechanisms.
  - Price band mechanisms (PB): set a maximum limit on the magnitude of retail price changes. Caps can be set as a proportion of the current retail price or in absolute amounts, but absolute caps can become less effective as international prices increase.
  - Under price caps, at the start of each period (e.g., each month) the retail price according to the full pass-through mechanism is determined based on last month’s average import cost. If the required retail price increase is above the maximum allowed increase (i.e., the cap), then the maximum allowed increase is implemented. If the implied price increase is below this threshold, then the full adjustment is implemented.

*Technical Notes and Manuals 12/03 | 2012 — Box 1. The Level and Structure of Fuel Taxes*

### Box 2. The Economics of Fuel Price Smoothing

### Box 2. The Economics of Fuel Price Smoothing

### Conceptual framework: efficiency trade-offs
- Objective: reduce short-term price volatility.
- Two main effects determine net efficiency gains:
  - Risk aversion: If the marginal utility of income decreases with income, risk-averse consumers prefer stable to unstable prices—reducing prices when they are high and increasing them when they are low transfers income from periods of low marginal utility to periods of high marginal utility.
  - Substitution possibilities: Price smoothing suppresses incentives for consumers to substitute away from fuel when prices are high and towards fuel when prices are low, producing an efficiency cost that can be high if close substitutes exist.
- Analytical condition: the sign of the net gain of price smoothing equals the sign of the expression s(r – 2μ)+ρ where:
  - s is the budget share of the commodity,
  - r is the coefficient of relative risk aversion,
  - μ is the income elasticity of demand,
  - ρ is the compensated price elasticity of demand.
- Illustrative parameter example for fuel:
  - ρs = 0.1, r = 1, ρ = –0.2, μ = 0.5
  - Result: the expression equals –0.2, i.e., an aggregate efficiency loss from fuel price smoothing.
- Efficiency loss increases with the marginal cost of public funds:
  - Decreasing volatility of consumer prices is typically achieved by increasing fiscal volatility.
  - The cost depends on how inter-temporal fiscal balance is achieved (debt adjustments, tax changes, or expenditure changes).
  - If balance is achieved via expensive debt, inefficient tax increases, or inefficient expenditure reductions, net welfare gains from price smoothing are lower.
  - Consumers can smooth income (e.g., via net savings); if consumers can do so more efficiently than government, the efficiency loss of public price smoothing is higher.

### Equity considerations and targeting
- Equity can motivate short-term price smoothing when governments lack efficient social protection instruments.
- Conditions that justify a role for government smoothing:
  - Poor consumers have relatively high fuel budget shares (including indirect fuel via energy-intensive goods and services).
  - Poor consumers have low fuel price and income elasticities.
  - Poor consumers are constrained in access to income smoothing instruments.
- Caveat: Universal price smoothing benefits disproportionately accrue to higher income groups, so there is a high return to developing more efficient transfer instruments.

### Smoothing mechanisms described
- Price bands (PB): impose a maximum monthly percentage change in retail price (e.g., under a 3 percent price band, a 10 percent international increase yields only a 3 percent domestic increase this month, followed by another 3 percent next month if no further international change).
  - Allows gradual catch-up to international price levels.
  - Important to limit declines as well for medium-term fiscal sustainability.
- Moving average mechanisms (MA): retail price adjustments based on average of past import costs (e.g., average of last three months).
  - Longer averaging periods reduce the magnitude of monthly price changes.
  - Adjusts more effectively to sustained rapid international price increases but is slower to respond to sharp reversals due to reliance on historical prices.
- Trade-offs:
  - Price bands: quick adjustment to current international prices, simple to explain/implement, but may cause continuously declining tax levels if international prices sustain large increases (may require additional tax adjustment rules).
  - Moving averages: smoother adjustment of import-cost input to formula, slower reaction to directional changes.

### Choice of smoothing mechanism — simulations and comparative performance
- Evaluated six mechanisms: 2-month, 4-month, and 6-month moving averages (MA2, MA4, MA6); and 3 percent, 5 percent, and 10 percent price bands (PB3, PB5, PB10).
- Compared to: FTP (full pass-through) and HIST (historical/actual retail price series).
- Assumptions: constant absolute margins and an initial desired tax level, consistent with mid-2000s country levels.

Findings on price volatility (Table 2 metrics preserved):
- Std. deviation of prices:
  - FTP: 3.09
  - HIST: 2.46
  - MA2: 2.97
  - MA4: 2.74
  - MA6: 2.49
  - PB3: 2.03
  - PB5: 2.50
  - PB10: 3.01
- Avg. monthly price change (sq):
  - FTP: 1.31
  - HIST: 0.14
  - MA2: 0.98
  - MA4: 0.72
  - MA6: 0.58
  - PB3: 0.68
  - PB5: 1.00
  - PB10: 1.25
- Largest single monthly price increase:
  - FTP: 3.22
  - HIST: 3.72
  - MA2: 2.58
  - MA4: 2.15
  - MA6: 1.24
  - PB3: 0.98
  - PB5: 1.76
  - PB10: 3.14
- Ranking summary (sum of price volatility rankings): FTP 39; HIST 22; MA2 27; MA4 21; MA6 11; PB3 7; PB5 19; PB10 34.
  - Price volatility rank order: FTP 8, HIST 5, MA2 6, MA4 2, MA6 1, PB3 4, PB5 3, PB10 7.

Findings on tax volatility (Table 3 metrics preserved):
- Std. deviation of taxes:
  - FTP: 0.00
  - HIST: 3.54
  - MA2: 0.85
  - MA4: 1.77
  - MA6: 2.38
  - PB3: 2.37
  - PB5: 1.45
  - PB10: 0.39
- Avg. monthly tax change (sq):
  - FTP: 0.00
  - HIST: 2.69
  - MA2: 1.14
  - MA4: 2.11
  - MA6: 2.65
  - PB3: 1.92
  - PB5: 1.04
  - PB10: 0.17
- Largest single monthly tax decrease:
  - FTP: 0.00
  - HIST: 3.21
  - MA2: 2.33
  - MA4: 3.84
  - MA6: 3.62
  - PB3: 2.79
  - PB5: 2.93
  - PB10: 1.87
- Ranking summary (sum of tax volatility rankings): FTP 53; HIST 41; MA2 63; MA4 33; MA6 37; PB3 27; PB5 20; PB10 10.
  - Tax volatility rank order: FTP 1, HIST 7, MA2 3, MA4 6, MA6 8, PB3 5, PB5 4, PB10 2.

Lowest tax levels under different regimes (Table 5 metrics preserved; three-month moving average tax levels):
- Lowest 3-month MA tax level:
  - FTP: 8.52
  - HIST: 3.37
  - MA2: 7.30
  - MA4: 5.63
  - MA6: 4.40
  - PB3: 3.99
  - PB5: 6.41
  - PB10: 8.34
- Avg. of 2 lowest 3-month MA tax levels:
  - FTP: 8.52
  - HIST: 3.54
  - MA2: 7.38
  - MA4: 5.70
  - MA6: 4.70
  - PB3: 4.30
  - PB5: 6.47
  - PB10: 8.34
- Avg. of 3 lowest 3-month MA tax levels:
  - FTP: 8.52
  - HIST: 3.76
  - MA2: 7.44
  - MA4: 5.79
  - MA6: 5.02
  - PB3: 4.70
  - PB5: 6.56
  - PB10: 5.56
- Ranking summary (sum of average tax rankings): 32, 48, 14, 18, 21, 11, 19
- Overall ranking (sum of all rankings): FTP 47; HIST 80; MA2 51; MA4 68; MA6 66; PB3 53; PB5 50; PB10 53.
  - Overall ranking order reported: 1 8 3 7 6 4 2 4 (as presented in tables).

Synthesis of simulation results:
- Smoothing mechanisms substantially reduce volatility of domestic price changes versus full pass-through.
- Smoothing avoids full pass-through of temporary sharp international price increases (e.g., mid-2008 example).
- Smoothing mechanisms produce higher and less volatile tax levels compared to the actual historical approach; tax volatility under smoothing is higher than under full pass-through (where tax is fixed) but always lower than in the actual historical case.
- Price bands perform best in simulations when balancing price and tax volatility (by simple sum of rankings) and are easier to implement/explain.
- Additional tax adjustment rules may be desirable to avoid continuous tax erosion under prolonged international price increases (e.g., floor on tax levels based on average of recent months).

### Transition strategy and implementation steps
- Steps to begin transition to an automatic adjustment mechanism:
  - Identify the price structure (formula) to be used; existing pricing formulas can be adopted short-term, with transparency-focused restructuring. There should be a formula for all government-controlled products.
  - Decide on the target net tax for each fuel product; these can vary across products. If specific taxes are maintained, they could be inflation indexed annually.
  - Specify the reference price, approach to smoothing, and timeline for adjustments. For importers adopting a 5 percent price cap with monthly adjustment, reference price = last month’s import price; monthly adjustment = min(new formula retail price − current retail price, 5 percent), achieved by adjusting the variable tax. A floor on tax levels can be adopted.
  - Specify responsibilities and procedures for announcing and implementing price changes to ensure timely, routine implementation.
  - If desirable, commission a study on cost structures of all government-controlled fuel products and develop guidelines for updating cost components regularly.
- Determinants of speed of adjustment to target net tax levels:
  - The higher the target net tax relative to current levels, the larger the required price increases.
  - Greater smoothing slows convergence (smaller increases per period).
  - Greater increases in international fuel prices slow convergence.
- Numeric examples (preserving dates and values exactly from the source):
  - Example starting on September 30, 2012 with a 15 cents per liter gap between existing retail price and target tax-inclusive price:
    - Instant full pass-through and no change in international fuel prices → retail price increases by full 15 cents on October 1, 2012.
    - Under the 3 percent price band → monthly prices increase by approximately 1.83 cents per liter over the next 8 months before reaching the target net tax by May 2013.
    - Under the 10 percent price band → monthly prices each increase by 6.1 cents per liter over the next three months at which time it would reach the target net tax.
  - Increases in international prices would delay the period of convergence.
- Medium-term refinements:
  - Update margins in the formula based on commissioned study and make regular adjustments.
  - Consider creating an autonomous body responsible for implementing the mechanism to de-politicize pricing (examples: Energy Regulation Commission or similarly structured independent committee).
  - Set out a plan for liberalizing fuel product supply and pricing; under liberalized pricing the formula’s role is regulatory (detect uncompetitive pricing).

### Supporting measures and communications
- Mitigating impacts on the poor:
  - Evidence: a review finds that, on average, a US$0.25 per liter increase in domestic prices decreases household real incomes by 5 percent, with this impact being similar across all income groups.
  - If an effective social safety net exists, expand budget for these programs to protect the poor while containing fiscal cost.
  - If no effective safety nets exist and fiscal space allows, adopt more gradual reform (e.g., maintain kerosene subsidies short term) and expand existing programs that can be quickly scaled (examples include school meals, reduced education and health user fees, subsidized mass urban transport, cash transfers to vulnerable groups, subsidies for water and electricity consumption below specified thresholds).
  - Alternatively, expand public expenditures that benefit broad population segments (education, health, roads, electrification).
- Public information campaign to increase support for reforms should highlight:
  - Subsidies impose a high fiscal cost and crowd-out financing for priority public expenditures such as investments in education, health, and physical infrastructure; full extent of subsidies should be transparently recorded in the budget.
  - Subsidies promote cross-border smuggling, shortages, black market activities, and corruption.
  - Higher-income groups capture most benefits from fuel subsidies.
  - Although international prices are outside government control, an automatic pricing formula will protect the population from large retail price increases while protecting the budget from escalating subsidies and high inflation; transparently publishing formula parameters reinforces this perception.
  - Passing-through price increases encourages greater energy efficiency, reducing adverse macroeconomic impacts of international price volatility via smaller external current account deficits and supporting growth and poverty reduction.

*Italic line: Source: IMF staff estimates (Technical Notes and Manuals 12/03, 2012).*

### Box 3. Mitigating Measures—Country Experience

### Box 3. Mitigating Measures—Country Experience

### Gabon (March 2007: gasoline and diesel prices increased by 26 percent)
- Social protection and targeting
  - National Social Guarantee Fund cash payments to the poor were resumed, while conducting a new and improved census of lower income households.
  - Assistance to single mothers via the existing program in the Ministry for the Family was increased.
  - Funding for microcredit program targeting disadvantaged women in rural areas was increased.
  - Households with monthly electricity and water bills of less than the expenditure thresholds for subscribers who already received the social rates were eligible for free electricity and water up to a limited quantity.
  - School enrollment fees were waived for pupils enrolled in public schools and school text books given free of charge to all primary school pupils.
- Public investment and services
  - PRSP investments related to the expansion of rural health services, electrification, and drinking water supply were accelerated.
  - The mass public transport network in Libreville was expanded (27 buses).

### Ghana (February 2005: domestic fuel prices increased by 50 percent)
- Education and health
  - Fees for attending primary and junior-secondary school were eliminated.
  - Extra funds were made available for primary health care programs concentrated in the poorest areas through the existing Community Health Compound Scheme.
- Infrastructure and electrification
  - Investment in the provision of mass urban transport was expanded and expedited.
  - Extra funds were made available to expand a rural electrification scheme.

### Mozambique (2008: fuel prices increased by 38 percent)
- Social protection expansions
  - Budgetary allocations to a range of social protection programs were increased substantially (Direct Social Support, Social benefits Through Work, Income Generation and Community Development).
  - The level of cash benefits received by beneficiaries of the Food Subsidy Program was increased, with the minimum benefit increasing from 70 MT to 100 MT and the maximum benefit from 140 MT to 300 MT.
  - The number of branches of the National Institute for Social protection was increased from 19 to 30 to facilitate an expansion of the program.

### Indonesia (March and October 2005: more than doubling prices; May 2008: prices of fuel products were increased by 25–33 percent)
- Cash transfers and targeting
  - A temporary cash transfer program to 19 million poor families, with targeting relying on existing databases, was implemented in 2005 to mitigate the impact of fuel price increases.
  - A similar cash transfer accompanied the fuel price increases in 2008 for a period of seven months.
- Reallocation and energy substitution
  - Some budgetary savings from reducing subsidies were reallocated to existing education, health and infrastructure programs that benefit low- and middle-income households.
  - The subsidies on kerosene are being reduced in conjunction with a program to increase the use of LPG as an alternative fuel source.

### Jordan (gradual reduction of fuel subsidies starting in 2005, culminating in full price pass-through in February 2008 when fuel prices were increased by 33–76 percent)
- Payroll and social transfers
  - The minimum wage was increased, and low-paid government employees received higher wage increases than other employees.
  - A one-time bonus was given to low-income government employees and pensioners.
  - Cash transfers were provided to other low-income households whose head is a non-government worker or pensioner.
- Utilities and safety nets
  - An electricity lifeline tariff was maintained at current low levels—electricity access is almost universal.
  - The government announced a plan to increase funding to the National Aid Fund as part of a program to improve the design and implementation of this national safety net program with World Bank assistance.

### Design, timing, and communication lessons to reinforce public support for pricing reforms
- Link pricing mechanism adoption to specific public expenditure increases
  - The adoption of the mechanism should be explicitly linked to specific public expenditure increases.
  - Make clear that pricing reforms are necessary to protect planned expenditure increases and finance additional expenditures that benefit the population broadly (e.g., education, health, and public infrastructure) as well as safety net expenditures to protect the most vulnerable.
  - A package of temporary and targeted measures to help internationally traded energy-intensive sectors become more energy efficient may also be warranted (e.g., improved access to credit at competitive rates to finance more energy-efficient investment).
- Timing considerations
  - If possible, launch the mechanism during a period when inflation is low or international fuel prices are falling to avoid the public associating the mechanism with price inflation and to mitigate the adverse impact on real incomes.
  - Being prepared to more quickly implement the pricing mechanism in the event of a decrease in international prices can emphasize that the formula also passes on price decreases.
  - If current net tax levels are well below target levels, then implementing a price increase well before the adoption of the mechanism will help to avoid large increases subsequent to its adoption and the public perception that the mechanism will only increase fuel prices.
- Product- and distributional-sensitivity
  - Emphasize gradual adjustment of prices for more socially sensitive commodities (kerosene and diesel) to reinforce public support.
  - Increase taxes or decrease subsidies for less socially sensitive products (such as gasoline) to help finance any short-term fiscal loss from gradual adjustment.

*Source: Box 3. Mitigating Measures—Country Experience, Technical Notes and Manuals 12/03 (2012).*

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