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

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."

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:

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.