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

IMF Blog, May 10, 2011

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

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Bibliographic details

• Authors: Masood Ahmed
• Published: May 10, 2011

Overview

• 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.
• Governments have recently raised subsidies in response to hikes in global commodity prices and regional political developments.
• Author: Masood Ahmed. Date: May 10, 2011.

Costs and scale

• The region accounted for almost two-thirds of petroleum price subsidies worldwide in 2009 (International Energy Agency estimate).
• Estimated regional subsidy cost in 2010: around $200 billion—equivalent to almost 8 percent of regional production.
• Share of subsidy types in that estimate: About 15 percent reflected the cost of food subsidies; the remainder were subsidies on fuels and electricity.

Key drawbacks of universal price 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.
• Encourage socially wasteful activities, such as smuggling and black-market dealings.
• Examples:
  • 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.

Targeting and alternatives to universal subsidies

• Price subsidies enjoyed by all are typically poorly targeted and should be regarded as stop-gap measures.
• Example of poor targeting: In Jordan, the poorest 40 percent of the population receives less than a quarter of total spending on fuel 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.
• Faster-to-implement targeted measures: school feeding programs; waiving fees for public services for the poor (health, education, public transport); labor-intensive public works.

Case studies and lessons

• Indonesia:
  • More than doubled fuel prices in 2005.
  • Increased fuel product prices by 25–33 percent in 2008.
  • 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.
  • By February 2008, domestic fuel prices followed international prices via a monthly automatic pricing regime.
  • Automatic fuel adjustment was temporarily suspended in January of this year due to social pressures.
  • Reforms were supported by measures to ease adjustment, including cash transfers to low-income households and increased allocations to the National Aid Fund.
• Lesson: Effective social safety nets as part of price subsidy reforms reduce the odds of reform reversal in case of sudden shocks.

Political economy and implementation considerations

• Subsidy reform is technically and politically complex; public buy-in is crucial.
• Sources of resistance:
  • Creation of vested interests.
  • Perception of cheap energy as an entitlement in oil-producing countries.
  • Broader weaknesses in public services—middle-income households may rely on subsidies as tangible benefits in lieu of quality public healthcare, schooling, or utilities.
• Important implementation elements:
  • 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 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; narrow subsidies first to products most important for the poor.
  • Ultimately replace price subsidies by price-indexed cash transfers.
  • Use automatic pricing mechanisms to help depoliticize price setting.
  • Move regionally, if possible—a broader or coordinated regional effort could help ease resistance.

Key recommendations

• Regard universal price subsidies as temporary stop-gaps, not long-term social protection.
• Prioritize building and expanding well-targeted cash transfer systems and other targeted social programs.
• Ensure transparency about subsidy costs and distributional beneficiaries.
• Use savings from subsidy reforms transparently for high-priority public spending.
• Sequence reforms with compensatory measures and communication to secure public support.

Source: IMF blog page “Subsidies—Love Them or Hate Them, It’s Better to Target Them” by Masood Ahmed, May 10, 2011.

Content in this bundle

• 051011a
  • 051011a (PDF)
• Regional Economic Outlook: Middle East and Central Asia - April 2011
  • Regional Economic Outlook: Middle East and Central Asia - April 2011 (Markdown version)
  • Regional Economic Outlook: Middle East and Central Asia - April 2011 (PDF)

References

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