The Magnitude and Distribution of Fuel Subsidies

David Coady
PSIA Group Fiscal Affairs Department International Monetary Fund

The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy

Structure of Presentation

Background to PSIA on fuel subsidies Objective of the PSIA studies Methodology, data, impacts (five steps) Mitigating measures plus pro-poor and progrowth expenditures Policy messages from PSIA

Background I: Market Structure

Most developing countries control the domestic pricing and distribution of petroleum products Recent FAD survey found that from 48 countries
15

had fully liberalized systems 8 had functioning automatic pricing formulae (+8 suspended recently) 21 had ad hoc pricing

Background II: Prices and Subsidies

(World prices have increased substantially since 2002)

Text Table A. Change in International Fuel Prices, 2003-06 1 Crude oil prices Gasoline Kerosene Diesel US$ per liter 0.4 0.6 0.6 0.6 Percent change 128.0 140.7 126.7 142.1

1/Increase during end-2003 to June 2006. The crude oil price is the average spot prices for Dated Brent, WTI, and the Dubai Fateh. The prices for the other fuels are the average fob prices for Rotterdam, New York, Gulf Coast, Los Angeles and Singapore.

Major Events and Real Price of U. S. Oil Imports, 19702006

$80

$70

Iran-Iraq War begins; oil prices peak Saudi Arabia abandons "swing producer" role; oil prices collapse

$60

$2005Q2 per barrel

$50

Prices spike on Iraq war, rapid demand increases, constrained OPEC capacity, etc. Prices rise sharply on OPEC cutbacks, increased demand Gulf War

$40

$30

$20

Iranian revolution; Shah deposed Iraq invades Kuwait 1973 Oil Embargo

$10

Asian economic crisis; oil oversupply; prices fall sharply

Prices fall sharply on 9/11 attacks

$1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Text Table C. Gasoline Pricing Mechansims, Prices and Price Pass-Through Pricing mechanism Number of countries Average price (US$ per liter) 2003 Ad hoc Automatic Liberalized 21 8 15 0.61 0.56 0.70 2006 0.98 0.84 1.03 0.83 1.00 1.13 Price pass though

Background II: Prices and Subsidies

Controlled prices have resulted in rising budget subsidies in many countries (% 2005 GDP, estimated)

Yemen, 9.2; Jordan, 5.8; Indonesia, 4.2; Bolivia, 0.8 Subsidy rates typically higher for kerosene and diesel as well as in exporting countries

Countries often respond by decreasing taxation, socalled tax expenditures (especially kerosene and diesel)

e.g. Bangladesh, India, Sri Lanka, Kenya, Zambia

Implicit subsidies also often substantial and take form of quasi-fiscal deficit financed by debt (%GDP2005, estimated)

Azerbaijan, 13.9 (2.8ex); Egypt, 4.1; Ecuador, 3.6; Bolivia, 5.2

Explicit Subsidies (%GDP)

2003 (a) Explicit subsidies Argentina Azerbaijan Bolivia Cameroon Congo, Republic of Dominican Republic Ghana Honduras Indonesia Jordan Lebanon Nigeria Pakistan Senegal Sri Lanka Yemen, Republic of 0.0 5.1 0.6 0.0 0.8 ... 0.2 ... 1.5 0.0 ... 0.0 0.1 ... ... 5.0 0.2 2.8 0.8 0.2 1.0 0.5 0.9 ... 4.2 5.8 0.1 0.0 0.2 0.6 0.8 9.2 0.2 1.9 1.3 0.3 1.0 0.4 0.7 0.6 2.5 1.2 0.1 1.0 ... 0.8 ... 8.5 Est. 2005 Proj. 2006

Implicit Subsidies (%GDP)

2003 (b) Implicit subsidies Armenia Azerbaijan Bangladesh Bolivia Cameroon Colombia Congo, Republic of Dominican Republic Ecuador Egypt Ethiopia Gabon Indonesia Nigeria Sri Lanka 0 10.0 ... 1.7 0.1 1.2 ... ... 1.4 3.9 ... 0.4 ... 1.6 ... 0 13.9 1.0 5.2 0.0 1.6 ... 0.2 3.6 4.1 0.7 1.6 ... 2.2 1 1.0 10.4 ... 6.6 Est. 2005 Proj. 2006

0.3 ... 6.2 2.8 0.3 ... ...

Text Table B. The Average Price Pass Through, 2003-2006 1 Gasoline Net oil importers Net oil exporters AFR APD EUR MCD WHD G-7 countries of which : USA Average 2 Countries in sample 2 1.09 0.46 1.06 1.05 1.25 0.56 1.00 1.11 0.89 0.96 44 Kerosene 0.91 0.43 1.07 0.37 ... 0.78 0.92 Diesel 1.15 0.70 1.11 0.83 1.54 0.78 1.30

0.83 29

1.07 39

1/ Post-tax retail prices; latest observation for the fisrt half of 2006. A number lower than one indicates less than full pass-through. 2/ excluding G7 countries

Pricing Regime (Selected Countries)

Retail fuel price (US$ per liter) Price mechanism Liberalized Ad hoc Liberalized Automatic Automatic Ad hoc Ad hoc Liberalized Ad hoc Price pass-through Tax % Gas Retail Prices (2006) 46.4 36.4 ... 38.4 ... 33.4 ... ... 42.0 43.9

Country Argentina Bolivia Brazil Colombia Dominica Ecuador Honduras Peru Uruguay

Gasoline Kerosene 0.65 0.46 1.27 0.64 ... 1.03 ... 3.33 1.25 1.45 0.47 0.34 ... ... ... 0.83 ... 2.27 0.91 0.89

Diesel 0.64 ... 0.92 0.47 ... 0.79 ... ... 0.85 0.95

Gasoline Kerosene Diesel 0.09 0.21 1.14 0.74 ... 1.78 ... ... 1.64 1.40 0.08 ... ... ... ... 1.49 ... ... 1.28 0.84 0.83 ... 2.92 0.65 ... 1.29 ... ... 0.99 1.14

DominicanRep Liberalized

Background III: Reform Agenda

Fuel subsidies seen as undesirable because

High fiscal cost with consequences elsewhere in budget (Indonesia/Yemen: subsidies exceeded combined health and education budgets) Inefficient: leads to over-consumption

Governments still reluctant to increase domestic prices in line with world prices

Concerns about impact on poor and politically unpopular PSIA can inform choice of appropriate policy response (so far: Angola, Bangladesh, Bolivia, Ethiopia, Gabon, Ghana, Honduras, Jordan, Madagascar, Mali, Moldova, Sri Lanka, Sudan)

Objective of PSIA

To identify the magnitude and financing of consumer subsidies To evaluate the aggregate and distributional incidence of their withdrawal on household real incomes To identify appropriate mitigation measures to offset adverse impact on poorest households To identify higher priority public expenditures (more pro-poor and pro-growth)

Methodology and Data

Higher domestic prices affect consumers through two channels

Direct effect from increase in price of fuels consumed by households Indirect effect from increase in prices of goods and services that use fuel as inputs

Indirect effect often substantial since over 50 percent of total consumption of fuel is as intermediate product

Step I: Identify magnitude and financing

This requires a reference price for each product and required price increases

For most countries, border (cif,fob) price (plus,minus) domestic trade and transport margins Often existing or desired tax levels included in reference price to allow for tax expenditures

Average price increase ranged from 34-68 percent (mostly including taxes)

Magnitude and Financing of Subsidies

P
Demand

Pm
A

B
E

Ps Pp Pc
D

Domestic refinery that imports product Import at P(m), produce at P(c) Subsidized domestic price is P(s) Produces Q(c), imports Q(s)-Q(c) Total consumer subsidy = (A+B+C)=Q(s)[P(m)-P(s)] Where shows up depends on price to producer. If taxes, P(p), P(s)
Explicit import subsidy=(B+C) Loss in profits=(A+D)+E Tax revenue=(D+E) Net fiscal position On budget: (D+E)-(B+C) Off budget: -(A+D+E)

Qc

Qs

Cameroon: More Transparent Formula

P e tro l
800 70 0
33

600 50 0 400 300 200

120 21 64 30 107

200 120

157

77

77

77

98

98

98 595

300

300

300

300

10 0 0 E x i s i t i ng
Im por t P r ic e

R e f o rme d
Cust om s

E f f i c i e nc y
VAT Input VAT

E q ui t y
Exc ise AE

A c t ua l
Ac t ua l P r ic e

Ma r gins

Sri Lanka: Eliminating subsidies required:

gas (12%), diesel (20%), kerosene (58%), average (23%)

100

104 93 84 79

80

60

61

43

0
Formula

20

40

Actual

Formula

Actual

Formula

Actual

Gasoline

Kerosene
Landed Cost Distribution Margins Excise Taxes

Diesel
Value Added Tax Consumer Price

Step II: Calculate direct effect

Need household survey with information on different fuel expenditures For each household, calculate budget shares as expenditure on fuel divided by total household consumption Multiply required price increases by budget share to get approx. real income impact Look at distribution of percentage real income effect across income groups (regressive vs. progressive)

Example of fuel consumption patterns in Sri Lanka

6

5.3

Budget Share

3.7 3.0 2.7 2.5 2.6

0
Bottom Decile

Second Decile

Second Quintile

Third Quintile

Fourth Quintile

Top Quintile

Kerosene LPG

Diesel and Petrol Electricity

Magnitude of direct effect

Fuel budget shares varied from 2-4.3 percent (3.16.6 percent including electricity)

Therefore, a 50 percent increase in average price implies a 1-2.1 percent (1.6-3.3 percent) decrease in real incomes

Fuel budget shares for lowest welfare quintile varied from 2-6 percent (2.7-7.1 percent)

Therefore, a 50 percent increase in average price implies a 1-3 percent (1.4-3.6 percent) decrease in real incomes Reflects importance of kerosene, which is typically relatively heavily subsidized

Direct effect found to be either neutral of regressive

Step III: Calculate indirect effect

An input-output table and a simple model can be used to calculate the increase in prices for other goods and services from higher fuel costs Aggregate household consumption data to get budget shares for input-output sectors Multiply budget shares by percentage price increases to get percentage real income effect Aggregate to get total indirect effect and look at distribution across different income groups Add to direct effect to get total impact of fuel price increase on household real incomes and distribution

Example from Ghana

Sector Budget Share (BS) 0.452 0.021 0.253 0.000 0.070 0.032 0.025 0.097 0.008 Price Effect (dP) 0.066 0.116 0.052 0.107 0.107 0.267 0.025 0.048 0.000

Impact=BS*dP 0.030 0.002 0.013 0.000 0.007 0.008 0.001 0.005 0.000

Agriculture Utilities and mining Manufacturing Construction Trade Transport Business Community Electricity

Magnitude of indirect effect

Indirect effect at least as large as direct effect and approximately neutral incidence A 50 percent average increase associated with a 3 percent decrease in real incomes Most of indirect effect comes through higher food and transport costs

Magnitude of total effect

Total effect ranged from 2-8.5 percent A 50 percent increase associated on average with a 4.6 percent decrease in real incomes Distribution typically regressive reflecting role of higher kerosene price increases

Step IV: Evaluate targeting efficiency

Calculate the share of the total subsidy (or, equivalently, the burden of subsidy removal) accruing to each income group Can do this separately for each product as well as the direct, indirect and total effects Individual product shares useful later when comparing alternative approaches to protecting the real incomes of low-income households

Fuel subsidies are badly targeted

A relatively high share of total fuel subsidies go to higher income groups

Share of bottom two quintiles varied from 15-25 percent (so 75-85 percent of subsidy benefit accrues to top three quintiles) So costs 4-6.7 units of income for every 1 unit transferred to bottom two quintiles

Even direct (mainly kerosene) subsidy is badly targeted

Between 70-80 percent leaks to top three quintiles so costs 3.3-5 units of income for every unit transferred to bottom two quintiles

Step V: Identify mitigating measures

Although badly targeted, withdrawal of fuel subsidies can have substantial adverse effect on poor (c2-9%) Can consider a number of alternatives and simulate using household-level data (budgetary cost minimized by better targeted transfers/expenditures)

Gradual withdrawal of specific fuel subsidies (kerosene, LPG) to minimize revenue-poverty trade-off Using some of budgetary savings to finance targeted public expenditures (education, health, roads, transport, electricity) Restructure electricity tariff schedules to reduces cost for poor Use savings to finance existing/reformed/new social safety net for poorest households

Example from Ghana

Bottom Benefit Shares Education Untargeted Targeted Health Untargeted Targeted Rural electrification Urban transport Proxy-means targeting Kerosene subsidy 0.149 0.148 0.329 0.299 0.373 0.178 0.193 0.229 0.251 0.128 0.277 0.211 0.208 0.208 0.212 0.185 0.205 0.227 0.207 0.226 0.135 0.280 0.111 0.209 0.244 0.189 0.074 0.108 0.035 0.174 0.215 0.204 0.225 0.279 0.219 0.249 0.187 0.170 0.154 0.098 2nd Quint 3rd Quint 4th Quint Top

Example from Sri Lanka

Kerosene subsidies Use of electricity lifeline rates

Potential benefits from restructuring tariff schedule

Highlight performance level of existing program Emphasize gains from reforming design and implementation

Use of existing Samurdhi transfer program

Even kerosene subsidies involves substantial leakage to the non-poor

15.2%

13.0%

10.7% 18.9%

22.0% 20.2%

Bottom Decile Second Quintile Fourth Quintile

Second Decile Third Quintile Top Quintile

Share of Gasoline Burden (Cameroon)

Share of Burden from Direct Effect--Gasoline

0.2% 0.2% 2.3% 3.9% 10.3%

83.0%

Bottom Decile Second Quintile Fourth Quintile

Second Decile Third Quintile Top Quintile

Share of LPG Burden (Cameroon)

Share of Burden from Direct Effect--LPG

0.7% 1.9% 6.0% 11.0%

58.1%

22.4%

Bottom Decile Second Quintile Fourth Quintile

Second Decile Third Quintile Top Quintile

Alternatively could subsidize electricity.......

Density of Electricity Consumption

50 100 150 200 Monthly Electricity Consumption (Kw/H) Existing Tariffs Restructured Tariffs Scaled Tariffs Cumulative Density

250

.2

.4

.6

.8

......but these appear badly structured.....

5
20th percentile 40th percentile

1
6

8 Log Per Capita Consumption Existing Tariffs Restructured Tariffs

10

Scaled Tariffs

.....and involve very substantial leakage to non-poor

Scaled Tariffs
2.0% 3.9% 7.9%

Restructured tariffs
4.8%

9.5% 26.8% 12.5% 49.6% 17.7%

22.5%

21.9%

21.0%

Bottom Decile Second Quintile Fourth Quintile

Second Decile Third Quintile Top Quintile

The Samurdhi program reduces leakage substantially.........

Samurdhi Food Stamps
4.6%

Reformed Samurdhi
1.0%

14.7%

17.4% 18.1% 14.8%

8.0% 24.9%

22.4% 18.9% 26.1% 29.1%

Bottom Decile Second Quintile Fourth Quintile

Second Decile Third Quintile Top Quintile

....and potentially provides a more costeffective approach to social protection

20

16.9

10

15

7.9

7.3

4.2 3.1 2.3

Scaled Electricity Fuel Existing Samurdhi

Restructured Electricity Kerosene Restructured Samurdhi

Policy messages from PSIA

Fuel subsidies are often substantial fiscal drain, crowdout priority expenditures and badly targeted So should be able to identify alternative uses that are more pro-poor and pro-growth:

Alternative approaches to social protection can provide same or better protection at substantially lower fiscal cost Higher priority public expenditures (nutrition, health, education, infrastructure) e.g. based on PRSP Access to effective system for targeting expenditures can be a crucial component for promoting efficiency-enhancing structural reforms

Policy messages from PSIA

Important to announce reforms as part of a package: budgetary savings to finance better targeted, higher priority expenditures that benefit low- and middle-income households Gradual reduction of better targeted fuel subsidies should be seen only as short term measure are developed since revenue-poverty trade off is large and efficiency cost from interfuel substitution large