The Magnitude and Distribution of Fuel Subsidies

David Coady

PSIA GroupFiscal 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 pro-

growth 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 systems8 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, 2003-061

US$ per liter Percent changeCrude oil prices 0.4 128.0Gasoline 0.6 140.7Kerosene 0.6 126.7Diesel 0.6 142.1

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

Major Events and Real Price of U. S. Oil Imports, 1970–2006

$-

$10

$20

$30

$40

$50

$60

$70

$80

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

$2

00

5Q

2 p

er b

arre

l

1973 Oil Embargo

Iranian revolution; Shah deposed

Iran-Iraq War begins; oil prices peak

Saudi Arabia abandons "swing producer" role; oil prices collapse

Iraq invades Kuwait

Gulf War

Asian economic crisis; oil oversupply; prices fall sharply

Prices rise sharply on OPEC cutbacks, increased demand

Prices fall sharply on 9/11 attacks

Prices spike on Iraq war, rapid demand increases, constrained OPEC capacity, etc.

Text Table C. Gasoline Pricing Mechansims, Prices and Price Pass-Through

Pricing Number of Average price Price pass

mechanism countries (US$ per liter) though

2003 2006

Ad hoc 21 0.61 0.98 0.83

Automatic 8 0.56 0.84 1.00

Liberalized 15 0.70 1.03 1.13

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, so-

called 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)

Est. Proj.2003 2005 2006

(a) Explicit subsidies

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

Implicit Subsidies (%GDP)

Est. Proj.2003 2005 2006

(b) Implicit subsidies

Armenia 0 0 1.0Azerbaijan 10.0 13.9 10.4Bangladesh ... 1.0 ...Bolivia 1.7 5.2 6.6Cameroon 0.1 0.0Colombia 1.2 1.6Congo, Republic of ... ... …Dominican Republic ... 0.2 0.3Ecuador 1.4 3.6 ...Egypt 3.9 4.1 6.2Ethiopia ... 0.7Gabon 0.4 1.6 2.8Indonesia ... ... 0.3Nigeria 1.6 2.2 ...Sri Lanka ... 1 ...

Text Table B. The Average Price Pass Through, 2003-2006 1

Gasoline Kerosene Diesel

Net oil importers 1.09 0.91 1.15Net oil exporters 0.46 0.43 0.70

AFR 1.06 1.07 1.11APD 1.05 0.37 0.83EUR 1.25 ... 1.54MCD 0.56 0.78 0.78WHD 1.00 0.92 1.30G-7 countries 1.11

of which : USA 0.89

Average 2 0.96 0.83 1.07

Countries in sample 2 44 29 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 pass-through

CountryPrice mechanism Gasoline Kerosene Diesel Gasoline Kerosene Diesel

Argentina Liberalized 0.65 0.47 0.64 0.09 0.08 0.83 46.4

Bolivia Ad hoc 0.46 0.34 ... 0.21 ... ... 36.4

Brazil Liberalized 1.27 ... 0.92 1.14 ... 2.92 ...

Colombia Automatic 0.64 ... 0.47 0.74 ... 0.65 38.4

Dominica Automatic ... ... ... ... ... ... ...

DominicanRep Liberalized 1.03 0.83 0.79 1.78 1.49 1.29 33.4

Ecuador Ad hoc ... ... ... ... ... ... ...

Honduras Ad hoc 3.33 2.27 ... ... ... ... ...

Peru Liberalized 1.25 0.91 0.85 1.64 1.28 0.99 42.0

Uruguay Ad hoc 1.45 0.89 0.95 1.40 0.84 1.14 43.9

Tax % Gas Retail Prices (2006)

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

Q

Pm

Pc

Pp

Ps

Qc Qs

Demand

A B C

D E

• 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)

Cameroon: More Transparent Formula

Petrol

300 300 300 300

107 98 98 98

30

6477 77 77

21

120 200120

157

33

595

0

100

200

300

400

500

600

700

800

Exisiting Reformed Effi ciency Equity Actual

Import Price Margins Customs VAT Input VAT Excise AE Actual Price

Sri Lanka: Eliminating subsidies required:

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

104

93

79

43

84

61

02

04

06

08

01

00

Pri

ce (

Rp

/ L

r)

Gasoline Kerosene Diesel

Formula Actual Formula Actual Formula Actual

Landed Cost Value Added TaxDistribution Margins Consumer PriceExcise Taxes

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

3.02.7

2.5 2.6

3.7

5.3

02

46

Bu

dg

et S

hare

BottomDecile

SecondDecile

SecondQuintile

ThirdQuintile

FourthQuintile

TopQuintile

Kerosene Diesel and PetrolLPG Electricity

Magnitude of direct effect

Fuel budget shares varied from 2-4.3 percent (3.1-6.6 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

Direct effect found to be either neutral of regressive– Reflects importance of kerosene, which is typically relatively

heavily subsidized

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)

Price Effect (dP)

Impact=BS*dP

Agriculture 0.452 0.066 0.030 Utilities and mining 0.021 0.116 0.002 Manufacturing 0.253 0.052 0.013 Construction 0.000 0.107 0.000 Trade 0.070 0.107 0.007 Transport 0.032 0.267 0.008 Business 0.025 0.025 0.001 Community 0.097 0.048 0.005 Electricity 0.008 0.000 0.000

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 2nd

Quint 3rd

Quint 4th

Quint

Top

Benefit Shares

Education

Untargeted 0.215 0.225 0.219 0.187 0.154

Targeted 0.204 0.279 0.249 0.170 0.098

Health

Untargeted 0.149 0.193 0.208 0.207 0.244

Targeted 0.148 0.229 0.208 0.226 0.189

Rural electrification 0.329 0.251 0.212 0.135 0.074

Urban transport 0.299 0.128 0.185 0.280 0.108

Proxy-means targeting 0.373 0.277 0.205 0.111 0.035

Kerosene subsidy 0.178 0.211 0.227 0.209 0.174

Example from Sri Lanka

Kerosene subsidies Use of electricity lifeline rates

– Potential benefits from restructuring tariff schedule

Use of existing Samurdhi transfer program– Highlight performance level of existing program– Emphasize gains from reforming design and

implementation

Even kerosene subsidies involves substantial leakage to the non-poor

13.0%

10.7%

22.0%

20.2%

18.9%

15.2%

Bottom Decile Second Decile

Second Quintile Third QuintileFourth Quintile Top Quintile

Share of Gasoline Burden (Cameroon)

0.2%0.2%2.3%3.9%

10.3%

83.0%

Bottom Decile Second Decile

Second Quintile Third QuintileFourth Quintile Top Quintile

Share of Burden from Direct Effect--Gasoline

Share of LPG Burden (Cameroon)

0.7%1.9%6.0%

11.0%

22.4%58.1%

Bottom Decile Second Decile

Second Quintile Third QuintileFourth Quintile Top Quintile

Share of Burden from Direct Effect--LPG

Alternatively could subsidize electricity.......

0.2

.4.6

.81

Den

sity o

f E

lectr

icity C

on

sum

ption

01

23

45

67

Tari

ff (

Rs/k

Wh)

0 50 100 150 200 250Monthly Electricity Consumption (Kw/H)

Existing Tariffs Scaled TariffsRestructured Tariffs Cumulative Density

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

20thpercentile

40thpercentile

12

34

5

Ave

rag

e T

ariff (

Rp

/Kw

)

6 8 10Log Per Capita Consumption

Existing Tariffs Scaled TariffsRestructured Tariffs

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

2.0%

3.9%

9.5%

12.5%

22.5%

49.6%

4.8%

7.9%

17.7%

21.0%21.9%

26.8%

Scaled Tariffs Restructured tariffs

Bottom Decile Second DecileSecond Quintile Third Quintile

Fourth Quintile Top Quintile

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

17.4%

14.8%

26.1%

22.4%

14.7%

4.6%

24.9%

18.9%

29.1%

18.1%

8.0%

1.0%

Samurdhi Food Stamps Reformed Samurdhi

Bottom Decile Second DecileSecond Quintile Third Quintile

Fourth Quintile Top Quintile

....and potentially provides a more cost-effective approach to social protection

16.9

7.97.3

4.2

3.12.3

05

10

15

20

Cost p

er

Rs. 1

for

bo

ttom

20

%

Scaled Electricity Restructured ElectricityFuel KeroseneExisting Samurdhi Restructured Samurdhi

Policy messages from PSIA

Fuel subsidies are often substantial fiscal drain, crowd-out 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 inter-fuel substitution large