The current approach to fuel pricing in many countries leads to large subsidies in times of rising international prices. These subsidies crowd out higher-priority uses of public funds, encourage inefficient fuel consumption, and accelerate global warming. Addressing this problem requires an effective reform strategy and a new approach to fuel pricing.
Petroleum Subsidies: Costly, Inequitable, and Rising
David P. Coady
October 4, 2010
Governments in all countries influence domestic prices of fuel products (including gasoline, diesel, and kerosene), either directly through price controls or indirectly through fuel consumption taxes. In times of rising international prices, many governments are unwilling to fully pass on these increases to domestic consumers, giving rise to fuel subsidies through two channels. First, subsidies arise when domestic consumer prices fall below the opportunity cost of supply. Since fuel products are internationally traded, subsidies therefore arise when consumer prices fall below the cost of importing fuel or the forgone revenue from not exporting. Second, because prices for fuel products should include taxes to contribute to government revenue and address domestic and global environmental damage, subsidies are actually higher if taxes are not high enough to meet revenue requirements and address environmental concerns. If taxes are too low, a consumer “tax subsidy” is essentially in effect. When consumer prices are below international prices, the total “tax-inclusive subsidy” is then the sum of the “pre-tax subsidy” and the “tax-subsidy”.
Because countries have differing revenue requirements as well as varying policy instruments available to raise government revenue and address environmental externalities, “optimal” fuel taxes differ around the world. For example, low-income countries tend to have to rely more heavily on consumption taxes for revenue so optimal fuel taxes are typically higher than in middle-income and high-income countries for a given government revenue requirement. Similarly, optimal fuel taxes are lower in countries that have more direct policy instruments for addressing local environmental concerns (for example, congestion charges). Other countries often rely on fuel taxes as a way of indirectly addressing environmental concerns such as congestion and accidents. Fuel taxes, however, should be at least as high as the standard rate of consumption tax in a country since the demand for fuel is often less sensitive to price increases compared to other consumption items (making it an efficient source of revenue) and because of the environmental damage associated with fuel consumption. However, although fully passing on international fuel price changes to consumers is desirable over the medium term both from efficiency and fiscal perspectives, there may be a case to limit the short-term volatility of domestic prices in order to minimize adjustment costs for the private sector.
How Large are Fuel Subsidies?
The global magnitude of fuel subsidies fluctuates with world prices. In 2003, pre-tax subsidies totaled nearly $60 billion. By mid-2008, they had increased more than eightfold—to $520 billion. Although subsidies fell sharply in the second half of 2008 as oil prices dropped, they increased again throughout 2009 as prices rebounded, and are projected to reach almost $250 billion by the end of 2010. Based on a common benchmark optimal tax of $1.14 per gallon (or $0.30 per liter), tax-inclusive subsidies are projected to reach $740 billion by the end of 2010, equivalent to 1 percent of global GDP.
Whereas emerging and developing countries account for all pre-tax subsidies, advanced countries account for a sizeable share of tax-inclusive subsidies. Of the projected pre-tax subsidy of $250 billion in 2010, emerging countries account for 65 percent and developing countries for the remaining 35 percent. Of the projected tax-inclusive subsidy of $740 billion in 2010, emerging countries account for 57 percent, developing countries for 20 percent, and advanced countries for the remaining 23 percent.
The Case for Subsidy Reform?
David P. Coady, Fiscal Affairs Department, International Monetary Fund
Economic theory provides strong arguments for avoiding fuel subsidies, and even for using fuel taxes to raise government revenue. The relatively low price elasticity of fuel demand (meaning that demand is only moderately impacted by increases in price) and the negative environmental externalities associated with fuel use provide strong arguments for fuel taxation. Fuel subsidies result in inefficiently high levels of consumption, exacerbate the adverse impact of rising international prices on economies that are net importers of fuel, and reduce the benefits of rising prices for net exporters. Less than full pass-through of increasing international prices to consumers dilutes the decrease in demand and so further increases international price volatility. Artificially low fuel prices also reduce the competitiveness of renewable energy technologies. Where fuel subsidies cause substantial differences in retail prices among neighboring countries, cross-border smuggling and disruption of domestic fuel markets can result.
Lower fuel prices are likely to be a very inefficient and costly approach to social protection. Not only do lower prices distort consumption patterns, but most of the benefits of fuel subsidies are captured by higher-income groups. Evidence for developing countries shows the richest 20 percent of households capture six times more in subsidies than the poorest 20 percent. Research in developed countries also finds that most of the subsidies go to higher-income households, reflecting their greater use for private transport and higher consumption of energy-intensive goods.
Even if the distribution of subsidy benefits can be made more progressive by focusing on fuels that are more important for the poor (such as kerosene in developing countries), this can result in a substantial distortion of domestic fuel markets. For example, subsidized kerosene is often redirected to other sectors of the economy or smuggled abroad, resulting in shortages of kerosene among poor rural households. Likewise, subsidized diesel can result in a switch from gasoline to diesel-engine cars.
Developed countries typically have access to more efficient social protection mechanisms—for instance progressive income taxes to redistribute wealth from higher-income households to low- and middle-income households, and direct welfare transfers to redistribute to the poorest households. Although these more efficient redistributive instruments might not be available in developing countries, governments may still have access to instruments that are far less distortionary and much better targeted than fuel subsidies, such as public works, school meal programs, and targeted cash transfer programs. At the very least, there is likely to be a very high efficiency gain from strengthening social protection systems in these countries.
The Reform Agenda
Reducing fuel subsidies can have a sizeable adverse impact on poor households, so it is important that reform strategies include mitigation measures. Where an effective social safety net exists, as in most developed countries, expanding the budget for these programs can address poverty concerns while containing the fiscal cost. For countries that do not have access to effective safety net programs, a gradual reform approach is the best option while more effective social protection systems are developed.
Because increasing retail prices is always a politically sensitive issue, governments need to prepare an effective public information campaign prior to reforms in order to increase public support. Transparently recording fuel subsidies in government fiscal accounts ensures that the magnitude of subsides is clearly understood. A public information campaign can then highlight that such subsidies crowd out higher priority public expenditures in areas such as education, health, and physical infrastructure. Populations should be made aware that not only are subsidies inefficient, but that they are mostly captured by high-income households. Governments should also highlight that subsidies can promote cross-border smuggling, shortages, black market activities, and corruption. The important role that fuel taxation can play in addressing climate change, which affects all countries, should also be emphasized.
A one-off reduction in fuel subsidies addresses only the symptoms of the problem. Avoiding the recurrence of fuel subsidies requires a new approach to fuel pricing in many countries. Government control of fuel prices gives the false impression that price changes reflect government policy, rather than international factors, with political pressure to avoid passing on international price increases but to pass through decreases. Although the best approach to petroleum pricing is to implement a fully liberalized regime accompanied by appropriate regulation to ensure competition, as an interim measure governments can adopt automatic pricing mechanisms that adjust prices regularly to reflect international price movements. These mechanisms can incorporate rules to reduce the magnitude of retail price changes compared to international price changes, ensure international price changes are fully passed on to consumers over the medium term, and avoid long periods of fixed prices that eventually necessitate large retail price increases if international price increases turn out to be persistent.