Appendix 1 List of Examined Countries14
Sub-Saharan Africa:
Mauritius (1992–95)*
Nigeria (1999–2000)*
North Africa and Middle East:
Algeria (1991–93)*
Egypt (1991–94)*
Iran (1992–95)*
Jordan (1990–92 and 1994–99)*
Europe and Central Asia:
Albania (1992–97)
Belarus (1997–99)*
Hungary (1992–94)*
Western Hemisphere:
Colombia (1997–99)*
Ecuador (1997–98)*
Jamaica (1984–93)*
South and East Asia and Pacific:
Bangladesh (1991)
India (1994–95)
Indonesia (1998–2000)*
Zambia (1991–93)*
Zimbabwe (1990–91)*
Morocco (1996–99)*
Tunisia (1989–99)*
Yemen (1997–99)*
Poland (1993)
Russian Federation (1994–99)*
Ukraine (1995–99)*
Mexico (1981–91)*
Peru (1990–91)*
Rep. Bolivariana de Venezuela (1989–91)*
Pakistan (1984)
Sri Lanka (1978–82)*
Appendix 2 The Nature of Price Subsidies
36. A price subsidy reduces the consumer price of a good or service below what it would be in the absence of the subsidy (consumer subsidy) or increases the price received by a producer above its market level (producer subsidy). In practice, consumer subsidies are often implemented with price controls, resulting in shortages of the subsidized item. Producer subsidies, on the other hand, are often administered through producer support prices. When support prices are set too high, there is an oversupply of the subsidized item.
37. Explicit price subsidies are recorded in the government budget as expenditures, although not necessarily under the category “subsidies.”15 Explicit subsidies can take many forms. In the case of a consumer subsidy, a public agency can make direct payments to producers to compensate them for charging lower prices for their output. Alternatively, the government can directly provide goods and services free of charge or at below-market prices through a public distribution system.
38. Implicit price subsidies are not easily identifiable in the government budget, but can show up as (1) losses of the banking system (e.g., owing to below-market interest rates or directed credits); (2) losses of state-owned enterprises, owing to setting prices below cost recovery levels; (3) differential tariffs for various consumers (e.g., by charging industrial users a higher tariff for electricity and water); (4) tax expenditures (e.g., tax exemptions, concessions, and deferrals); (5) below-market procurement prices, which act as a tax on producers and a subsidy for consumers; (6) equity participation in state-owned enterprises without an expectation of a market return or net lending to them at preferential interest rates; (7) regulations that alter market prices or restrict market access (regulatory subsidies); and (8) distribution of donor-provided commodities at below-market prices. All these subsidies affect the government budget, although some (tax expenditures, equity participation, and net lending) more directly than others.
39. A price-subsidy policy can be helpful in pursuing social and economic goals. Price subsidies can be designed to correct market imperfections. For example, the provision of basic education and childhood immunizations free of charge or at reduced tariffs can promote broad-based human and economic development. Subsidies can also be used to address domestic market imperfections in domestic factor and product markets of traded goods. In that case, a subsidy policy is preferable to imposing tariffs (Bhagwati and Ramaswami, 1963). Other price subsidies, such as for basic commodities, can provide food security and improve the well-being of the lowest-income individuals and households in a society. Transitory subsidies may be the only means of cushioning against sharp losses of purchasing power (e.g., following the CFA franc zone exchange reform, and in the wake of the 1997 financial crisis in Indonesia).
40. In practice, price subsidies have also been motivated by other goals, including providing subsidies to nonpoor special interest groups (e.g., in 1999, only 21 percent of kerosene subsidies reached the poorest 30 percent of households in Indonesia).
41. Even when price subsidies achieve their intended objectives, their economic and social benefits have to be weighed against their costs:
Explicit and implicit price subsidies burden the government budget and can aggravate the country’s fiscal position. Government spending on subsidies averaged 1.6 percent of GDP in a group of 65 advanced, developing, and transition economies in the mid-1990s.16 Such spending was relatively high in industrial countries (1.8 percent of GDP), especially in the European Union. On the other hand, in developing countries, spending on subsidies averaged 0.9 percent of GDP, and in transition economies, 2.3 percent of GDP.17
Price subsidies reduce allocative efficiency by distorting relative prices. Consumer price subsidies often are associated with overconsumption or underprovision of the subsidized item, and producer subsidies with excess production. The welfare cost of such price distortions (i.e., the excess burden of price subsidies) increases faster than the rate of subsidization. In addition, price subsidies have been associated with smuggling (e.g., subsidized wheat and wheat flour in Yemen and subsidized petroleum products in Nigeria have all been smuggled out of these countries) and waste (e.g., subsidized bread was used as animal feed in Belarus, Jordan, Ukraine, and the Russian Federation, and wheat flour was used to mark soccer fields in Peru). In some cases, subsidizing of inappropriate commodities has led the poor to consume a less nutritious diet (e.g., in the Dominican Republic, the poor’s intake of calories and protein fell when they substituted less nutritious subsidized chicken for rice, beans, and oil plantains). In the European Union, estimates for 1978–95 suggest a net income loss of between 0.3 percent and 2.7 percent of GDP from the Common Agricultural Policy. The inefficiency of this policy is also reflected in its high cost; in 1980, the budgetary cost of transferring $1 to a farmer was, on average, close to $2 (Rosenblatt and others, 1988).
The methods used to finance subsidies—higher taxation or higher deficit financing—further worsen resource misallocations.
The capture of benefits of subsidies by middle- and upper-income households raises issues of equity and fairness. Moreover, price controls—used frequently to implement price subsidies—often result in black markets that limit the access of the poor to scarce items.
Subsidies for certain activities—agriculture, energy consumption, and timber exploitation—can contribute to environmental degradation. For example, subsidies for certain activities, including cattle raising, under the Polamazonia Program in Brazil in the 1970s adversely impacted the environment in the Amazon (Davis, 1977).
Appendix 3 Examining the Short-Term Impact of Reducing Price Subsidies on Real Household Incomes: An Illustration
42. This appendix provides two competing pragmatic approaches to estimating the impact of price-subsidy reform on households in the short term.
- Estimate the loss of real household income as the arithmetic mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This amounts to the following:
where RL denotes the impact on real household income in percent, wi is the share of item in household expenditures, Pi(1) is the new (in most cases, higher) price of item i, and Pi(0) the price before the reform of price subsidies. This estimate of the loss of real household income can be illustrated with an example. Suppose the price of subsidized rice rises by 50 percent, and that the weight of rice in the expenditures of poor households averages 30 percent, and that of non-poor households, 10 percent.18 Using the above equation, the average impact on the real income of poor households can then be estimated at 15 percent. For nonpoor households, the corresponding loss in real income is smaller—5 percent, on average.
This estimate provides an upper boundary on the increase in living costs. If households respond to changes in relative prices by shifting away from the item for which the price has increased, the actual loss will be smaller. The loss will be close to the above estimate if the subsidized item is a basic commodity for which no ready substitutes are available. If there is a perfect substitute, households will react to even a small change in the price of the subsidized item by shifting completely out of that item and into the substitute, suffering no loss in real income. The procedure below recognizes the likelihood of a consumer response.
- Alternatively, estimate the real loss of household income as the geometric mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This can be calculated as follows:
Using the same example as before, the estimated loss of poor house-holds from a rise in the price of rice by 50 percent can be calculated at 13 percent, and for nonpoor households, 4 percent. These estimates reflect the case when households are responsive—but not infinitely so—to changes in relative prices.19
43. Which estimate of real-income loss is more appropriate? The above approaches provide a reasonable range within which the correct answer is likely to fall. Which point in this range is most relevant for estimating the desirable level of compensation for price-subsidy reform depends on many factors, including whether the subsidized item is a basic commodity and some substitution possibilities exist. To be more precise, which estimate is more accurate depends on the size of the income effect of the price change versus the substitution effect. What is reassuring, however, is that the difference between the two estimates is typically small for poor households. In the above example, the estimates differ by only two percentage points.
Index Guide to Concepts and Issues20
Administrative capacity, 7, 14, 16, 23, 25, Box 1, and Table 1.
Available financing, 7 and 26.
Benefit incidence and equity, 19–20, 28, 31–32, 35, and 40.
Cash transfers, 8–11, 15–16, 29, and Boxes 3–4.
Delivery mechanism, 15, and Box 3.
Exogenous factors, 29, 33, and Box 1.
Efficiency of compensation mechanisms, 12–13 and 34.
Fiscal savings, 1–2, 5–7, 26, 33, and Boxes 1–3.
Mass information campaigns, 32, and 35.
Middle class and other nonpoor groups, 7, 28–29, and 32.
Political disruption, 28–32, and Box 4.
Political support for price-subsidy reform, 6–7, 28–32, and Boxes 1 and 4.
Price-subsidy reform in the longer term, 9, 32, and 34.
Rationale for price-subsidy reform, 1, 4, 18, 20, and 41.
Reversal of price-subsidy reform, 6–7, 33, and Box 1.
Social impact and disruption, 2, 4–5, 20–21, and Boxes 1 and 3.
Social safety nets and social compensation instruments, 5, 7–10, 15–16, 23, 25–26, 32, 34, Boxes 1–4, and Table 1.
Speed of price-subsidy reform, 5–7, 33, and Box 1.
Stakeholder approach, 32, 35, and Box 4.
Subsidies by type,
Subsidies and environment, 27 and 41.
Targeting by type,
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Before 1994, generalized subsidies in Jordan covered many food items at an average cost to the budget of 2.2 percent of GDP. These subsidies took two forms: (1) coupons distributed to all households for buying rice, sugar, and milk; and (2) wheat price controls, which provided an implicit subsidy for bread. In 1995, the government also began issuing coupons for bread, but the price of bread remained extremely low, leading to wasteful consumption (bread was used for animal feed) and smuggling. In 1996, the price of wheat was increased and the government replaced coupons with a cash transfer for bread. This also led to an increase in prices of other foods like poultry and dairy products, which provoked food riots. In 1999, the fall in international wheat prices offered the opportunity to align the domestic price with its international level and integrate cash transfers into the targeted social assistance programs administered by the National Aid Fund. But the authorities set the domestic price of bread somewhat below its production cost, and a small subsidy reappeared. The domestic price of wheat continues to be controlled, and the bread subsidies may rise if wheat import prices increase.
In some instances, the government awarded wage increases at the time of price liberalization. This policy is tantamount to a cash compensation targeted to workers in the public sector and recipients of social security benefits.
Korea has been successful in phasing out safety nets after the effects of the 1998 financial crisis dissipated.
Based on a sample of 24 targeted-subsidy and cash-transfer programs in 11 countries in Latin America, Grosh (1994) finds that the administrative cost as a share of total program cost ranges from 3 percent to 10 percent for self-targeted programs, against 4 percent to 16 percent for geographically targeted programs, and 1/2percent to 29 percent for programs that assess eligibility individually for each participant. These wide differences in administrative cost are not reflected in the targeting efficiency; for all programs for which data were available, the share of benefits accruing to the poorest 40 percent was within or near the 70 percent to 75 percent range. This result can be attributed to the small share of screening cost of participants in the overall administrative cost of subsidy programs and disparity in the availability of existing mechanisms to channel benefits. Another reason might be that the administrative costs do not vary significantly with the level of the benefits; administration of a scheme that pays beneficiaries very little will thus tend to absorb a large share of the total program cost, independent of the targeting mechanism (see Foster, Gomez-Lobo, and Halpern, 2000).
See also Van de Walle (1998). Several studies have shown that the targeting of social safety nets tends to become more efficient over time; see Hammer, Nabi, and Cercone (1995) and Lanjouw and Ravallion (1999).
Targeted food supplements and nutrition interventions for women and children, including school feeding programs, are a special case of such targeting. The drawbacks of these programs are imperfect coverage of the poor and high administrative costs. On the other hand, they are not associated with labor market disincentive effects, and are subject to minimal leakage.
In Zambia, where cash-for-work road construction projects offered a relatively high wage rate, some beneficiaries subcontracted their jobs to others at a lower wage.
The principal factors that underlie self-targeting in the broader sense are the opportunity cost of time used for obtaining benefits in work programs, the attractiveness of products to the poor, and social stigma.
In practice, the design of price-subsidy reforms will be the outcome of a collaborative process involving the country authorities, the IMF, the World Bank, and other stakeholders, particularly if such reforms are part of a poverty reduction strategy paper.
If full information from existing sources is lacking, substantial resources would be required to take into account all relevant considerations set forth in the guide.
For a number of countries, World Bank staff carries out analyses of the impact of price subsidies in the context of the Poverty Assessments and Public Expenditure Reviews.
However, Pitt (1985) found that kerosene subsidies in Indonesia disproportionally benefited the nonpoor and that the elasticity of substitution between firewood and kerosene was very small.
Hausmann (1994) argues that entitlements, such as subsidies, imply a negative-sum game leading to a highly inefficient but stable political (Nash) equilibrium. Moving to a better, Pareto-efficient equilibrium, requires a package of policies that yields benefits over the medium term for all groups. Ravallion and Lokshin (2000) examine support for government redistribution in the Russian Federation in 1996. They find that support for redistribution not only depends on whether the population is poor or well-off, but also on whether it expects to suffer an income loss or gain.
An asterisk indicates that data on public spending on price subsidies before and after reform are available for the country.
Subsidies paid to consumers, as opposed to producers, are typically classified as transfers in the public sector accounts. Subsidies that are administered by extrabudgetary funds (such as agricultural subsidies in a number of countries) are sometimes not consolidated with the budget.
Data on subsidies are from the United Nation’s System of National Accounts (SNA), which defines subsidies as current unrequited government payments to enterprises on the basis of their production, sales, or imports. Thus, the SNA data on subsidies exclude payments to consumers, such as food stamps, which are recorded under transfers, as well as implicit subsidies. The IMF’s Government Finance Statistics (GFS) uses a similar definition of subsidies as the SNA; however, for most countries, the GFS does not report separately on subsidy payments but instead lumps these outlays together with government transfers.
Clements, Rodriguez, and Schwartz (1998) find that a large government, a large external current account deficit, and a relatively large manufacturing sector are associated with a higher level of explicit subsidies.
Data on household expenditures can be obtained from household surveys.
The estimate reflects households who respond to price changes in such a way that the shares of spending on different consumption items in their total expenditures remains constant. This behavior is consistent with preferences that can be described by (a monotonic transformation of) a Cobb Douglas function, which has unitary compensated own-price and cross-price elasticities. Preferences of this type also underlie calculation of the Consumer Price Index in a number of countries, including many components of the CPI for the United States.
The numbers refer to paragraphs, text boxes, and tables.