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The State Budget May Not Afford It All: Educate and Cure or Subsidize

Author(s):
International Monetary Fund. Research Dept.
Published Date:
March 2015
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Christian Ebeke and Constant Lonkeng Ngouana

Energy subsidies have important fiscal, distributional, and environmental costs. They are often publicized by governments as sheltering the purchasing power of the less wealthy from high energy costs. But are they really a free-lunch? We attempt to provide an answer to this question in a large cross-section of emerging markets and low-income countries. To account for the fact that energy subsidies and public social spending may be jointly determined (e.g., at the time of the budget), we instrument energy subsidies in a given country by the subsidy intensity in neighbor countries. We find that public spending in education and health are on average lower by 0.6 percentage point of GDP in countries where energy subsidies are 1 percentage point of GDP higher. Moreover, the crowding-out is exacerbated in the presence of weak domestic institutions, narrow fiscal space, and among the net oil importers. Finally, consistent with our empirical findings, we show that high energy subsidies and low public social spending can emerge as equilibrium of a political game between the elite and the middle-class when the delivery of public goods is subject to bottlenecks, reflecting weak domestic institutions.

International agencies have warned governments around the globe on the fiscal cost and environmental damage of energy subsidies (e.g., IEA, 2011; IMF, 2013; World Bank, 2010; Parry and others, 2014). A comprehensive assessment by Clements and others (2013) suggests that pre-tax energy subsidies amounted to 0.7 percent of global GDP in 2011. The figures are even more alarming when the negative externalities from energy consumption are factored-in—the authors evaluated post-tax energy subsidies to 2.9 percent of global GDP in 2011, equivalent to 8.5 percent of total government revenues. In addition, generalized energy subsidies have important distributional effects—they accrued mostly to upper-income groups, given their high energy consumption (see Arze Granado and others, 2012, for a survey of micro-based evidence).

From a political economy standpoint, governments’ repeated argument that energy subsidies shelter the purchasing power of the poor against high energy costs would fade out, if energy subsidies, owing to budget constraints, come at the cost of lower public social spending. This is precisely because the high energy subsidies and low social spending mix is likely to have a net negative impact on lower-income groups who can hardly afford alternative market-provided services.

Against this backdrop, we assess whether or not energy subsidies crowd-out public social spending, defined narrowly (for the purpose of our analysis) as public expenditures in education and health. Our focus on public social spending is motivated by three factors. First, in contrast to energy subsidies, public social spending is less likely to be regressive, given the relatively limited access of poor households to (costly) private schools and hospitals. Second, because it is “less visible,” public social spending is likely to generate a relatively low political premium and might be more prone to crowding-out in the budgetary process. Third, and perhaps most importantly, public social spending is likely to improve human capital and productivity, thereby boosting the economy’s growth potential.

Figure 1 provides some insights into our question. The facts are quite striking: while subsidies did decrease in developing and emerging Asia between the two identified sub-periods (2002–2006 and 2007–2011), they did increase in Sub-Saharan Africa. Interestingly, social spending moved in opposite directions in and across both regions, pointing to a potential trade-off between subsidies and social spending. In contrast, social spending did not move much in the resource-rich Middle East and North Africa (MENA), despite the sharp increase in energy subsidies, suggesting that countries’ endowment or resource space may condition the crowding-out.

Figure 1:Energy Subsidies and Social Spending—Change Between the First and Second Sub-periods

(in percent of GDP)1

Citation: 16, 1; 10.5089/9781475551389.026.A002

1 The first (second) sub-period covers 2002–06 (2007–11). Averages are considered for each sub-period. CIS refers to the Commonwealth of Independent States.

Source: Clements and others (2013), World Development Indicators (2013), and authors’ calculations.

Figure 2 provides a more disaggregated picture (at the country level) and paints a quite similar story: (i) Although energy subsidies rose around the globe between the two identified sub-periods (most countries in the sample are on the right of the vertical axis), especially in resource-rich countries, the evolution of social spending was uneven (countries are almost equally split below and above the horizontal axis); (ii) some resource-rich countries were somewhat able to afford higher energy subsidies without slashing public social spending (in nominal terms), and even when public social spending did decrease in resources-rich countries, the decline was much lower than the increase in subsidies (above the 45 degree line); and (iii) in general, where social spending did increase, the increase was lower than the increase in subsidies (below the 45 degree line). Consequently, only very few countries went through the virtuous cycle of lower energy subsidies and higher public social spending (second quadrant); Moldova and Indonesia are notable exceptions.

Figure 2:Energy Subsidies and Social Spending Across Countries: What Happened?

Source: Clements and others (2013), World Development Indicators (2013), and authors’ calculations.

We estimate the impact of energy subsidies on public social spending more systematically in a large cross-section of emerging markets and low income countries.1 Because subsidies and social spending are jointly determined (e.g., in the budget process), naïve ordinary least squares (OLS) estimates would be biased. To address this simultaneity bias and other potential sources of endogeneity, we instrument energy subsidies in a given country by subsidy intensity in neighbor countries.2 Our instrumental variable estimations indeed suggest a causal relationship running from energy subsidies to public social spending. More specifically, we find that public expenditures in education and health are on average 0.6 percentage point of GDP lower in countries where energy subsidies are 1 percentage point of GDP higher. Moreover, the crowding-out is stronger when the fiscal space is narrow, rising to about 0.8 when the debt-to-GDP ratio reaches 70 percent, and among the net oil importers. Also, consistent with a central prediction of our theoretical model, weak domestic institutions exacerbate the crowding-out effect, estimated to be almost one-to-one in countries with government ineffectiveness above the 75th percentile of the sample distribution.3

A natural question is, therefore, why the poor would support energy subsidies—a form of redistribution that disproportionally benefits upper income groups—in equilibrium. Or put differently, under which conditions high energy subsidies and low public social spending could occur in equilibrium? We show that high energy subsidies and low public social spending may emerge as an equilibrium outcome of a political game between the elite and the middle-class when the delivery of the public good is subject to bottlenecks, reflecting weak domestic institutions. Intuitively, the poor support that equilibrium because energy subsidies provide a small but certain benefit to consumption, whereas the delivery of public spending is subject to important leakages (e.g., in the form of corruption or lack of commitment by the politician). The elite, internalizing this, set a subsidy rate that is sub-optimally high, crowding-out public social spending, especially when the fiscal space is narrow. The model also implies that resource wealth limits the severity of the crowding-out, as the size of the pie is bigger. In addition, we show that the energy subsidy and public social spending mix could be improved endogenously if the rich have more skin in the game. This would for instance be the case if the social contract is such that energy subsidies are financed using additional income taxation or if the public good represents a worthwhile alternative to market-provided services.

Our findings have important policy implications. On the one hand, they suggest that non-resource-rich countries with a narrow fiscal space would have to move expeditiously with subsidy reform in order to relax the constraints weighting on public social spending. On the other hand, it will prove challenging to resource-rich economies to keep energy subsidies at their current high levels moving forward, in view of mounting social spending pressures, including from the youth, given the volatile nature of resource revenues. The recent sharp drop in global oil prices seems to vindicate this point. Indeed, in line with our conceptual framework and empirical findings, resource-rich countries were somewhat able to afford high energy subsidies with relatively limited crowding-out of public social spending, thanks to their large fiscal space at a time when oil prices were relatively high and on the rise. Those subsidy regimes will clearly be harder to sustain at much lower international oil prices, as existing fiscal buffers get eroded.

On the positive side, energy subsidy reform is likely to pose less political headache when global oil prices are relatively low. Governments around the world—resource-rich and non-resource-blessed alike—are therefore presented with a golden opportunity to reform energy subsidy at this juncture of high energy subsidies and low global oil prices. In that vein, depoliticizing domestic energy pricing, for instance by adopting an automatic pricing mechanism (see Coady and others, 2012), seems to be a good transition toward fully-deregulated energy prices.

References:

    Arze Del GranadoF. J.D.Coady and R.Gillingham2012. “The Unequal Benefits of Fuel Subsidies: A Review of Evidence for Developing Countries,World Development40(11) 22342248.

    ClementsB.D.CoadyS.FabrizioS.GuptaT.Alleyne and C.Sdralevich2013. Energy Subsidy Reform: Lessons and Implications. Washington, DC: International Monetary Fund.

    DavidC.et al.2012. “Automatic Fuel Pricing Mechanisms with Price Smoothing: Design, Implementation, and Fiscal Implications,Technical Notes and Manuals 12/03. Washington, DC: International Monetary Fund.

    EbekeC. and C.Lonkeng Ngouana. 2015. “Energy Subsidies and Public Social Spending: Theory and Evidence,IMF Working Paper forthcoming. Washington, DC: International Monetary Fund.

    International Energy Agency. 2011. “Chapter 14: Development in Energy Subsidies,” in World Energy OutlookParis: International Energy Agency (IEA).

    International Monetary Fund. 2013. “Energy Subsidy Reform: Lessons and Implications,Board Paper. Washington, DC: International Monetary Fund.

    ParryI.D.HeineE.Lis and S.Li. 2014. Getting Energy Prices Right: From Principle to Practice. Washington, DC: International Monetary Fund.

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The choice of the cross-sectional econometric approach over a panel specification is motivated by three main factors: (i) the relatively short time period for which subsidies data are available (2000–11); (ii) the dominance of the between-country variation in the subsidies-to-GDP ratio over the within-country changes; and (iii) the inertia in public social spending and some of its determinants (demographics, institutions, urbanization, natural resource dependency, etc.), which implies that fixed-effects would absorb most of the variations in panel estimations.

Energy subsidies in neighboring countries are found to explain about one-quarter of the variations in subsidies across the 109 countries in our sample, and half of the variation among net oil exporters. We also find that the constraints on the executive condition the level of energy subsidies in a country.

We also control for traditional determinants of social spending such as demographics (dependency ratio, urbanization rate), macroeconomic conditions (output volatility), and the size of the government.

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