Fiscal Policy Formulation and Implementation in Oil-Producing Countries
Chapter

16 The Impact of Gasoline Price Subsidies on the Government and the National Oil Company

Author(s):
Jeffrey Davis, Annalisa Fedelino, and Rolando Ossowski
Published Date:
August 2003
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Author(s)
Ramón Espinasa1

One aspect seldom analyzed when discussing the distributive effects of gasoline subsidies in oil-exporting countries is the distribution of subsidy losses between the government and the national oil company (NOC).2 It is usually assumed that losses are borne by the government and have a direct fiscal effect. However, it will be shown that when part of the subsidy is absorbed as an NOC profit loss, this share of the subsidy will have only an indirect effect on government finances with a time lag, as NOC investment is reduced, affecting production and income and resulting in lower government oil revenue in later periods.

A second aspect often missed in gasoline price subsidy analyses is the role played by domestic transportation and retail sale costs. Many studies compare the netback refinery gate price of export products with the domestic retail product price at the gas station. Such an analysis misses the local transportation and retail sale costs. These costs are not negligible and ignoring them can underestimate by a sizable amount the magnitude of the retail price subsidy.

In what follows, a simple oil sector accounting model is developed to study the distributive effects of price subsidies when they are shared between the government and the NOC as well as to assess the subsidy with respect to domestic transportation and retail sale costs. For the sake of simplicity, it is assumed that a state monopoly produces, refines, and markets crude oil and products—as is the case in a number of oil-exporting developing countries.

I. Revenue

It is assumed that the country produces a quantity Q of gasoline3 that it sells either to the international (Qx) or domestic (Qd) market:

It is also assumed that the country always produces at capacity (which is assumed fixed in the short run), and therefore that an increase in domestic sales is at the expense of exports. Thus,

Three prices are relevant in this framework:4 two prices at the refinery gate for sales to the international 5(px) and the domestic markets (pd) and the retail price at the pump to the local final gasoline consumer (Pr).

The retail price at the pump is assumed to be the same as the domestic price at the refinery gate,6

The export price at the refinery gate will be higher than the domestic market price at the refinery gate,

The revenue forgone or implicit subsidy (s) per unit sold to the domestic market is7

Current revenue (Y) from a quantity (Q) of oil products sold to the international and domestic markets at refinery gate prices (px) and (Pd) is

The revenue forgone (ΔY) due to an increase (ΔQd) in domestic sales at the expense of (ΔQx) of export sales can be derived from (7) as

Thus, substituting (6) into (8), the forgone public sector revenue (ΔY) at the refinery gate can be expressed as the increase in the volume of products sold to the domestic market (ΔQd) times the unit subsidy (s),

II. Operational Costs

Assuming that export terminals are next to the refineries, the operational costs of the NOC are those that result from producing and transforming each unit of export product (cx) and producing, transforming, distributing, and retailing each unit of gasoline to the domestic market (cd) times the respective quantities,

The retail cost of selling a unit of product on the domestic market (cd) will be larger than the cost of selling it at the export terminal (cx),

The difference will be the costs of domestic distribution and retail sale, and they will be referred to generically as retail sale costs (cr),

This point needs to be highlighted because in many studies of domestic price subsidies the netback refinery gate price of export products is compared to the domestic retail product price at the gas station or to the final consumer. This comparison misses the cost of domestic marketing and retail costs, which can be large.8

Substituting (12) in (10), the increase in operational costs due to shifting output from the export market to the domestic market is

III. Operational Surplus

The operational surplus (OS) is defined as current revenue (Y) minus operational costs (OC),

Substituting (7) and (10) in (14), the operational surplus in terms of prices and costs is

An increase in the supply to the domestic market brings about a squeeze in the operational surplus as the operational costs increase according to (13) and revenue is forgone according to (9). The reduction in operational surplus is derived from (15) and results from adding the lower revenue and the increase in costs times the change in domestic supply,

IV. Government Take

The forgone public sector revenue and the increase in operational costs affect the NOC and the government according to how the NOC’s operational surplus is distributed between them.

The government take (GT) from the operational surplus has three components: royalty payments (R), income tax (T), and paid-in dividends (D),9

The government take will be affected by subsidized sales to the domestic market depending on how each of the three components varies with such sales,

Royalty

Royalty payments are calculated as a royalty rate (r) applied to total production (Q) times the international f.o.b. price10(px),

As the royalty payments are independent of domestic prices or volumes, this component of government take is independent of domestic product sales.

Income Tax

Government revenue from petroleum industry income tax (T) is calculated as a tax rate (t) applied to profits, taking royalty payments as a production cost. Assuming that there are only operational costs, the taxable revenue is the operational surplus minus the royalty payments,

The change in income tax from the petroleum industry due to changes in sales to the domestic market is the tax rate times the change in operational surplus given by (16), since there is no change in royalty payments,

Paid-in Dividends

Net profits after tax (II) are the operational surplus shown in (15), assuming there are only operational costs, minus the royalty payments given by (19) and the income tax payment calculated in (20),

The change in net profits due to changes in domestic sales amounts to the change in operational surplus given by (13) and the change in income tax shown in (19) since there are no changes in royalty payments,

Substituting (21) in (23),

As the sole shareholder of the NOC, the government is entitled to a fraction (α) of the net profits as paid-in dividends (D),

Paid-in dividends will fluctuate with net profits,

Substituting (23) in (26),

V. Change in Government Take

Once the changes in the different components of the government take due to subsidies and the cost of sales to the domestic market have been measured, the change in the overall government take can be calculated, substituting (21) and (27) in (18),

Substituting (16) in (28),

Thus, for a given increase in the volume supplied to the domestic market, the change in government take due to higher subsidies and retail costs will be the total reduction in operational surplus multiplied by (t + α - αt).

It can be shown that (t + α -αt) is always positive and less than one, since

Thus, given (29) and (31), the drop in government take is a fraction of the price subsidy plus retail costs fluctuating between zero and one. The rest of the subsidy will be absorbed by the NOC as reduced retained dividends.

It can be seen from (29) that the lower the oil income tax rate (t) and the lower the share of paid-in dividends (α), the lower the drop in government take due to petroleum products price subsidies and marketing and retailing costs associated with increases in domestic sales. On the other hand, the higher the income tax rate (t) and the government’s share in the NOC’s profit after tax (α), the higher the pass-through of those subsidies and costs to lower government take.

VI. Change in Retained Dividends

The retained dividends (RD) are the share of profits after tax not paid to the shareholder in (25),

The change in retained dividends due to changes in profits is

Substituting (24) in (33) it is possible to measure the change in retained dividends due to a reduction in operational surplus because of product price subsidies and retail sale costs, given an oil income tax rate (t) and a share (a) of paid-in dividends,

Substituting (16) into (34),

(ΔRD) will always be positive and a fraction (1 - t - α + αt) of (ΔOS) since, given (31),

From (36) it is clear that the lower the oil income tax rate (t) and the government’s share in profits after tax (α), the higher will be the share of domestic product price subsidies and marketing costs (Qd(cr + s)) absorbed by the NOC in the form of lower retained dividends.

VII. Breakdown of Losses Between the Government and the NOC

For a given oil industry tax regime, the breakdown of losses between the government and the NOC due to price subsidies and retail costs can be calculated. For illustrative purposes, Table 16.1 shows four hypothetical fiscal regimes, ranging from a combination of high royalty and low income tax rate to a regime with a high income tax rate and no royalty.

Table 16.1.Distribution of Losses Between Government and NOC1(In percent)
Oil Industry Fiscal Regime
IIIIIIIV
Fiscal regime
Royalty rate (r)303017
Income tax rate (t)34506780
Government share of net profits (α)1010
Breakdown of losses
Government share34557180
NOC share66452920
Source: Author’s calculations.

Assumes a fully vertically integrated NOC.

Source: Author’s calculations.

Assumes a fully vertically integrated NOC.

It can be seen that, since the royalty payment is independent of profits (losses) while the income tax is calculated on profits, under scheme I (high royalty and low income tax rate), the NOC bears the bulk of losses. Conversely, under scheme IV (high income tax rate and no royalty), the government absorbs the higher share of the losses.

In addition, it should be noted that retained dividends are likely to be the main source of financing for NOC fixed capital formation. Therefore, an increase in product subsidies and marketing costs would, through lower NOC investment, result in lower future production and revenue, thereby affecting government revenue in the medium term. How and when lower NOC investment will affect government revenue will depend on the magnitude of the losses and the characteristics of investment. The greater the share of investment devoted to the maintenance of productive capacity, the more immediate will be the effect on production, exports, and fiscal revenue from lower investment associated with reductions in retained dividends.

VIII. Private Retail and Excise Taxes

In countries with a state monopoly on crude oil production and refining, the domestic distribution and retail sale of gasoline may be carried out by private companies. In addition, excise taxes are often levied on domestic gasoline sales as a source of government revenue. These two cases will be discussed briefly below.

In some cases, private companies are allowed to buy gasoline from the NOC at the domestic refinery gate price (pd) and sell it at a retail sale price (pr), with both prices controlled by the government. The retail price will be higher than the domestic refinery gate price, thus relaxing the assumption in (4) and replacing it with

The revenue of the private companies per unit of gasoline sold in the domestic market (yr) is equal to the price differential,

and their profit margin per unit (πr), given unit distribution and retail costs (cr), is

From (39) it can be seen that the private companies’ profit margin will depend on government policy regarding the price differential and on the private companies’ productivity and ability to reduce distribution and retail costs. In particular, assuming costs increase due to inflation, the profit margin may be squeezed unless the government lowers the refinery gate price or increases the retail price.

In some instances, the government may introduce an excise tax on petroleum products. If the NOC acts as the collection agency, the new tax (Tg) will be added to the domestic price at the refinery gate (pd), yielding a final retail price to the consumer (pr) equal to

Assuming the domestic price at the refinery gate is left unchanged, the private distributors and retailers would be squeezed if an excise tax were introduced and the retail price not fully adjusted.

IX. Conclusions

A few conclusions can be drawn from the simple accounting model presented in the previous sections. First, the fiscal regime applied to the NOC can have a significant bearing on how the subsidies on domestic gasoline sales affect government revenue. Oil tax systems with higher royalty rates and lower income tax rates make the NOC bear the bulk of the subsidy cost in the form of lower retained dividends. In turn, lower NOC investment as a consequence of reduced financial resources will affect government revenue with a lag.

Second, domestic marketing and retail sale costs—usually not accounted for when assessing gasoline price subsidies—can make these subsidies substantially larger than often recognized.

Third, in the case of a mix of government monopoly up to the refining stage and private distributors and retail sellers, if both the refinery gate and retail sale prices are controlled, the profit margins of the private companies will be squeezed if higher costs are not accompanied by price adjustments. Profit margins would also be squeezed if the refinery gate price for sales to the domestic market were increased without a corresponding increase in the retail price.

Finally, the introduction of an excise tax on refined oil products can generate fast cash for the government; however, as long as the domestic price at the refinery gate is not changed, it does not change the NOC subsidy to domestic petroleum product consumption. Furthermore, a fully vertically integrated NOC or the private companies distributing and selling gasoline could see their margins squeezed if an excise tax is introduced and the retail price is not fully adjusted.

This paper is based on my experience at Petroleos de Venezuela S.A. (PDVSA), where I worked for 20 years and was chief economist between 1992 and 1999. It also reflects the experience I gained working on other Latin American countries over the past three years at the Inter-American Development Bank. I am grateful to Annalisa Fedelino and Rolando Ossowski for their accurate and useful comments. However, the responsibility of what is said in this paper is exclusively mine.

In the first part of this paper, the NOC is assumed to be a fully vertically integrated commercial oil company, with a single taxation regime for the oil industry, consisting of royalty and income tax. The government is assumed to be the NOC’s sole shareholder, with access to company profits as paid-in dividends. Later in the paper, the case involving private sector participation in distribution and retail is considered.

Gasoline is assumed to be the only crude oil product manufactured and traded, given its importance as the main oil product. For the sake of simplicity, it is also assumed that all crude oil produced is transformed into gasoline, and that there are no crude oil exports.

For the sake of simplicity (and without loss ci generality), both the international price at the refinery gate and the domestic price are assumed to be constant through time.

The country is assumed to be a price taker in the international oil products market.

This assumption is consistent with the fact that the NOC is assumed to be a fully vertically integrated company, which has a monopoly on production, transformation, transportation, distribution, and retail sale of crude oil and gasoline. The assumption will be relaxed later when private participation in domestic distribution and retail sale is introduced.

The domestic price of gasoline at the refinery gate (pd) may be lower than the cost of producing it. In this case, the noc would be facing not just an implicit loss in terms of revenue forgone but a direct cash loss.

Marketing and retail costs in the United States are between one-fourth and one-third of the final retail price. These costs can represent between 1 percent and 2 percent of GDP in developing oil-exporting countries.

The relative importance of these components varies from country to country and depends on the legal and institutional oil sector framework.

The royalty payment is often made on the basis of the wellhead international crude oil price. For the sake of simplicity, in this model the royalty is calculated on the basis of the price at the refinery gate of the exported gasoline (the only exported product; see footnote 3).

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