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)| false Gupta, S., B. Clements, K. Fletcher, and G. Inchauste, 2003, “ Issues in Domestic Petroleum Pricing in Oil-Producing Countries,” in Fiscal Policy Formulation and Implementation in Oil Producing Countries, ed.by ( J. Davis, R. Ossowski, and A. Fedelino Washington: International Monetary Fund).
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All the authors are with the International Monetary Fund. We would like to thank staff in the Africa, Asia and Pacific, Fiscal Affairs, Middle East and Central Asia, and Western Hemisphere Departments for their helpful comments.
In order to avoid sharp and frequent changes in domestic prices, automatic formulas typically use an average of past world prices and trigger changes in domestic prices once the average change in world prices exceeds a certain range. These formulas often also include an element of taxation. See the Regional Economic Outlook for Sub-Saharan Africa (May 2006) for a discussion of how countries in this region dealt with higher energy prices. For a discussion of the welfare and fiscal implications of alternative price smoothing rules, see Federico, Daniel and Bingham (2001). See Gupta and Mahler (1995) and Gupta and others (2000, 2003) for reviews of experiences with petroleum pricing in developing and developed countries.
We will use the terms “fuel subsidies” and “petroleum product subsidies” interchangeably throughout the paper.
Between July 2003 and August 2005, the international price of crude oil increased by more than 200 percent, from US$26 to US$60 per barrel. This increase is perceived to reflect structural changes generating higher demand (e.g., from relatively high growth in India and China), low stocks, and short-term supply constraints.
Increasing domestic fuel prices is often an extremely politically sensitive issue, especially in crude oil-producing countries. For example, increases in Yemen in July 2005 led to widespread social disruption, which resulted in 22 deaths and hundreds injured. Similar public reactions have occurred in the past in Ecuador (1998), Indonesia (1998), Nigeria (2000), and Venezuela (1990). However, Gupta and others (2000, p. 13–14) conclude that such “violent reactions to subsidy reform are the exception rather than the norm, and often are not triggered by the reform alone.”
For example, Iran, which has some of the lowest prices in the world, is one of the most energy-intensive countries in the world.
It is possible that other, second-best considerations may dilute the argument for relatively high taxation of commercial energy. For example, high energy prices may encourage rural households to switch to the use of already overexploited natural resources such as fuelwood. However, a more efficient policy response to such overexploitation may be to directly manage these resources more efficiently and to improve access by these households to commercial energy sources. Note also that large cross-price effects between alternative commercial energy sources suggest that distorting their relative prices is a very inefficient approach to achieving distributional or environmental objectives. It is quite common for low kerosene prices to lead to inefficient substitution toward kerosene and illegal adulteration of diesel or gasoline. Such substitution toward low-taxed commodities results in revenue losses so that higher average tax rates are required to raise a given amount of revenue.
We use the term “income distribution” to represent the distribution of consumer welfare. We typically use total household consumption per household member to proxy for welfare. For simplicity, we refer to the distribution of this variable as the income distribution.
To simplify exposition we are implicitly assuming that domestic trade and distribution margins are zero.
Using the “distributional characteristic” widely used in tax reform analysis, Hughes (1987) summarizes the results of the application of a similar model to that used here to analyzing fuel price increases in Indonesia, Thailand, and Tunisia. Hope and Singh (1995) derive estimates for the direct impact of price increases for kerosene and electricity during the 1980s in Colombia, Ghana, Indonesia, Malaysia, Turkey, and Zimbabwe.
This point is made by Gupta et al (2000, p. 4) in the context of subsidies in general. They argue that the speed of subsidy reform can be faster when an effective social protection system exists in a country. Many of the countries in their sample adopted a gradual approach to subsidy reform, while simultaneously adapting existing social protection instruments or establishing a new safety net.
A more detailed discussion of alternative approaches to protecting poor households is available in Gupta et al (2000). Coady, Grosh, and Hoddinott (2004) provide a detailed discussion of alternative methods of targeting transfers in developing and transition economies.
Similar problems with smuggling subsidized fuel to neighboring countries with higher prices have been encountered in Iran, Iraq, Nigeria, and Yemen.
Typically subsidy rates are higher for kerosene than for diesel, although absolute diesel subsidies are typically substantially higher due to higher consumption levels. Gasoline usually carries lower subsidies and is often taxed. The import cost of gasoline, diesel, kerosene, and LPG are approximately equal.
Typically kerosene is used for lighting and heating, especially where households do not have access to electricity. Diesel is typically used in goods and passenger transport, agriculture (e.g., pumps and engines) and industry—the latter two channels are incorporated through the indirect effects. Gasoline is typically used for transport. Diesel and kerosene are near perfect substitutes since large quantities of kerosene can be added to diesel fuel without much impact on vehicle performance—low kerosene prices relative to diesel thus usually result in the diversion of kerosene to the automotive diesel sector. Adulteration of gasoline with kerosene in other than small quantities can cause damage to vehicles. In the long run, gasoline and diesel are close substitutes, e.g., through the switching from gasoline- to diesel-powered vehicles with an associated worsening of air pollution.
Similar findings have been reported for other countries: in the early 1990s, the top 20 percent of households in Venezuela received six times the subsidy received by the bottom 30 percent. A study of fuel subsidies in Indonesia in 1999 found that only 20 percent of subsidy benefits went to the poorest 30 percent of households.
In Indonesia, for example, public perception was that any expansion of existing safety net expenditures would likely be captured by higher income households. To counteract this, the government introduced an unprecedented cash (as opposed to in-kind) transfer, delivered directly to most eligible households via an extensive network of post offices. This program helped avoid a repetition of the riots, deaths and widespread social and political disruption that accompanied previous fuel price increases. It is still unclear how effectively this program has been implemented.
See Esfahani (2002) for a political economy interpretation of policy reform in the context of fuel subsidies.
Both the Community Health Compound Scheme (which targets areas without basic health facilities and provides a community nurse, basic infrastructure, training, and basic transportation) and an education “capitation grants” scheme had been identified in the country study as potential uses of budgetary savings from eliminating fuel subsidies. The latter program had been in existence since September 2004 in 40 of the most deprived districts in the country (out of a total of 138 districts).
For Jordan, targeted increases in the minimum wage and pensions for low-paid government employees, poorer workers, and retirees had been identified in the country study as potential ways for mitigating the adverse effects of fuel price increases on the poor. Note also that one-time bonuses may generate future budgetary claims if these are expected every time prices increase.
The pricing formula includes excise and value-added taxes as well as a “mitigation levy” to raise funds estimated at 0.35 percent of GDP to finance mitigating expenditures.
Throughout, we assume that the country has no monopoly or monopsony power on the world market. However, in the presence of such power, our discussion goes through if the world price is replaced by the marginal revenue or cost at world prices. See Gupta, and others (2004) for discussion of an endogenous world price.
The notational convention used in this section is that lower case italics represent row vectors and upper case italics represent matrices.