Abstract
This paper attempts to assess the impact of the oil shock on South Asian economies, including Sri Lanka, as well as policy responses to deal with the shock, and the real income loss for low-income households if fuel subsidies were fully removed. The most important impact has been on the balance of payments followed by the results of poverty and social impact analysis (PSIA) conducted for Sri Lanka. Finally, the paper explores to what extent Sri Lanka’s large receipts of worker remittances serve as a hedge against shocks.
II. The Fiscal and Distributional Impacts of Fuel Subsidy Reform and Alternative Mitigating Measures4
A. Summary and Introduction
1. Sri Lanka has recently moved towards full pass-through of oil prices and automatic pricing adjustments for petroleum products. World oil prices more than doubled in the past two years. In 2005, in spite of a series of increases in domestic fuel prices, fuel subsidies remained at an estimated 1.1 percent of GDP while quasi-fiscal losses generated from administered electricity charges were around ½ percent of GDP. The 2006 budget targeted removing fuel subsidies through price adjustments. Domestic fuel prices were increased in April, June, August, and September 2006, completing the full pass-through for petrol and diesel, and substantially reducing subsidies for kerosene. The pricing formula for fuel products was also revised in September to set the stage for oil companies to determine domestic prices from September onwards.
2. Reducing fuel subsidies is desirable from both fiscal and efficiency perspectives. Fuel subsidies can crowd out desirable social expenditures. For example, the budget cost of the main safety net program (the Samurdhi program), at 0.4 percent of GDP, is substantially smaller than fuel subsidies. In 2005, government expenditures on health and education were 1.9 percent and 2.6 percent of GDP, respectively. In addition, subsidizing domestic fuel prices is not conducive to energy efficiency and creates potential fiscal and external risks.
3. However, the fiscal and efficiency gains from higher domestic prices obviously come at the cost of lower real income for households. This raises the issue of how best to mitigate the impact of fuel price adjustments on the poor.5 This chapter simulates the likely magnitude of the real income loss for households resulting from the price increases required to move to formula pricing starting from the prices that existed in July 2006. The simulated price increases therefore mirror the actual price increases that occurred in August and September 2006 with the exception that the subsidy to kerosene is completely eliminated.
4. The chapter also identifies options for mitigating these adverse impacts on low-income households. These could include: (i) differential pricing of petroleum products, especially kerosene which is an important source of energy for the poor; (ii) the use of lifeline electricity tariffs; and (iii) the allocation of some of the budgetary savings to existing safety net transfer programs (such as the Samurdhi program). The analysis therefore builds on existing work being undertaken at the World Bank with regard to broader energy sector restructuring and reform of the existing system of social assistance.
5. The main conclusions of the analysis are as follows:
The fuel subsidies that Sri Lanka maintained until July 2006 were regressive as well as being inefficient, as evidenced by the substantial leakage to high-income households. About 52 percent of the subsidies went to the top two income quintiles compared to only 31 percent to the bottom two-income quintiles. Therefore, it cost the budget approximately Rs. 3.2 to transfer Rs. 1 to the poorest 40 percent of households via fuel subsidies.
The household welfare loss from the full pass-through of oil prices is estimated at about a 1.2 percent decrease (on average) in household real incomes. Households in the bottom income quintile would experience on average a 1.8 percent decline in their real incomes compared to a 1.0 percent decrease for the top income quintile.
Kerosene is a relatively important source of energy for poor households, but the bulk of kerosene subsidies still leak to nonpoor households. Over 34 percent of kerosene subsidies accrue to the top two quintiles and it costs the budget Rs. 2.2 to transfer Rs. 1 to the poorest two quintiles via kerosene subsidies. In addition, maintaining kerosene subsidies while removing other fuel subsidies is likely to result in inefficient substitution towards kerosene away from other fuels (especially diesel), resulting in a second-round increase in the subsidy bill.
Increased domestic fuel prices could lead to higher quasi-fiscal losses of the power sector if electricity tariffs were not adjusted. Given the low access rates to electricity for poor households, most of the benefits of the current subsidies have accrued to middle-income households. The leakage of the electricity subsidies in the current system of tariffs is even greater than that for kerosene subsidies, with the top income quintile receiving half the aggregate subsidy compared to less than 6 percent to the bottom income quintile.
As an illustration, an alternative option to protect the poor from price adjustments is to use the budgetary savings to expand the existing Samurdhi program. Only 19 percent of Samurdhi transfers leak to the top two quintiles, coverage of the poorest households is high, and it costs the budget Rs. 1.7 to transfer Rs. 1 to the poorest 40 percent of households. A better-targeted transfer program could decrease leakage and increase coverage, and decrease the budget cost to less than Rs. 1.4 per rupee transferred to the poorest 40 percent of households.
6. The format of the paper is as follows. Section B discusses the structure of energy pricing in Sri Lanka and motivates the price increases to be simulated in the analysis. Section C describes the approach used to evaluate the magnitude and distribution of the real income losses due to these price increases as well as the data sources used in the analysis. Section D presents estimates of the likely real income effects of eliminating energy subsidies. Section E compares the relative effectiveness of alternative approaches to mitigation in terms of how well they protect the poorest households from the adverse effects of price increases. Section F discusses the potential for mitigation policies specifically aimed at addressing increases in agricultural production costs and household transport costs. Section G provides some concluding comments.
B. The Structure of Energy Prices
7. Prior to September 2006, domestic prices of petroleum products in Sri Lanka had not been increased in line with the substantial increases in import prices. Until early 2002, domestic petroleum prices were adjusted on an ad hoc basis and motivated primarily by fiscal constraints. In February 2002, a pricing formula was introduced (for kerosene, petrol, diesel and fuel oil), which linked domestic prices to world prices and triggered domestic price adjustments whenever the formula price deviated from the actual price by Rs. 0.25 per liter.6 Price adjustments were in principle monthly and also limited to a maximum of Rs. 2 two per liter. However, fuel subsidies were reintroduced in February 2003 in the face of continued increases in international oil prices. Since then the formula has been used solely to determine the magnitude of the budget subsidy to importers and distributors. Losses not covered by the budget have been allowed to be offset against corporate tax payments (as in the case of the state enterprise, Ceylon Petroleum Corporation) or have been absorbed by distribution companies (as in the case of the privately owned Lanka IOC).
8. Price increases in August and September 2006 have virtually completed full pass-through for petrol and diesel, while substantially reducing subsidies for kerosene. Figure II.1 shows the structure of the revised pricing formula based on the benchmark import prices of August 2006, indicating that kerosene subsidies remain at about 40 percent.7 During April-September, domestic fuel prices increased by about 35 percent (weighted average), reducing the current fuel subsidies to less than 0.1 percent of GDP. Value added tax on diesel was removed in August 2005.
Sri Lanka: Formula and Retail Petroleum Product Prices
(In Sri Lankan rupee per liter)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Formula and Retail Petroleum Product Prices
(In Sri Lankan rupee per liter)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Formula and Retail Petroleum Product Prices
(In Sri Lankan rupee per liter)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
C. Methodology and Data
9. Estimating the likely impact of higher fuel prices on household real incomes requires an estimation of both the direct effect due to higher prices for fuel products consumed directly by households as well as the indirect effect due to increases in the prices of other goods and services consumed by households.8 For each household, multiplying each price increase by the share of the corresponding good or service in total household expenditures gives an estimate of the percentage decrease in household real income due to that price change. For example, if the price of petrol increases by 20 percent and the share of petrol in total household expenditures is 5 percent then the price increase leads to a 1 percent decrease in the real income of the household. For each household, these real income effects are aggregated across all price increases to get the total decrease in household real income, which can be separated into that due to the direct effect (i.e., due to increases in the prices of energy consumed directly by households) and that due to the indirect effect (i.e., due to increase in the prices of other goods and services that use petroleum products in their production).
10. To analyze the distribution of the real income effect, each household is allocated to a welfare quantile, where household per adult equivalent consumption is used as the welfare criterion. The real income impact is then averaged over all households in each quantile to get the average percentage decrease in household real income in each quantile. If this average is relatively high (low) for low-income households, then the price changes are seen as regressive (progressive). Regressivity (progressivity), therefore, implies that the share of low-income households in the aggregate real income loss is greater (less) than their share in aggregate income.
11. Low energy prices are often justified as a way of protecting the real incomes of poor households. Therefore, it is important to compare the protection afforded by these subsidies to that which would be afforded by alternative approaches to social protection. To evaluate the cost effectiveness of fuel subsidies at protecting low-income households, the share of the aggregate fuel subsidies accruing to each quantile is calculated. As an illustration, if the poorest 40 percent of households receive only 20 percent of the aggregate fuel subsidy then this implies that it costs the budget Rs. 5 to transfer Rs. 1 to these households (i.e., Rs. 100/Rs. 20). This measure is compared across alternative approaches to protecting low-income households. If more cost-effective approaches can be identified then the same level of protection can be achieved at much lower cost with a resulting improvement in the government’s budgetary position (i.e., a net decrease in budgetary expenditures including both subsidy expenditures and transfer expenditures).
12. The analysis of the likely magnitude and distribution of the household real income decrease resulting from the removal of energy subsidies uses two main data sources. Firstly, the estimation of the price increases for goods and services due to higher fuel prices uses information on the input-output structure of the economy. This is taken from an input-output table for 2001 provided by the Institute for Policy Studies (Amarasinghe and Jayatilleke, 2005), which provides information on the cost structures of 40 sectors in the economy. Secondly, the estimation of the real income effects of price increases for fuel and other goods and services uses expenditure information available in the Sri Lanka Integrated Survey for 1999 (SLIS1999). The SLIS1999 also contains information on receipt of the Samurdhi program which is used to simulate the targeting performance of this program as well as to simulate that for a “new improved” transfer program with eligibility based on a model similar to that being developed by the World Bank. Where possible, estimates based on SLIS1999 were compared with those based on the Household Expenditure and Income Survey for 2001 and similar results were found.
D. The Impact of Fuel Subsidy Reform
13. This section illustrates the likely impact on households’ real incomes of the price increases required under the September 2006 pricing formula. Starting from the actual domestic prices of July 2006, at per liter prices of Rs. 93 for petrol, Rs. 61 for diesel, and Rs. 43.5 for kerosene, the corresponding required formula prices (based on August 2006 import prices) were Rs. 104, Rs. 70, and Rs. 68 respectively. These prices provide the basis of the simulated price increases of 11.5 percent for petrol, 15.3 percent for diesel and 57.2 percent for kerosene. They approximate the actual full pass-through in August and September, with the exception of kerosene for which the prevailing price (at Rs. 48.5 per liter) is lower than the full pass-through price used in the simulation.
14. The level and composition of energy consumption varies substantially across households at different parts of the income distribution. Figure II.2 presents the budget shares for petroleum products and electricity using the information available in the SLIS1999. On average, households allocate 3.4 percent of their total consumption (approximately Rs. 927 per month) to these energy sources, mostly to kerosene (1.1 percent) and electricity (1.3 percent).9 But this average masks substantial variation across income groups. Whereas the bottom three quintiles allocate between 2.5–3.0 percent of total consumption to energy (i.e., Rs. 180 – 250 per month); the top two quintiles allocate between 3.7 5.3 percent (i.e., Rs. 546– 1,445 per month). The energy budget share was also found to be substantially higher for all income groups in urban areas compared to rural areas. In both urban and rural areas, kerosene is more important in the budgets of low-income households whereas electricity, petrol and diesel, and LPG are most important for higher income groups.
Sri Lanka: Budget Shares of Energy Products by Consumption Quantile
(In budget share)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Budget Shares of Energy Products by Consumption Quantile
(In budget share)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Budget Shares of Energy Products by Consumption Quantile
(In budget share)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
15. The direct income effect on households from increases in fuel prices is higher for low-income households reflecting the substantial increase in the price of kerosene. Figure II.3 presents the average real income impact by quantile in terms of the percentage decrease in household real incomes. On average, the direct effect is equivalent to a 0.7 percent decrease in household real incomes, and this varies from 1.4 percent for the bottom income decile (or Rs. 84 per month) to 0.5 percent for the top income quintile (or Rs. 137 per month). For low-income households, this direct income effect comes almost completely from increased kerosene prices sufficient to completely eliminate kerosene subsidies. For the top quintile, 40 percent of the aggregate direct effect comes from price increases for petrol.
Sri Lanka: Direct and Indirect Real Income Effects by Consumption Quantile
(In percent of total consumption)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Direct and Indirect Real Income Effects by Consumption Quantile
(In percent of total consumption)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Sri Lanka: Direct and Indirect Real Income Effects by Consumption Quantile
(In percent of total consumption)
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
16. The indirect effect on income from increases in the prices of other goods and services is slightly lower than the direct effect but varies very little across income groups. Figure II.3 also presents the average indirect effect and its distribution across income groups. On average, the indirect effect on prices leads to a 0.5 percent decrease in real incomes (or Rs. 75 per month), this being very similar across quantiles. On average, the indirect effect accounts for 42 percent of the total (i.e., direct plus indirect) income impact. The bulk (i.e., around 67 percent) of the indirect effect reflects the indirect effect on processed and nonprocessed food prices combined with the relatively high food expenditure share. The indirect effect coming through increases in prices for services is also relatively substantial.
17. Although the total effect (i.e., combined direct and indirect effects) on real incomes is greater for low-income households, high-income households account for a substantially greater share of the aggregate real income loss. The average total effect is equivalent to a 1.2 percent decrease in real incomes and varies from 1.8 percent for the bottom decile (or Rs. 107 per month) to 1.0 percent for the top quantile (or Rs. 275). This pattern reflects the pattern of income effects from the direct effect. However, the top two quintiles account for 52 percent of the total real income loss compared to 31 percent for the bottom two quintiles. The corollary of this is that lower income households receive a relatively low share of the existing subsidy benefits: the subsidy received by the top two quintiles is nearly 1.7 times that received by the bottom two quintiles (i.e., 52/31). It costs the budget Rs. 3.2 for every Rs. 1 transferred the bottom two quintiles via fuel subsidies.
E. Impact of Mitigating Measures
18. The results presented above clearly indicate that fuel subsidies are not a cost-effective approach to protecting the real incomes of low-income households. This section considers alternative options for protecting low-income households and their potential for mitigating the impact of higher domestic fuel prices. We consider three different approaches to social protection:
Maintaining subsidies only on kerosene. Kerosene is typically much more important in the budgets of poor households than other petroleum products. Maintaining these subsidies is therefore often recommended as a way of mitigating the effect of fuel subsidy reforms on poor households.
Using some of the budgetary savings from eliminating all fuel subsidies to finance a decrease in the average electricity tariff. Two different approaches are considered. First, the existing tariff schedule is scaled down for all households. Second, the average tariff is similarly scaled down but the tariff schedule is also restructured to decrease the average tariff for low-level users and increase it for high-level users.
Using some of the budgetary savings from eliminating all fuel subsidies to finance a targeted transfer program. The effectiveness of this approach will depend on how well the existing Samurdhi program is targeted at poor households. The World Bank is recommending an alternative approach to identifying the poor based on socio-economic characteristics more strongly correlated with poverty status (World Bank, 2005). The analysis therefore considers two alternatives: (i) providing protection using the existing program, and (ii) providing protection using a reformed program.
19. The following analysis illustrates the budget allocations to social protection with budget neutral comparisons. Based on 2005 fuel consumption volumes, annual kerosene subsidies amount to Rs. 6.3 billion as of July 2006, equivalent to nearly 0.3 percent of GDP and around 17 percent of total fuel subsidies. When considering the use of electricity tariff reforms or the Samurdhi program to mitigate the impact of eliminating all (including kerosene) subsidies, the budget cost of these measures is kept at this level.
20. Although kerosene subsidies are better targeted than other energy subsidies, there is still substantial leakage of subsidy benefits to high-income households. Nearly 65 percent of households consume some kerosene and thus receive some of the kerosene subsidy. The percentage receiving some subsidy (i.e., coverage) is substantially higher for the lower income deciles compared to the top quintile (81 percent versus 45 percent), although the middle quintiles also have relatively high coverage. This high coverage of the poorest households is often seen as a very attractive feature of universal price subsidies. On average, existing kerosene subsidies are equivalent to a 1.4 percent increase in real income for the bottom decile (or Rs. 84 per month) compared to a 0.2 percent increase for the top quintile (or Rs. 54 per month). However, there is still substantial leakage of kerosene subsidy benefits to higher income groups, with just under 54 percent of the total subsidy going to the top three quintiles. It therefore costs the budget Rs. 2.2 to transfer Rs. 1 to the bottom two quintiles using kerosene subsidies, compared to the Rs. 2.8 for all fuel subsidies combined.
21. Reducing electricity tariffs is even less cost effective than kerosene subsidies since electricity access is substantially lower in the bottom income quantiles and electricity consumption rises with income. Overall, nearly 62 percent of households have access but this varies from 30 percent for the bottom decile to 88 percent in the top quintile. The actual tariff schedule involves an increasing multi-block structure with tariffs increasing with total electricity consumption levels. Using the budgetary savings from the removal of kerosene subsidies to lower average tariffs for all households with access (i.e., scaling down the existing tariff schedule) would decrease the average tariff from Rs. 3.5/kWh to Rs. 2.7/kWh.10 However, only 15 percent of the aggregate implicit subsidy would accrue to the bottom two quintiles so that it costs the budget Rs. 6.7 to transfer Rs. 1 to these households. Restructuring tariffs to lower average tariffs for lower income households and raise them for higher income households (see Figures II.4 and II.5), could improve targeting slightly by increasing the subsidy share accruing to the bottom two quintiles to just under 30 percent.11 But this is still substantially less cost effective than kerosene subsidies since it costs the budget Rs. 3.3 to transfer Rs. 1 to this group.
Existing and Restructured Electricity Tariff Structure
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Existing and Restructured Electricity Tariff Structure
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Existing and Restructured Electricity Tariff Structure
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Average Electricity Tariffs by Income Groups
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Average Electricity Tariffs by Income Groups
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
Average Electricity Tariffs by Income Groups
Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A002
22. An alternative to maintaining kerosene subsidies would be to allocate the budgetary savings from their removal to expanding the existing Samurdhi safety net program. This program was introduced in 1995 (extended to North and East in 1997), and its budget allocation averaged at around 1 percent between 2000–02, but had fallen to 0.4 percent of GDP by 2004 and 2005 (or Rs. 9.4 billion). Eligibility is determined by local administrators through local Samurdhi organizations and in principle is based on their assessment of household income and economic status. The Samurdhi food stamps component is the mainstay of the system. The analysis, therefore, assumes that the budgetary savings from removing kerosene subsidies are allocated to expanding food stamp transfers.
23. Although the existing Samurdhi transfer program is often criticized as being badly targeted, it is substantially better targeted than existing kerosene subsidies and has similar coverage of the poorest households. Just over 40 percent of all households receive food stamps, this being much higher for the lower-income quintiles than for the higher-income quintiles so that 56 percent of all recipients come from the poorest 40 percent of households. If the budgetary savings from kerosene subsidies are allocated to existing households in proportion to existing transfers (i.e., to scale up transfers), then this will lead on average to 0.5 percent increase in household real incomes, varying from 1.4 percent for the bottom decile (or Rs. 83) to 0.1 percent for the top quintile (Rs. 27 per month). Out of total transfers, 32 percent goes to the bottom quintile compared to 24 percent under kerosene subsidies. It costs the budget Rs. 1.7 to transfer Rs. 1 to the two lowest income quintiles.
24. However, if effectively implemented, the new targeting approach suggested by World Bank (2005) for a reformed transfer program could substantially improve its cost effectiveness by both reducing leakage to higher income quintiles and increasing coverage of the bottom quintiles. If the 40 percent of households currently participating in the program were instead selected based on this approach, then the coverage rate for the lowest decile would increase from 67 percent to 84 percent while that for the top two quintiles would decrease from an average of 44 percent to 15 percent. The proportion of total beneficiary households coming from the bottom quintile would increase from 31 percent to 44 percent, while the transfer levels are increased for this group at the expense of lower transfer in the top quintiles. The net result is that leakage of transfers to the top two quintiles decreases from 19 percent to less than 9 percent. With this targeting performance, it costs the budget less than Rs. 1.4 for every Rs. 1 transferred to the bottom two quintiles.
25. Of the mitigating approaches considered, only the targeted transfer program fully protects the poorest households from fuel price increases within the simulated program budget. Table II.1 presents the net impact on household incomes of fuel subsidy reform combined with the various mitigating measures, keeping the “mitigation budget” equal to the size of existing kerosene subsidies. Maintaining kerosene subsidies reduces the impact from a 1.8 percent decrease in income for the bottom decile when all subsidies are removed to 0.5 percent decrease when kerosene subsidies are retained. Reducing average electricity tariffs equally for all households, or restructuring the tariff schedule so as to reduce average tariffs for low-level users and increase them for high-level users, provides very little protection to poor households. The average income effect for the poorest decile falls only to 1.3–1.5 percent. Both the existing Samurdhi program and the reformed targeted transfer program provide the highest levels of protection with the net income impact on the bottom deciles being a 0.1 percent decrease in income using the existing program and a 0.7 percent increase in income using the reformed program.
Sri Lanka: Impact of Fuel Price Increases with Compensating Measures
(Percent loss)
Sri Lanka: Impact of Fuel Price Increases with Compensating Measures
(Percent loss)
| Bottom Decile | 2nd Decie | 2nd Quantle | 3rd Quantile | 4th Quantile | Top Quantile | All Households | |
|---|---|---|---|---|---|---|---|
| Eliminating all fuel subsidies | 1.8 | 1.4 | 1.3 | 1.1 | 1.1 | 1.0 | 1.2 |
| Maintaining kerosene subsidies | 0.5 | 0.6 | 0.6 | 0.6 | 0.7 | 0.8 | 0.6 |
| Reducing average electricity tariffs for all households | 1.5 | 1.0 | 0.9 | 0.8 | 0.6 | 0.4 | 0.8 |
| Restructuring tariff schedule | 1.3 | 0.8 | 0.7 | 0.6 | 0.6 | 0.6 | 0.7 |
| Existing Samurdhi program | 0.1 | 0.3 | 0.5 | 0.6 | 0.7 | 0.9 | 0.5 |
| Reformed Samurdhi program | -0.7 | -0.1 | 0.3 | 0.6 | 0.9 | 1.0 | 0.4 |
Sri Lanka: Impact of Fuel Price Increases with Compensating Measures
(Percent loss)
| Bottom Decile | 2nd Decie | 2nd Quantle | 3rd Quantile | 4th Quantile | Top Quantile | All Households | |
|---|---|---|---|---|---|---|---|
| Eliminating all fuel subsidies | 1.8 | 1.4 | 1.3 | 1.1 | 1.1 | 1.0 | 1.2 |
| Maintaining kerosene subsidies | 0.5 | 0.6 | 0.6 | 0.6 | 0.7 | 0.8 | 0.6 |
| Reducing average electricity tariffs for all households | 1.5 | 1.0 | 0.9 | 0.8 | 0.6 | 0.4 | 0.8 |
| Restructuring tariff schedule | 1.3 | 0.8 | 0.7 | 0.6 | 0.6 | 0.6 | 0.7 |
| Existing Samurdhi program | 0.1 | 0.3 | 0.5 | 0.6 | 0.7 | 0.9 | 0.5 |
| Reformed Samurdhi program | -0.7 | -0.1 | 0.3 | 0.6 | 0.9 | 1.0 | 0.4 |
F. Agriculture and Transport Sectors
26. Higher food and transport prices are the two most important channels whereby households are indirectly affected by higher fuel prices. These sectors are often singled out as areas where specific mitigating measures are warranted. In the context of food, policy makers are often concerned that higher production costs cannot be fully passed on to consumers so that farmers have to absorb these higher costs. In the context of transport, low-income households typically rely relatively more on public transport thus providing the potential for better targeting of transport subsidies. This section addresses these two issues in turn.
27. Higher fuel prices can increase agricultural production costs through a number of channels, including higher prices for chemical fertilizers and sprays, higher costs of irrigation and higher costs of using or hiring tractors. Table II.2 provides information on the prevalence and magnitude of these costs for farmers at different parts of the national income distribution. Use of chemical fertilizer and sprays is very common among farmers at all income levels, averaging around 89 percent. Also, a high proportion of land is irrigated either through a major or minor irrigation scheme at all income levels. Both chemical fertilizer/spray and tractor charges are quite large relative to household income, averaging around 57 percent and 32 percent respectively.
Sri lanka: Input Costs, Assets and Irrigated Land for Farmers 1/
In rural areas, 33.3 percent of households farm land, compared to 5.4 percent in urban areas.
Sri lanka: Input Costs, Assets and Irrigated Land for Farmers 1/
| Bottom Decile | 2nd Decile | 2nd Quintile | 3rd Quintile | 4th Quintile | Top Quintile | All Households | ||
|---|---|---|---|---|---|---|---|---|
| Percentage of households incurring costs or owning assets | ||||||||
| Fertilizer costs | 83.8 | 86.8 | 88.1 | 90.6 | 90.5 | 86.9 | 88.5 | |
| Irrigation charges | 3.9 | 2.9 | 2.3 | 6.6 | 7.3 | 7.0 | 5.2 | |
| Tractor fees | 37.5 | 31.6 | 49.5 | 57.1 | 55.9 | 54.7 | 50.8 | |
| Owns diesel pump | 1.2 | 0.0 | 1.2 | 2.5 | 2.5 | 5.8 | 2.4 | |
| Owns tractor | 0.0 | 1.4 | 3.7 | 6.4 | 7.5 | 13.7 | 6.2 | |
| Expenditure on farm inputs (percent of total consumption) | ||||||||
| Fertilizer | 52.1 | 59.5 | 59.5 | 57.4 | 58.9 | 52.1 | 57.3 | |
| Irrigation | 0.3 | 0.2 | 0.3 | 0.6 | 1.1 | 0.7 | 0.6 | |
| Tractor chargers | 22.3 | 20.2 | 39.9 | 37.0 | 28.9 | 27.9 | 32.1 | |
| Share of total costs | ||||||||
| Fertilizer | 3.2 | 7.1 | 19.7 | 22.7 | 22.5 | 24.9 | 19.3 | |
| Irrigation | 1.7 | 2.6 | 10.6 | 22.1 | 32.4 | 30.5 | 20.2 | |
| Tractor chargers | 3.1 | 5.0 | 24.5 | 27.0 | 21.8 | 18.6 | 19.4 | |
| Percentage of land cultivated irrigated by: | ||||||||
| Major irrigation scheme | 19.1 | 17.1 | 15.7 | 17.6 | 21.3 | 16.5 | 17.7 | |
| Minor irrigation scheme | 26.9 | 23.1 | 22.1 | 19.6 | 16.2 | 18.5 | 20.2 | |
| Well/lift irrigation | 2.0 | 1.0 | 4.6 | 4.2 | 7.8 | 6.0 | 4.8 | |
| Rainfed | 48.5 | 57.1 | 52.4 | 53.2 | 50.3 | 56.5 | 53.1 | |
In rural areas, 33.3 percent of households farm land, compared to 5.4 percent in urban areas.
Sri lanka: Input Costs, Assets and Irrigated Land for Farmers 1/
| Bottom Decile | 2nd Decile | 2nd Quintile | 3rd Quintile | 4th Quintile | Top Quintile | All Households | ||
|---|---|---|---|---|---|---|---|---|
| Percentage of households incurring costs or owning assets | ||||||||
| Fertilizer costs | 83.8 | 86.8 | 88.1 | 90.6 | 90.5 | 86.9 | 88.5 | |
| Irrigation charges | 3.9 | 2.9 | 2.3 | 6.6 | 7.3 | 7.0 | 5.2 | |
| Tractor fees | 37.5 | 31.6 | 49.5 | 57.1 | 55.9 | 54.7 | 50.8 | |
| Owns diesel pump | 1.2 | 0.0 | 1.2 | 2.5 | 2.5 | 5.8 | 2.4 | |
| Owns tractor | 0.0 | 1.4 | 3.7 | 6.4 | 7.5 | 13.7 | 6.2 | |
| Expenditure on farm inputs (percent of total consumption) | ||||||||
| Fertilizer | 52.1 | 59.5 | 59.5 | 57.4 | 58.9 | 52.1 | 57.3 | |
| Irrigation | 0.3 | 0.2 | 0.3 | 0.6 | 1.1 | 0.7 | 0.6 | |
| Tractor chargers | 22.3 | 20.2 | 39.9 | 37.0 | 28.9 | 27.9 | 32.1 | |
| Share of total costs | ||||||||
| Fertilizer | 3.2 | 7.1 | 19.7 | 22.7 | 22.5 | 24.9 | 19.3 | |
| Irrigation | 1.7 | 2.6 | 10.6 | 22.1 | 32.4 | 30.5 | 20.2 | |
| Tractor chargers | 3.1 | 5.0 | 24.5 | 27.0 | 21.8 | 18.6 | 19.4 | |
| Percentage of land cultivated irrigated by: | ||||||||
| Major irrigation scheme | 19.1 | 17.1 | 15.7 | 17.6 | 21.3 | 16.5 | 17.7 | |
| Minor irrigation scheme | 26.9 | 23.1 | 22.1 | 19.6 | 16.2 | 18.5 | 20.2 | |
| Well/lift irrigation | 2.0 | 1.0 | 4.6 | 4.2 | 7.8 | 6.0 | 4.8 | |
| Rainfed | 48.5 | 57.1 | 52.4 | 53.2 | 50.3 | 56.5 | 53.1 | |
In rural areas, 33.3 percent of households farm land, compared to 5.4 percent in urban areas.
28. An inability to pass on higher fuel prices would result in a substantial decrease in income for low-income farmers. Fuel price increases were estimated to increase chemical fertilizer and spray prices by 4.0 percent. For farmers in the bottom quintile, this would result on average in an income loss equivalent to over 2.0 percent of total consumption (i.e., 0.52*4.0). However, since food prices are now assumed to be fixed (i.e., farmers cannot pass on higher agricultural production costs), the previously estimated indirect effect arising from higher food prices is no longer incurred. For the bottom two deciles this was estimated at 0.27 percent (i.e., around 67 percent of the indirect effect of 0.4 percent). Combined with the estimated direct effect of fuel price increases for these deciles (i.e., 1.4 percent), this suggests that low-income farmers would experience approximately a 3.1 percent decrease in income from this channel alone.
29. However, universal input subsidies would not only encourage inefficient input use but also involve a substantial leakage of the subsidy to farmers in the highest income groups. For example, only 30 percent of fertilizer subsidies would benefit the bottom two-income quintiles. As with fuel subsidies above, a more cost-effective approach to protecting low-income farmers would be to use better-targeted direct transfers through a well-designed and implemented safety net program. Household characteristics correlated with farmer poverty could be used to target higher assistance to poor farmers. Applying an approach similar to that proposed for the reformed targeted transfer program would result in farmers from the top two quintiles receiving only 6.9 percent of the transfers compared to over 77 percent going to farmers in the bottom two quintiles. To the extent that farm productivity is a concern, this issue is best addressed by a program of extension services, which might provide knowledge of improved practices and maybe even some subsidized inputs as an incentive to participate. Such a program should be aimed at increasing the diffusion of efficient farming practices, is desirable even in the absence of fuel subsidy reform, and should eventually be withdrawn.
30. Subsidies to the transport sector are also often advocated to mitigate the adverse effects of fuel price increases, but universal transport subsidies are not well targeted. Table II.3 provides information on the proportion of total consumption expenditures allocated to transport expenses by income group. Since the budget shares of each transport mode increase with income, universal transport subsidies for all transport modes involve substantial leakage to higher income groups. For example, 42 percent of a universal subsidy for train and bus travel would accrue to the top two quintiles compared to 36 percent to the bottom two quintiles. It may be possible to target such subsidies better by focusing on a finer differentiation of transport modes.
Sri Lanka: Expenditure and Subsidy Shares by Transport Mode
Sri Lanka: Expenditure and Subsidy Shares by Transport Mode
| Bottom Decile | 2nd Decile | 2nd Quintile | 3rd Quintile | 4th Quintile | Top Quintile | All Households | |||
|---|---|---|---|---|---|---|---|---|---|
| Expenditure shares | |||||||||
| Trains and buses | 1.4 | 1.7 | 2.0 | 2.2 | 2.3 | 1.9 | 2.0 | ||
| Van and taxis | 0.1 | 0.2 | 0.2 | 0.3 | 0.4 | 0.7 | 0.3 | ||
| School transport | 0.3 | 0.3 | 0.3 | 0.4 | 0.7 | 0.7 | 0.5 | ||
| Ships and airlines | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||
| Total transport | 1.9 | 2.3 | 2.8 | 3.5 | 4.8 | 7.1 | 4.1 | ||
| Subsidy share | |||||||||
| Trains and buses | 7.3 | 8.6 | 20.1 | 21.7 | 22.9 | 19.4 | 100.0 | ||
| Van | 2.3 | 5.0 | 11.2 | 18.5 | 24.1 | 38.9 | 100.0 | ||
| School transport | 5.4 | 5.7 | 14.3 | 18.5 | 27.9 | 28.1 | 100.0 | ||
| Ships and airlines | 0.0 | 0.0 | 7.0 | 0.0 | 0.1 | 93.0 | 100.0 | ||
| Total transport | 4.6 | 5.5 | 14.0 | 17.4 | 23.6 | 34.9 | 100.0 | ||
Sri Lanka: Expenditure and Subsidy Shares by Transport Mode
| Bottom Decile | 2nd Decile | 2nd Quintile | 3rd Quintile | 4th Quintile | Top Quintile | All Households | |||
|---|---|---|---|---|---|---|---|---|---|
| Expenditure shares | |||||||||
| Trains and buses | 1.4 | 1.7 | 2.0 | 2.2 | 2.3 | 1.9 | 2.0 | ||
| Van and taxis | 0.1 | 0.2 | 0.2 | 0.3 | 0.4 | 0.7 | 0.3 | ||
| School transport | 0.3 | 0.3 | 0.3 | 0.4 | 0.7 | 0.7 | 0.5 | ||
| Ships and airlines | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||
| Total transport | 1.9 | 2.3 | 2.8 | 3.5 | 4.8 | 7.1 | 4.1 | ||
| Subsidy share | |||||||||
| Trains and buses | 7.3 | 8.6 | 20.1 | 21.7 | 22.9 | 19.4 | 100.0 | ||
| Van | 2.3 | 5.0 | 11.2 | 18.5 | 24.1 | 38.9 | 100.0 | ||
| School transport | 5.4 | 5.7 | 14.3 | 18.5 | 27.9 | 28.1 | 100.0 | ||
| Ships and airlines | 0.0 | 0.0 | 7.0 | 0.0 | 0.1 | 93.0 | 100.0 | ||
| Total transport | 4.6 | 5.5 | 14.0 | 17.4 | 23.6 | 34.9 | 100.0 | ||
Concluding Remarks
31. The results presented show that fuel subsidies are a significant drain on public funds and that the bulk of fuel subsidies accrue to higher income groups. Eliminating subsidies is clearly desirable from both a fiscal and an efficiency perspective. However, their elimination will have an adverse effect on poor households so that the desirability of subsidy reform from an equity perspective will depend on the availability of more cost-effective approaches to protecting these households. The high leakage of fuel subsidies to high-income groups suggests that it should be possible to protect poor households from the adverse effect of higher fuel prices and still generate additional budgetary savings that can be used to finance more desirable public expenditures.
32. Of the alternative mitigating measures considered, the existing Samurdhi program is the most cost effective and could be made more so by introducing improvements in its design and implementation. A reformed transfer program could increase both coverage of poor households as well as substantially reduce leakage of transfers to higher income households. The lack of access of poor households to electricity means that lifeline tariffs are not a cost-effective approach to compensating poor households for higher fuel prices. However, a restructuring of the tariff structure could provide protection to poor households with electricity access as well as middle-income households. Although maintaining kerosene subsidies is a more cost-effective approach to protecting poor households compared to relying on a lifeline electricity tariff and general fuel subsidies, they still involve substantial leakage to higher income households. In addition, maintaining kerosene subsidies while eliminating other fuel subsidies is likely to result in inefficient substitution from these other fuels to kerosene, with second-round revenue losses and possibly a diversion of kerosene to other uses.
33. To the extent that it takes time and resources to introduce a reformed transfer program, it may be desirable to retain kerosene subsidies in the short term. Some of the budgetary savings from the removal of diesel subsidies could be used to finance a reformed transfer program and additional funding from the removal of the kerosene subsidy in the medium term could be made conditional on evidence that the program has improved its cost effectiveness. A cost-effective transfer program will also provide a basis for promoting structural reforms more generally.
34. Although higher agricultural production costs and transport costs are a major factor behind lower incomes for low-income households, universal input and transport subsidies would involve substantial leakage to high-income households and reduce incentives for consumers to respond efficiently to higher prices. A reformed transfer program would provide a more cost-effective approach to social protection. Finer targeting of specific sectoral measures, including targeting extension services to farmers or subsidizing transport modes that are used primarily by low and middle-income households, could also be considered.
References
Amarasinghe, D., and S. B. Jayatilleke, 2005, “Input-Output Tables for Sri Lanka, 2000,” Macroeconomic Policy Series No. 16 (Colombo, Sri Lanka: Institute of Policy Studies).
Department of Census and Statistics, 2002, Household Expenditure and Income Survey 2002, Final Report (Colombo, Sri Lanka).
Munasinghe Institute of Development, 2004, “Impact of Power Sector Policy and Regulation in Sri Lanka with Emphasis on Poor Consumers” (Colombo, Sri Lanka).
Narayan, A., T. Vishwanath, and N. Yoshida, 2006, “Sri Lanka: Welfare Reform,” in Poverty and Social Impact Analysis of Reforms, eds. by A. Coudouel, A. Dani, and S. Paternostro (Washington: World Bank).
———, and Nobuo Yoshida, 2005, “Proxy Means Test for Targeting Welfare Benefits in Sri Lanka,” SASPR Working Paper 33258 (Washington: World Bank, Poverty Reduction Group and Social Development Department)
World Bank, 2005, Poverty and Social Impact Analysis for Sri Lanka: An Analysis of the Impact of Welfare Reform (Washington: World Bank, Poverty Reduction Group and Social Development Department).
———, 1999, Sri Lanka Integrated Survey (Washington).
Prepared by David Coady and David Newhouse, Poverty and Social Impact Analysis (PSIA) Group, Fiscal Affairs Department. The authors are extremely grateful to the following persons for useful discussions and providing ready access to background documents and data: Matt Davies, Olin Liu, Erik Lueth, Shehan Ramanayake, and Marta Ruiz-Arranz (all IMF), Amber Narayan, Tara Vishwanath and Nobuo Yoshida (all World Bank). The authors also benefited from discussions with the authorities and other development stakeholders, including the Institute for Policy Studies and the Munasinghe Institute for Development, during a presentation of the findings at a workshop in Sri Lanka in July 2006.
The headcount poverty rate based on the official national poverty line was estimated as nearly 23 percent in 2002 (World Bank, 2005).
The reform in pricing policy was introduced as part of a package of reforms that also allowed private sector participation in the import and distribution of petroleum products, which was previously the exclusive domain of the Ceylon Petroleum Corporation (CPC). In 2003, a subsidiary of the Indian Oil Company (Lanka IOC) was allowed to import and distribute fuel products and now controls approximately one third of all retail outlets.
Latest developments in world oil markets since the analysis was undertaken might have changed the magnitude of these figures slightly.
The estimation of the indirect price effect on other goods and services assumes that all cost increases are pushed forward onto output prices. Since much of the cost increases come through trade and distribution margins, which are nontraded, this is probably a good approximation. However, in the context of agriculture, we also consider the implications of not being able to fully push higher fuel costs onto output prices.
Throughout this chapter, absolute rupee values are at 2005 prices, calculated by inflating 1999 values by a factor of 1.68 reflecting inflation over the period.
These rates reflect the tariff in place at the time of the survey data. Note that these tariff levels are substantially below the existing cost recovery tariff for residential consumers, which has been estimated at Rs. 12/kWh (Munasinghe Institute for Development, 2004). The cost recovery tariff is expected to decrease over time with planned investments in more efficient plants.
The results are based on a restructured and simplified schedule with three blocks, with lower rates for the lowest block and higher for the higher blocks. Other more complex structures were tried but without any improvement on the reported structure.
