Islamic Republic of Iran: Selected Issues

This Selected Issues Paper on Iran reviews that monetary factors are the main determinants of inflation in the country. Government spending out of oil revenues leads to large liquidity injections that the central bank accommodates owing to its efforts to prevent a significant nominal appreciation of the rial and the lack of effective sterilization instruments. The growing discontent with inflation, however, has compelled policymakers to focus on this issue, bringing it to the forefront of the policy agenda.

Abstract

This Selected Issues Paper on Iran reviews that monetary factors are the main determinants of inflation in the country. Government spending out of oil revenues leads to large liquidity injections that the central bank accommodates owing to its efforts to prevent a significant nominal appreciation of the rial and the lack of effective sterilization instruments. The growing discontent with inflation, however, has compelled policymakers to focus on this issue, bringing it to the forefront of the policy agenda.

II. Subsidies in the Islamic Republic of Iran 15

This chapter estimates explicit and implicit subsidies in Iran with a view to evaluating their size and the potential benefits from their elimination. Overall subsidies are estimated at about 27 percent of GDP in 2007/08. Phasing them out would help improve the population’s welfare, provide room for growth and employment-generating public expenditure, and strengthen the public finances.

A. Introduction

27. Iran is endowed with large hydrocarbon energy resources. The government has a number of options to ensure that citizens share the benefits accruing from these resources. In Iran, as in some other resource-rich countries, the government has chosen to distribute a significant portion of natural resource wealth in the most direct way: by setting domestic prices for hydrocarbon-based energy products at about the cost of bringing them to users and consumers, irrespective of their international market value. 16 Moreover, Iran maintains relatively large explicit subsidies for first necessities (e.g., food and medicine) and some producers.

28. This chapter analyzes the fiscal and macroeconomic implications of explicit subsidies (i.e., direct subsidies included in the budget) and implicit (indirect) subsidies in Iran, and recommends phasing them out. The chapter is organized as follows. Section B presents estimates of the size of explicit and implicit subsidies in Iran. Drawing on this information, Section C analyzes fiscal and economic costs of subsidies in Iran. Section D concludes by making a case for a gradual elimination of subsidies and by providing a brief review of reform options.

B. The Size of Subsidies in Iran

29. Subsidies usually take two forms: explicit (often referred to as direct or fiscal) or implicit (referred to as indirect or quasi-fiscal). Iran’s budget classification framework provides detailed information on explicit subsidies facilitating their analysis. However, the information on implicit subsidies needs to be pieced together from various sources.

Explicit subsidies

30. Explicit subsidies are paid directly from the budget (central, sub-national, or local) to the beneficiaries—consumers or producers. In most cases, their objective is to reduce the price of a good or service to the consumer. The price reduction is often justified as a means of promoting social equity, or consumption of certain goods and services because of their perceived benefits to individuals or the society. Explicit subsidies are typically implemented by providing suppliers of goods or services with direct co-payments from the budget. The subsidy can be calculated and paid per unit of output sold (per liter of milk, per apartment built or rented, per education unit, etc.), per unit of input purchased to produce a desirable product (subsidy to a baker for wheat purchased to produce bread), or as a lump sum paid to producers to lower overall production costs (including research and development costs). Explicit subsidies are usually transparent and easy to identify and calculate. In many countries, market liberalization, fiscal pressures, and strong growth in per capita income, as well as the broad political agreement on the suboptimal nature of explicit subsidies compared to direct targeted cash transfers to consumers, have made explicit subsidies increasingly difficult to justify and maintain.

31. In Iran, explicit subsidies, excluding imported gasoline subsidies, have remained relatively stable in recent years. They mainly include financial support for agriculture and subsidies to imported food, and their level is comparable to that of many other oil-producing countries (Tables II.13).

Table II.1.

Islamic Republic of Iran: Central Government Expenditure on Subsidies in Selected Oil-Producing Countries, 2001-07

(In percent of GDP)

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Sources: National fiscal and statistical agencies; and Fund staff estimates.

Includes government expenditure on gasoline imports during 2005-07. Fiscal years begin on March 21.

Table II.2.

Islamic Republic of Iran: Central Government Expenditure on Subsidies in Selected Oil-Producing Countries, 2001–07

(In percent of central government expenditure)

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Sources: National fiscal and statistical agencies; and Fund staff estimates.

Includes government expenditure on gasoline imports during 2005-07. Fiscal years begin on March 21.

Table II.3.

Islamic Republic of Iran: Subsidies Paid Through the Consumer and Producer Protection Organization, and Other Subsidies, 2000/01–2006/07

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Sources: CBI; and the Consumer and Producer Protection Organization.

32. In 2004, the government made subsidies on imported gasoline explicit by compensating the National Iranian Oil Company (NIOC) for the difference between the gasoline import cost and domestic gasoline prices.17 During 2004/05–2006/07, international gasoline prices increased sharply, but domestic prices were not adjusted. As a result, explicit gasoline subsidies increased from 1.6 percent of GDP in 2004/05 to 2.2 percent in 2006/07. To contain the increase in subsidies for imported gasoline, the government decided to raise gasoline prices to Rls 1,000 (or $0.11) per liter and to introduce rationing starting in June 2007. Since then gasoline consumption and imports have fallen, though subsidies to imported gasoline have declined by less than initially expected as international gasoline prices have risen sharply. Also, a black market for gasoline has emerged as the rationed amount has not been sufficient for many motorists. In response, the authorities increased the rationed amount and allowed gasoline sales above it at a higher price (Rls 4,000 or $0.45 per liter) in March 2008.

Estimates of implicit subsidies (quasi-fiscal expenditure) in the energy sector

33. Implicit subsidies do not involve cash transfers. They arise when an unfunded mandate is imposed by the government (central, sub-national, or local) on producers to provide goods or services at prices that are below their opportunity cost, usually a free market level. Administrative controls, such as price, interest rate, and exchange rate controls, and certain regulations, such as production quotas and service delivery requirements, are the most widely used mechanisms giving rise to implicit subsidies. For example, price controls take the form of administrative requirements imposed on producers to provide unremunerated or under-remunerated goods or services to the general public or specific target groups (such as cheap loans for housing construction for young families). Implicit subsidies are more difficult to estimate, less transparent, and harder to eliminate.

34. Implicit subsidies in Iran dwarf explicit subsidies. Implicit subsidies are heavily concentrated in Iran’s energy sector, and they have increased rapidly in the past few years, reflecting the growing discrepancy between administratively controlled domestic energy prices and their international benchmarks.

Implicit subsidies for petroleum products

35. Consumers of petroleum products (e.g., gasoline, diesel, fuel oil, kerosene, and petrochemicals) benefit from large implicit subsidies. To simplify the estimates of the implicit subsidies arising from the underpricing of the petroleum products, this paper calculates the difference between the export border crude oil price and the assumed transfer crude oil price in the domestic production chain (Table II.4).18 While these estimates are less precise than product-by-product price comparisons, they do not require detailed information on volumes and prices of each product. Equally important, the suggested methodology focuses mainly on the foregone resource rent rather than costs and margins in oil refining and petrochemical companies. Based on this methodology, the government lost an estimated $32 billion (11 percent of GDP) by under-pricing crude oil and its derivatives in the domestic market in 2007/08. The loss may exceed $60 billion (17 percent of GDP) should the average price for Iranian crude in 2008/09 remain at current international market levels of about $115 per barrel.

Table II.4.

Islamic Republic of Iran: Implicit Subsidies in the Oil Sector, 2005/06–2008/09

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Sources: CBI; and Fund staff estimates.

GDP calculated at current (low) energy prices. An increase in domestic energy prices will raise the contribution of the energy sector to Iran’s GDP and the nominal value of GDP.

Implicit subsidies for gas

36. Natural gas users, in particular electricity-generating companies, benefit from large implicit subsidies in Iran. The domestic prices of natural gas varied widely, depending on the buyer category, but all gas users paid prices that are well below the prevailing regional level. Had Iran priced its gas sold domestically at the regional level of $150 per thousand cubic meters (t.c.m.), its revenues from gas would have been $25 billion (9 percent of GDP) higher in 2007/08 (Table II.5). Should regional gas prices remain at their current elevated levels, implicit subsidies in the gas sector may exceed $30 billion (9 percent of GDP) in 2008/09.

Table II.5.

Islamic Republic of Iran: Implicit Subsidies in the Gas Sector, 2005/06–2008/09

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Sources: CBI; and Fund staff estimates.

GDP calculated at current (low) energy prices. An increase in domestic energy prices will raise the contribution of the energy sector to Iran’s GDP and the nominal value of GDP.

Implicit subsidies for electricity

37. Implicit subsidies are also high in the electricity sector. In 2005/06, electricity tariffs ranged from 1.1 U.S. cents/kwh for residential users to 2.0–2.4 U.S. cents/kwh for public and industrial users, and up to 5 U.S. cents/kwh for other users. The average electricity tariff stood at 1.7 U.S. cents/kwh, which was well below the regional border price. The implicit subsidy is estimated at $4.3 billion (2.3 percent of GDP) in 2005/06, assuming a border price of 5 U.S. cents/kwh (Table II.6). Assuming electricity production grew at an annual rate of 8 percent, the value of implicit subsidies may have exceeded $5 billion (1.8 percent of GDP) in 2007/08.

Table II.6.

Islamic Republic of Iran: Implicit Subsidies in the Electricity Sector, 2005/06-2008/09

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Sources: CBI; and Fund staff estimates.

GDP calculated at current (low) energy prices. An increase in domestic energy prices will raise the contribution of the energy sector to Iran’s GDP and the nominal value of GDP.

Indirect energy taxes

38. In most countries, energy products are subject to indirect taxation on the following four grounds:

  • To minimize economic distortions due to taxation, optimal tax policies call for putting the highest tax burden on goods and services that exhibit the lowest price elasticity of demand. As demand for energy is relatively price inelastic, taxing energy through excises makes economic sense.

  • Taxing transportation fuels is justified as a fair and efficient way of paying for road construction and maintenance. Therefore, by taxing transportation fuels, governments ensure that heavier road users cover a higher share of expenditure on road construction and maintenance.

  • Energy use generates negative externalities, such as pollution and greenhouse gases. Therefore, taxing hydrocarbon-based fuels can be justified as a way of defraying at least some of the costs incurred from burning hydrocarbons.19

  • Energy products should be also subject to VAT as any other consumption good.

39. In Iran, total indirect taxes on petroleum products are estimated at less than 4 percent of domestic sales. This level does not cover negative externalities associated with energy consumption or the cost of road maintenance (paragraph 41). Thus, an increase in indirect taxation of energy should be considered. For example, a combined indirect energy tax rate (VAT and excises) of 20 percent on the value of energy products estimated at international benchmark prices would have generated an additional $8–9 billion (2.5–3.0 percent of GDP) in budgetary revenues in 2007/08.

C. Economic Costs of Subsidies

40. The low extraction costs and public ownership of natural resources have historically made it politically difficult for governments to sell domestically publicly-owned natural resources at prices significantly higher than the relevant accounting extraction and processing costs. In fact, in Iran, the average extraction cost of oil is less than $5 per barrel compared with the current market price of about $115 per barrel. While other MCD oil-producing countries face similar political pressures, Iran’s petroleum product prices are one of the lowest in the region (Table II.7).

41. There is a sound rationale for eliminating implicit energy subsidies based on efficiency, social equity, and fiscal sustainability considerations.20

  • Forgone revenue from energy products limits the ability of Iranian and potentially foreign companies to invest into oil and gas extraction and processing, as well as electricity generation.

  • Lower fiscal revenue curtails the level of the sustainable non-oil primary deficit, reducing Iran’s capacity to increase productive expenditure vital to raising its economic growth potential and creating jobs.

  • Cheap energy favors economic development based on energy-intensive technologies, resulting in economic structures that might not fully reflect Iran’s competitive advantage and raising the cost of an eventual transition to international energy prices.

  • Subsidies to hydrocarbon-based electricity generation reduce the attractiveness of research and development of promising alternative energy-generating technologies, such as wind and solar.

  • At the consumer level, implicit subsidies result in over-consumption of energy (through the substitution effect) at the expense of under-consumption of non-energy products and services. For Iran, the deadweight loss21 from oil under-pricing is estimated at about 1½ percent of GDP in 2007/08.22

  • Overuse of hydrocarbon-based energy has contributed to significant environmental degradation and related social costs. 23 Several studies attempted to quantify these costs for Iran. The overall health damage from air pollution in 2001 was estimated at about $7 billion (8.4 percent of GDP). The damage cost to the global environment from flaring of natural gas, assessed on the basis of a carbon price of $10 per ton of carbon dioxide, was estimated at 0.6 billion per year. Another study estimated the annual cost of environmental degradation in Iran at 4.8 to 10 percent of GDP, with a mean estimate of 7.4 percent (equivalent to $8.4 billion).24

Table II.7.

Domestic Oil Prices in Selected Oil-Producing Countries, 2003-07

(In U.S. dollars per liter, end-of-period)

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Sources: National statistical agencies; DataStream; and Fund staff estimates.

For gasoline and kerosene prices, Amsterdam ARA FOB; and for Diesel, No. 2 New York Harbor Low Sulfur FOB

D. Recommended Reforms

42. The elimination of subsidies may need to be spread over several years in Iran. High economic costs of implicit subsidies justify an immediate start of reforms. However, significant transition costs justify some gradualism in price increases.25

43. A reform package could include a mix of the following measures:

  • Streamline explicit subsidies. The effectiveness of financial support for agricultural producers needs to be examined with a view to curtailing wasteful expenditure that results in inefficient production and consumption.

  • Gradually increase energy prices. In particular, it is recommended increasing petroleum product prices to their international level (i.e., import border price, given Iran’s insufficient refining capacity), gas prices to the prevailing regional level, and electricity tariffs to cost recovery, assuming higher fuel input prices. The pace of the price adjustments should depend on progress in supporting reforms, such as the implementation of targeted social assistance and restructuring of energy-intensive enterprises.

  • Review energy sector taxation. The taxation of energy companies, including the NIOC, needs to be reevaluated in light of the expected increase in their revenues. Regarding indirect taxes, externalities warrant higher energy excises, and the VAT that is planned to be implemented in the second half of 2008/09 should be applied to energy products.

44. The impact of energy price adjustment on the CPI depends, to a great extent, on demand management policies. The one-off direct impact on the CPI of the increase in energy prices to the current level of the recommended benchmarks is estimated at 10–13 percentage points, depending on the benchmark oil price ($85–$115 per barrel). The indirect impact will depend on the macroeconomic policy stance. The latter should aim at limiting the pass-through of energy price increases to other prices. The international experience of energy price adjustments suggests that in countries where appropriate demand management policies were pursued, significant energy price increases resulted in a relatively small increase in inflation (Table II.8).26

Table II.8.

Islamic Republic of Iran: Energy Price Increases and Change in Inflation in Selected Countries

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Source: World Bank

Change in the annual inflation rate from two years before the price change to two years after the price change.

Revenue gains of governments due to energy price rises as percentage of total central government revenues.

Change in the annual growth rate from two years before fuel price change to two years after fuel price change.

45. Energy price reform will facilitate the achievement of the government’s social and developmental objectives. To ensure political support for the price reform, and in line with the authorities’ desire to distribute hydrocarbon wealth to Iranian citizens, the energy price increases should be accompanied by strengthened targeted social assistance and, possibly, some form of cash transfers from oil revenue to households.27 The additional budget revenue (net of transfers to households) could be channeled to productive expenditure within a sustainable medium-term expenditure envelope, as discussed in Chapter III.

References

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15

This chapter was prepared by Roman Zytek.

16

Zamani (2007) reviews energy use in Iran. Petri, Taube, and Tsyvinski (2002) provide an in-depth discussion of energy sector subsidies in several energy-rich countries of the Former Soviet Union in the 1990s. Hossain (2003) discusses taxation and pricing of petroleum products in developing countries.

17

Iran’s refining capacity is insufficient to satisfy domestic demand for gasoline.

18

IMF (2002), Saavalainen and Berg (2006), and Tchaidze (2007) provide in-depth reviews of the methodology for estimating implicit subsidies.

19

See McMorran and Nellor (1994) for a discussion of tax policy and environmental issues.

20

World Bank (2003) provides a detailed proposal for reforming energy sector pricing to optimize the use of energy wealth for economic development in Iran. World Bank (2007) focused on the benefits of energy price reforms to Iran’s electricity sector.

21

A deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal. In other words, either people who would have more marginal benefit than marginal cost are not buying the good or service or people who would have more marginal cost than marginal benefit are buying the product.

22

This estimate is calculated assuming a constant compensated elasticity of the demand function (see Gupta and others, 2003).

23

For a detailed review of the environmental impact of low energy prices in Iran, see Shafi-Pour and Ardestani, (2007).

24

World Bank (2004, 2005, 2006).

25

For a discussion of reform options in countries with high implicit energy subsidies, see UNEP-DTIE, IEA (2002), IMF (2005), Baig and others (2007), and Cosse (2003).

27

The authorities could use Alaska’s Permanent Income Fund as a model by opting to save some of the revenues from higher domestic hydrocarbon prices in a trust fund and use some of the fund’s earnings to pay annual dividends to all Iranians into perpetuity.