The Chronicles of Subsidy Reform

EghtesadOnline: A paper recently authored by economists Roman J. Zytek and Mohammad Reza Farzin has reviewed the experience of Iran’s Targeted Subsidies Reform. The study addresses several criticisms of the key elements of the reform design, implementation record and broader economic and social impact, identifying and elaborating on the most critical design and implementation shortcomings.

News ID: ۷۷۳۶۶۲

02 February 2017

Zytek served as senior desk economist for Iran in the International Monetary Fund in 2006-11 and 2013-15.

Farzin is a professor at the Allameh Tabatabaie University in Tehran. During 2008-11, he was Iran’s deputy minister of finance and was in charge of the subsidies’ reform headquarters.

The paper has been divided into several parts, the first of which is presented below. Other parts will be published in the coming days, Financial Tribune reported.

Background

In 2010-11, the Iranian government committed to an ambitious reform of subsidies. The reform envisaged replacing highly inefficient distribution of hydrocarbon rents through implicit subsidies to energy users with explicit cash transfers to the entire population.

In the first phase of the reform, the government increased energy prices, though not up to the international level and distributed the revenue windfall from the increase to the entire population through periodic cash transfers. The transfers were set at a fixed monthly rate of 455,000 rials (about $45 at the 2010 exchange rate) per person. To ease the inevitable hardships, households and enterprises were to continue to benefit from limited and declining quotas of lower-priced fuels during an unspecified transition period.

A number of external events made the reform more difficult than it would have been in a more favorable environment. Iran’s external environment deteriorated severely during the course of the reform implementation. The surge in international food prices in late 2010 and early 2011 (FAO food price index reached an all-time high in February 2011) contributed to domestic food price inflation.

The imposition of limits on oil imports from Iran by the international community severely undermined Iran’s oil exports and fiscal revenues, and led to a significant deterioration in external and internal macroeconomic stability.

The decline in fiscal revenues and sanctions on Iran’s financial sector further complicated efforts to reduce energy intensity of the economy. Moreover, and more importantly, not all domestic economic policies were consistent with the design and demands of the reform.

Early Reform Impact

As expected, macroeconomic indicators deteriorated following the implementation of the reform on December 19, 2010. The rate of growth of the real Gross Domestic Product decelerated to 5.3% by March 2012, from 6.5% in the year ending March 2011.

The non-oil and gas sectors expanded by a respectable 5.4% in the period, though down from the 7% growth in the prior year, all at constant basic prices of 2004-5. The overall Consumer Price Index jumped due to the massive step-like increase in energy prices.

In March 2011, the CPI was 10% above its November 2010 level. Month-on month CPI inflation accelerated to an annualized rate of almost 50% in March 2011, from an annualized rate of 14% in November 2010. The higher energy costs increased production costs of Iranian manufacturers and farmers, and pushed transportation and retail distribution costs higher. In addition, the 40% increase in international food prices between June 2010 and February 2011 contributed to the increase in domestic prices for selected food items.

However, the inflation rate decelerated rapidly by summer 2011. In US dollar terms, non-oil exports rose from $22.6 billion in 2010-11 to $26.7 billion in 2011-12. Iran’s current account remained in surplus that reached 11.5% of GDP and foreign exchange reserves increased by $20 billion in 2011.

The rial remained relatively stable and well supported in the domestic official and parallel foreign exchange markets throughout most of 2011. Only starting in the last quarter of 2011, the spread between the two rates started to widen and reached 54% in January 2012, when new rounds of international sanctions on Iran gradually reduced Iran’s ability to export oil and draw on its international reserves to support the rial.

The reform, at least initially, resulted in drastic improvement in income distribution among the Iranian households. The Gini coefficient declined from 0.411 in 2009-10 to 0.365 in 2011-12, as the cash transfers disproportionately benefitted the poorest households in relation to their income on the eve of the reform.

In March 2014, the Iranian government began implementing the second phase of the subsidy reform. Most energy prices were raised, though the increases were relatively modest. In some cases, the nominal price increases were too small to restore the real—adjusted for inflation or exchange rate depreciation—price level of the energy products achieved in late December 2010.

Prices of electricity, water, and gas were raised in March. On April 25, 2014, the remaining energy prices were raised. The price discount of gasoline sold under the quota system was reduced from 43% to 30%. The price increase brought the domestic price of gasoline to $1.10 per gallon compared to about $3.60 per gallon in the US retail market and $2.80 in the Persian Gulf coast’s wholesale market.

Also, the government encouraged more affluent households to relinquish their cash transfers voluntarily and ultimately tried to de-register the more affluent from the list of beneficiaries. However, these efforts ran into both political and technical challenges.

At the technical level, identifying and continuously updating the roster of upper income families proved next to impossible. Politically, such efforts were difficult to justify given the national ownership of Iran’s hydrocarbon resources.

Therefore, most of the administrative efforts focused on minimizing fraud, identifying Iranians living abroad and encouraging the more affluent to donate their transfers to charities.

Some of the additional revenues from the price increases were allocated in the 2014-15 budget to support reforms and expenditure in healthcare, support for municipalities and other local governments, as well as investment in oil and gas infrastructure.

Challenges

As expected, the reform exposed vulnerabilities in the corporate and banking sectors. The corporate profitability declined, reflecting the drastic increase in energy input costs, slowing economic activity, as well as the inability of enterprises to reduce employment or wages.

In some cases, firms were unable to raise output prices due to administrative price controls.

Vulnerabilities in the corporate sector spilled over into the banking sector. Companies unable to pay suppliers and employees were even less able to service their bank debts. The quality of bank assets and profitability deteriorated.

The share of non-performing loans in all loans denominated in rials rose from 13.9% in March 2011 to 15.1% in March 2012. These developments set the stage for re-acceleration in inflation in 2012, when companies, unable to cover their cost from revenues, resorted to bank financing.

The reform immediately improved the transparency and allocation of hydrocarbon rents, as intended. It turned the hydrocarbon rent into cash and transferred the cash into the hands of the Iranian population. The cash transfers initially shifted an estimated $30 billion per year into private hands. These empowered the Iranian citizens to spend a larger share of the country’s oil and gas rent as they desired, instead of forcing them to either buy cheap energy or forgo the benefit.

Thus, the allocation of final demand in the economy and consumer welfare improved, as households redirected some of their spending from energy to other goods or services, supporting the expansion of small- and medium-sized private enterprises in diverse sectors of the economy.

Unfortunately, most of the benefits of the reform may have been diluted over the past five years. Though the size of the hydrocarbon rent collapsed with the decline in the international price of oil to their long-term averages, the efficiency of rent distribution inside Iran has improved by less than feasible. Most of the rent continues to accrue to less than optimally efficient state enterprises.

The study addresses several popular criticisms of the key elements of the reform design, implementation record and broader economic and social impact, identifying and elaborating on the most critical design and implementation shortcomings.

Farzin is a professor at the Allameh Tabatabaie University in Tehran. In 2008-11 he was Iran’s deputy minister of finance and was in charge of the subsidies’ reform headquarters.

The paper has been divided into several pieces, the first of which was published in Thursday’s edition. The following is part 2 and the remaining will be out in the coming days.

Reform Objectives, Controversies

The reform was controversial and faces several criticisms. Some of the controversies are due to poor understanding of the reform’s objectives. Some of the criticisms are misplaced, while others are justified.

The reform’s design was innovative and its implementation and impact were ambitious. Ambitious and innovative reforms tend to be controversial. Unchallenged and uncorrected, these criticisms could turn into popular myths. They could undermine future reforms in Iran and other oil and gas exporting countries. For this reason, we discuss each one of these criticisms.

Innovative and Ambitious for a Reason

The reform had to be innovative. No other country has ever before attempted to substitute implicit subsidies with explicit cash transfers to the extent that Iran aimed to do. Most countries that tried eliminating energy price subsidies have been energy importers. These countries did not earn hydrocarbon rents. The subsidies they paid to support low domestic prices came from current and future fiscal revenues. The few large hydrocarbon exporters that managed to impose high energy prices in the domestic market did so at a large cost: reduced social welfare, when the hydrocarbon rent was saved; or economic inefficiencies, when the hydrocarbon rent was used to pay directly for in-kind social benefits, such as higher direct public spending on health care or education. Therefore, Iran as the reform leader had to come up with an innovative reform design.

The reform had to be ambitious. Given the extremely low energy prices in Iran on the eve of the reform in 2010, the reform needed to be strongly front-loaded.

The front-loading was needed to break the habit of energy waste and generate significant cash revenues to make the transfers to households meaningful to buy popular support.

A more gradual reform would have steadily pushed consumer prices higher, likely triggering widespread wage and price indexation.

The international experience of past subsidy reformers, such as in East and Central European Transition countries in the 1990s, supported the need for strong front-loading of the reforms.

Gradualism was out of the question, given the fact that some of the key primary energy sources (such as diesel) were priced at less than 2 US cents per liter, or about 2% of their international price.

Understanding the Reform Objectives

Critics of the reform design tend to misunderstand the fundamental economic idea that underpinned the design of the Iranian reform. Specifically, the reform’s sole objective was to raise broadly defined economic efficiency.

This was to be accomplished by raising energy and overall economic efficiency by, to a large extent, increasing the share of the income from the national hydrocarbon rent available for use by the lower income households.

Ensuring fairness of access to the hydrocarbon wealth by equalizing the per capita value of the hydrocarbon income accruing to each person would reverse the socioeconomic costs and inefficiencies attributable to widespread implicit subsidies that had benefited mostly the richest households in the past. The more equitable distribution of Iran’s hydrocarbon rent would have allowed poorer households to boost spending, including on improving human capital, and thus support long-term productivity growth and economic development.

These two inseparable objectives were to be accomplished by making energy prices reflect their full opportunity cost, and empowering the Iranian consumer to determine what the Iranian economy should produce and what it should import.

The reform offered Iran a choice between an inefficient, supply-driven delivery of many consumer goods and services, including social services, and an efficient, demand-driven supply that would respond to genuine individual consumer choice. Therefore, the reform did not envisage allocating hydrocarbon rents to producers.

In an efficient economy, producers bid for financing in competitive credit and equity markets; they do not get grants to reduce their production costs.

Similarly, the reform would not allocate the windfall from the price increase to the government budget beyond what the government needed to pay for its own higher energy and related bills after energy prices had been raised.

Impact on Lower Income Households

The removal of subsidies and introduction of equal in value cash transfers to all Iranian citizens disproportionately benefited poorer households. In fact, the reform initially hurt the richer households most, because the transfer payments compensated for only a fraction of the increase in energy costs borne by the more affluent households.

The reform would make almost all Iranians better off in the longer term by improving economic and energy efficiency, stimulating faster economic growth, reducing time wasted in traffic (benefitting those with the highest opportunity cost of time), and reducing the environmental and health damage from energy-related pollution.

The only group that would lose were those who derived disproportional benefits from low cost energy that could not be compensated by cash transfers, faster economic and income growth, and improving environmental and health conditions.

This group was likely small. Its members included energy product smugglers to neighboring countries and investors into exporters of energy intensive products who were able to capture a large share of the hydrocarbon rents before the reform.

The reform was never meant to engineer a permanent transfer of over 20% of GDP in annual hydrocarbon rents to the poor, or even the bottom 70% of the population. Such a transfer would be very unlikely to garner much political support.

Moreover, administering the income-based transfer system would have posed a logistical nightmare. In a dynamic society, today’s poor and the middle class advance along the income and social status ladders.

Engineering a targeted transfer of hydrocarbon rents would have required a massive government monitoring system to ensure that people moving between the top 30th percentile and bottom 70th percentile were added to and taken off the beneficiaries’ lists every time they advanced or fell below the threshold.

The system would have introduced prohibitively high marginal tax rates on the people just below the 70th percentile threshold and large subsidies and negative income taxes for those just above the threshold.