Iran: Reform of Energy Subsidies

At long last and after decades of talking about doing something about the subsidies, there is a bill before Iran’s majlis to target (but not remove) subsidies.  I could not locate the bill itself but my impression is that it only addresses energy subsidies and not other subsidies such as food and medicine.  So far only 5 of the bill’s 14 articles have been passed, but the government already has the mandate to raise prices on energy products over the next five years.

The bill has been criticized from both the Right and the Left, which leads me to think it must be a move in the right direction.  Opponents of the bill criticize it for its potential to increase inflation and poverty, and proponents think it can end waste while reducing poverty.

Inflation is not a necessary outcome but it should be taken for granted that it will rise as energy prices are adjusted upward.  Much depends on the speed of the adjustment and the extent to which the Central Bank accommodates the price increases.  The bill allows the government to raise prices to generate revenues of $10-20 billion (for roundness, in this post I use $1=10,000 rials) per year.  It limits the total revenues raised instead of individual price increases.  So, there is room for gradualism that could ease its inflationary impact.

The subsidy reform has the potential to reduce poverty because about half of the revenue it raises is to be distributed back to the poorer half of the population.  An average family of five can expect roughly $1,000-$2,000 per year, which is a significant sum given that families below the median spends on average about $4,000 per year ($3,800 in 2007).  The cash-back part of the bill explains the striking fact that a measure to remove subsidies, a policy that is more often associated with the so-called neo-liberal thinking, has received strong support from the Ahmadinejad government, which is not known for its pro-market stance, but has been opposed by more liberal politicians.

Both sides seem to focus on the redistribution part of the bill because it can win hearts and minds for whoever is in charge of the redistribution, but who knows how the price increase will go down politically?

Greater equity and poverty reduction are only potential benefits, not certain by any means.  The devils are in the details, which I will explain after reviewing a bit of history.

General subsidies have been a big part of the welfare state in post-revolution Iran.  They grew out of the rationing system during the war and the government’s commitment to the poor, and over time increased in volume, especially for energy products as world energy prices increased while consumer prices in Iran stayed low.  The results have been both good and bad.  Food and medicine subsidies have played an important role in increasing child nutrition and lowering child mortality, both of which contributed to lower fertility (and hence the modernization of the average Iranian family).  The important role of subsidies in these transformations becomes evident when we note that they started in the mid-1980s when the economy was still in a very bad shape — that is, they are not the consequence of economic growth as in other countries.

The worst part about general subsidies is waste.  Iranians throw too much food away, take too many pills, and pollute with inefficient use of energy.  Energy subsidies have become especially large in the last decade as oil prices skyrocketed.  I remember that about 18 years ago when I gave a talk on energy subsidies at Iran’s Institute for International Energy Studies, people were amused to hear that someone was worrying about energy subsidies in oil rich Iran.  I estimated energy subsidies at about $5 billion for 1993, when food and medicine subsidies were $3.2 billion.  (That study was published by the Oxford Energy Institute and a version appeared in an edited book.)  The latter has not changed much while energy subsidies have grown to $50 billion!  Add to that the realization that energy subsidies go mostly to those above the median income and cause pollution, and you get a consensus to do something about them, which is why both Khatami and Ahmadinejad governments agreed on this one issue.

General subsidies for food and medicine are not the best way to raise the living standards of the poor, but they are effective in raising their nutrition and health.  They target needs rather than the needy.  They are favored when identifying the needy is difficult and intra-household allocations of expenditures favor the adult males in the family.  Economists often advocate cash assistance in place of general subsidies, but if you do not know who the poor are general subsidies is the only way to reach the poor.  Even when you can identify the poor (by where they live, for example), money given to the head of a poor family may not be spent on child nutrition and education.  This was an important finding in the development literature a couple of decades ago, that money from foreign aid given to men was more likely to go to adult male goods (such as beer and tobacco) than to milk, children’s clothing, health, and education, which are considered female-type goods.

The targeting of needs does not really apply to energy subsidies, which makes the case for their removal much less complicated.  For households, natural gas and gasoline are the two most important items and in both cases a greater share of the subsidy goes to the upper half of the population.  Gasoline sells in Iran at about 40 cents a gallon, compared to $2 in the US, and natural gas is delivered to homes at about 1.4 cents per cubic meter compared to 14 cents in the US.  Price adjustments will be huge and can have a large impact both on overall consumption and on the distribution of income.  Politically, raising prices without a cash-back mechanism is unthinkable.

But paying back cash to deserving individuals is much easier said than done.  There are two distinct questions: which families should get cash back and who inside those families should actually receive it.  The latter is a question of how household resources are allocated between family members (intra-household allocations), a question on which there is little research for Iran but, as I mentioned earlier, is serious in many developing countries.  Without the facts, it is hard to know the extent of the problem we face if all the cash is given to the head of the household.  But you don’t need rocket science research to know that if the head of the households (often a male) is an addict the money is likely to go to drugs unless it is controlled by his spouse.

The targeting of the needy is a more serious problem.  It appears that the government intends to use the information it collected last year using a very crude survey instrument.  About 60% of the households returned a filled questionnaire, but no one knows how accurate is the information in them.  The Statistical Center of Iran is heavily involved with identifying the low income families, a task that runs counter to its mandate to guard the confidentiality of all individual information it collects.  Its involvement has negative ramifications for future reporting of income and wealth through its numerous surveys.  In the upcoming census of 1390 (fall 2011), when SCI interviewers will ask about ownership of assets — homes, cars, and appliances — they are less likely to get a straight answer.  The government plans to also use the information available from other agencies, such as Behzisti and Komiteh Emdad, to identify those below median income.  But in the end, there is likely to be lots of bad feelings about giving money back to the wrong people.  For those who believe they are right around the median, there will be endless tension and maneuvering to hide their assets and income, not to mention disincentives to earn or accumulate less with the hope of qualifying for the cash back program.

This is a good time for Iran to think about introducing a legally binding annual reporting of incomes for all individuals with income, similar to what the Internal Revenue Service does in the US.  Over time, the earning history of a person provides a much better indication of its economic status than answers to one questionnaire.

The bottom line is that none of these problems are reason enough to keep energy prices in Iran at one-tenth of their world levels and for Iran to engage in massive waste of energy.  The effort to reduce energy consumption in a way that equity does not suffer needs everyone’s support.  I only wish that the specifics of the bill could benefit from greater expertise than is currently applied to the immensely complex issues the bill raises.

Djavad Salehi-Isfahani is a Dubai Initiative research fellow at the Belfer Center for Science and International Affairs at Harvard University.  This article was first published in his blog Tyranny of Numbers on 22 October 2009; it is reproduced here for non-profit educational purposes.

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