Fuel Subsidies: The World’s Dumbest Transportation Policy?

There are plenty of transportation policy ideas which get my spider-sense tingling. But in most cases, I think it’s at least possible to form a coherent case in favor which doesn’t strain the basic tenets of logical argumentation. However, I am pretty much at a loss when it comes to government subsidies for transportation fuel, a strong candidate for the title of the world’s dumbest transportation policy.

In the developed world, governments often don’t tax fuel enough to make up for the externalities produced by driving. (Yes, United States, stop shuffling your feet and looking at the ground, I mean you.) But I’ve whined about that enough in the past.

In this post, let’s look at an even more egregious situation that is disturbingly prevalent in the developing world, especially in oil-producing countries (see this). Many governments not only do not tax fuel enough, but actually expend revenue to subsidize fuel and keep gas prices artificially low. In effect, they are paying people to drive.

According to a recent IMF study on which this blog post is based, as of 2011, $480 billion was spent subsidizing fuel. This is equivalent to 0.3 percent of global GDP, or 0.9 percent of worldwide government revenues, literally going up in smoke.

What are the many implications of this? To illustrate using a single nation, which is admittedly one of the more grievous offenders, I’m going to pick on poor Egypt. We hear lots about the conflict between Islamists and secularists there, but the backdrop for the current unrest, which threatens not just Egypt’s stability but that of the region, is an economy teetering on collapse.

Given the parlous position of Egypt’s government finances (its current budget deficit amounts to 13 percent of GDP, the worst of any country among the 42 in this week’s Economist, and three times the bad-enough figure for the U.S.), one would think Egypt would have better things to do than paying people to drive. But as of 2011, it was expending 30 percent of its government revenue subsidizing petroleum products, in order to keep the domestic unleaded gas price at about $1.14/gallon.

Statistics about budget deficits may leave you cold, but consider the opportunity costs, i.e. the other things that could be done with that money. Given widespread poverty, and unemployment north of 13 percent, surely Egyptians would be better off if nearly a third of their government spending went to things like education, health care, nutrition, social welfare, economic development, or even tax cuts.

In addition to the basic waste of revenue, additional budgeting problems arise from fuel subsidies. As we all know, the price of gas is very volatile. When global oil prices rise, so does the amount that subsidizing countries like Egypt have to spend to keep prices low. This creates a lot of uncertainty for governments and makes fiscal planning for the future very difficult.

Why else is this policy senseless? Let us count the ways.

Most basically, spending on fuel subsidies makes Egyptians, on the whole, poorer. The reason is that subsidies lead people to undertake activities for which the benefits are actually lower than the costs of doing them. For example, consider a cab ride which provides eight dollars of benefit to the passenger, but which would require inputs that are actually worth ten dollars (thanks to driver time, wear and tear on the vehicle, and of course fuel). In a subsidizing country, this ride may actually get taken, when otherwise the traveler would forego it if the government weren’t footing part of the bill. In this case, the cab ride destroys two dollars of wealth. This goes on in Egypt every day.

Also, on the macroeconomic front, for oil-importing countries (which Egypt is these days), encouraging fuel consumption and thus oil imports can exacerbate trade deficits and drain foreign exchange reserves. (Egypt’s have fallen by over 40 percent in the last two years alone.)

Also, when subsidies are off of the government’s budget, and are borne by energy companies, they make fuel production and refining less profitable and can discourage development in this sector. This will eventually harm the broader economy, and may in turn necessitate even greater subsidies.

Also, paying people to drive creates traffic congestion. I have not been to Egypt, but have been assured that Cairo’s traffic jams are of epic proportions. Does the government really need to spend itself into bankruptcy to make them worse?

Also, obviously this policy does no favors to air quality. Even if appeals for the future of the planet as a whole do not move the Egyptian government, fuel subsidies lead to more local air pollution, like ozone, which directly contributes to ill-health. Egypt is paying to poison its citizens, and, as the photo shows, it is in fact doing so quite successfully.

Egypt's Tax Dollars at Work (Photo: Vyacheslav Argenberg)

Also, subsidies harm efforts to economize on resources. Egypt’s are discouraging its consumers from buying more fuel-efficient vehicles.

Also, fuel subsidies ensure the accelerated depletion of what is, after all, a finite resource—oil. A world in which Egypt and numerous other countries pay people to consume fuel leads, unsurprisingly, to higher demand for oil and thus a higher global price, creating a drag on the world economy. Fuel is used inefficiently in Egypt when it could be used more productively elsewhere. The IMF calculates that if we begin phasing out fuel subsidies now, the price of oil will be 8 percent lower than it would otherwise be in the year 2050. 

Also, fuel subsidies create an incentive for smuggling, from high-subsidy countries to low-subsidy ones. This is widespread in many regions. In the case of Egypt, such smuggling has been widely blamed (including by the former regime) for its recent chronic fuel shortages. The disappearance of gas from the pumps—at any price—was a major cause of the unrest leading to the military takeover.

Also, there is the issue of income distribution. I suppose it is possible to make a case for subsidizing, say, bread, which is truly a necessity and where the tax dollars expended would benefit the poor far more than the rich.

But who are fuel subsidies flowing to? I doubt the 40 percent of Egyptians who live on $2 a day or less are much worried about gassing up their Volvos. The IMF calculates that, for a middle-income country, 61 percent of fuel subsidies flow to the top 20 percent of the income distribution, even taking into account the fact that subsidies reduce the prices of goods that the poor consume. Do we really need policies that transfer funds from the legions of the desperately poor to the elites? If we care about basic fairness, how about expanding free education, providing subsidized health care, or making direct, means-tested, welfare payments?

I could go on, but at this point the wear on the “A,” “L,” “S,” and “O” keys on my keyboard is getting pretty bad. So, to be fair, let’s switch to the good aspects of fuel subsidies.

Uh, well, uh, hmmmm. Oh wait… no, forget it. To be honest, for once I’m at a loss for words. I can barely think of a few arguments in fuel subsidies’ favor, and these are very weak. So for fun, I’ll give you all a chance to prove you’re more clever than I. In the comments section, let’s see if anybody can write a succinct and cogent defense of this policy. To the talented sophist out there who can make tenable the untenable, I will present a coveted piece of Freakonomics swag. Good luck—I think you’ll need it.

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  1. Pete says:

    Caveat-you should mention that you are just talking about subsidizing “oil” to be used for gasoline. What are the implication for subsidizing alternative fuels-natural gas, wind, solar etc.? Surely not all as negative as the effects you mention here. Would be very interested in a follow up.

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    • Allen says:

      Alternative fuels, wind, and solar subsidies are the sec0nd-dumbest transportation policy. The same list presented by Eric applies: substitute “chopping up birds” or “higher food prices” for “creating ozone”

      Mathematically, anytime government subsidizes someting, somebody wins and somebody loses. And the total lose is always greater than the total win.

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      • rfburke says:

        Subsidies for wind/solar are to stimulate the market for the goods which us required & has benefit. Therefore in this case the effect would be to increase demand, lowering the cost to the consumer to the point where it’s competitive. You can then eliminate it.
        BTW, Wind turbines don’t kill birds, it’s bats, & they aren’t getting chopped up.

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  2. Brendan says:

    Hidden due to low comment rating. Click here to see.

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  3. Nate says:

    Interesting subject. How do you feel about the blending tax credit for ethanol in the USA? How does a direct subsidy like you mentioned about Egypt compare?

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  4. Dave Witzel says:

    I suspect “avoiding riots” is one of the better arguments for maintaining a fuel subsidy.

    e.g., in Nigeria (http://www.france24.com/en/20120103-lagos-nigeria-end-petrol-subsidy-riots-clashes-police) and Indonesia (http://www.nytimes.com/1998/03/20/news/20iht-jak.t_3.html). Can I have my swag now?

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    • Enter your name... says:

      If there had been no subsidy in the first place, then taking it away would not distress anyone.

      Similarly, very slowly phasing it out should not result in riots, especially if you announce that the price is going up 2%, without mentioning that it will go up another 2% and another 2% and another, until there is no more subsidy.

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      • Shane L says:

        Just as the Romans had difficulty in repealing the grain dole, once the people got used to it.

        Daniel Kahneman’s “Thinking, Fast and Slow” said that people are loss averse. Once we have something, we dislike losing it. People enjoying subsidies are much more angry by their removal than people who never enjoyed subsidies in the first place.

        Therefore governments should be cautious about rolling out subsidies, because their loss will be politically difficult to handle.

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    • Linch says:

      Correct. Governments, or rather, individuals in top places in governments, are typically much more concerned about whether they stay in power than overall macroeconomic/societal optimality. Classic case of the principle-agent problem.

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  5. Brendan says:

    In the case of the Egyptian regime, the other things you suggest spending money on, like education, health care, nutrition, social welfare, and economic development, would largely show return at some point in the future. Given the political volatility in the country, it is unlikely the regime that implemented these changes will still be around when returns begin to be paid out.

    Gas prices spiking if the 30% subsidy were dropped would be something Egyptian citizens would see immediately, and would ironically be adding fuel to the fire of political protest by means of subtraction of fuel. So the subsidy isn’t necessarily there for the good of the taxpayers, but the good of the people employing the subsidy.

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  6. Warren says:

    I agree that the fuel subsidy as a policy is beyond stupid. The reason I can give to defend it is the transitional gains trap. Now that the subsidy is in place, taking it away would have immediate negative effects even if in the long run it would be substantially beneficial. Given the fragility of politics in Egypt, suddenly eliminating a popular subsidy could lead to a popular backlash.

    Also, even if all of the fuel subsidy were suddenly transferred to eliminate poverty, I am highly skeptical that the money would actually go to eliminate poverty. I speculate it would mostly go to corrupted bureaucrats. At least this way if you buy gas you get something.

    In conclusion, it is an inane policy but eliminating it could lead to more political unrest and the money would be funneled to more corruption. But in the long run it would be better.

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  7. John Eberle says:

    The good is not in the subsidies themselves, but in the value to the subsidizers.

    In classic Freakonomics fashion – look for the reason behind the reason. If the act itself is not rational, then it must have a rational sub or secondary benefit.

    In the case of fuel subsidies it is a transfer of wealth from a non-supporting group to a supporting group thus benefiting yet a 3rd party. So government subsidizes fuel and gets power, contributions or influence in return. Joi-La! Logic!

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  8. Ben says:

    Maybe in the light of promoting infrastructure, say the govt is prepared to spend a lot of money to make sure there are companies that are providing the country with pipelines, pumping stations, a mobile population, a petrochemical industry, roads (via private investments),.. because it believes oil prices will go down and thinks it can fasten development or it wants to become the regions logistic hub and thinks this is a good way to make it happen .

    I had to try really hard and the real reason probably is a mix between cronyism and populism, but it’s not impossible to think of benefits, although I would agree the disadvantages are far greater.

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