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.


Steve

While in general I agree with you. I have one very good reason why fuel subsidies are actually a good idea, espec in a developing country.

Fuel subsidies are not so far removed from other transport subsidies such as public transport or roads. So think about why we subsidise these things. A region with decent roads and public transport enables people within the city to get to their jobs, it encourages the transport of goods across the region and to other regions and enables a region's businesses to serve a much wider area. This dramatically increases the value of being located in the city. It is much the same as removing other barriers to the transportation of goods, people and services such as the removal of trade barriers. Most economists would support subsidised public transport, the removal of trade barriers and public building of roads; subsidising fuel is exactly the same.

i.e. a population that is more able to get around the region is more able to buy goods and services, is more able to produce those goods and services, is more easily able to share knowledge encouraging economic growth. In particular in a developing country, where transport is a large barrier to economic participation, fuel subsidies are able to get those people moving and participating in the economy, rather than being isolated within the small part of the city they can walk (or ride a horse) to.

Admittedly it is a poorly targeted policy in that it is the richest 20% or so who draw the most benefit, but for those on the margin of that 20% (and even many of those below who only occasionally use motorised transport) it significantly enables economic participation.

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Steve

Actually, think of the cost of fuel like a tax you pay in order to participate in work. If the cost of you getting to work is almost as much as you earn, what's the point in working? A high cost of fuel relative to income is like a very high tax and encourages people not to work. A subsidy on fuel is like a tax cut for these people where fuel is a large portion of their income.

Tno

So you think Egypt subsidizes fuel?
Just look at Venezuela, where the price of gas at the pump is LESS than ten US cents per gallon.
Once you start subsidizing fuel you are basically trapped and have to continue doing so. Back in 1989, the Venezuelan government attempted to lift the subsidy and the result was a popular revolt that almost brought down a democratically elected Government. Yes, subsidies dont make any economic sense and yet there is a psychological component to it. People perceive it as a necessity. Especially if the cost of your bus fare, the one that gets you to work, is kept down.

Phillip

If the point is to line the pockets of the rich, then the program has been quite successful, wouldn't you say? I mean, aren't you just assuming that governments are SUPPOSE to help the poor and create a healthy economy?

greenoacean

Well said, but then without subsidy, the hike in oil price will cause uncontrollable inflation in the country itself. Imagine if the price of fuel in developing countries is the same like the price of fuel in developed countries. It would then drive inflation which in the end will deprive the competitiveness of countries which are labor intensive instead of technology intensive. I guess there must be a balance.

James

An increase in oil prices does not cause inflation, it causes an increase in real prices as the increased price is factored across the economy. Inflation is an unwarranted increase in the money supply, leading to each individual dollar, shekel, or whatever being worth less. Again, not much different from the Romans, except that they had to debase their currency the hard way, by adding base metal to their coins, while we have bankers & accountants who can do it all on paper (or these days, with computers).

Matt O.

Here goes nothing:

A fuel subsidy reduces the costs of travel (at least, the perceived costs). This improves the mobility of the people, which allows them a wider range of employment and housing opportunities.

Jaime

It´s an excellent analysis what you just did here. I´m from El Salvador and I can assure you that subsidies on fuel could be better invested in other areas like education or development of new energy sources. I agree with your arguments, especially when your refer to externalities.

However, I think there are a couple of arguments in favor of fuel subsidies. For example - and the one I consider the most important- what would happen if there these subsidies didn´t exist? I mean, there is a lot of people who constantly use their car for going to their jobs. Okay, you could think in some substitutes like the public transportation service- a bus-, but when in very poor countries-like mine- this service is extremely inefficient and insecure.

What I really mean is that it could be interesting to apply your ideas to poor countries. I think Egypt couldn´t be the better example. Also, I think the other arguments goes realted to political position. I mean, if a government removed a subsidy...well, just imagine how prices would go up in a short term.

Excellent analysis. Best wishes from El Salvador.

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Jonatan

1. There will be more jobs in the gas station attendant and cab driver professions.

2. The smuggling might move the oil to a poorer country, thus increasing global equality.

I can't think of any more, but I thought of another disadvantage:

- it will promote people living farther away from their workplace. Thereby increasing their use and dependency on fuel, even if the subsidies are later removed.

Eloka

My sentiments exactly. Last year, the Nigerian government tried to remove subsidies but there was not enough buy-in from the public and the timing was wrong. That said, Nigeria needs to yank off subsidy and fund priorities like Health and Education. It would be a long battle but it is a necessary action.

Chris

Aiming for the Freakonomics Swag here goes.

I have 2 points that could argue this is a good policy for a new and inexperienced government who is still working out what all the levers do.

Point 1, taxing fuel causes a certain amount of price rising as pretty much everything is delivered somewhere. So subsidising fuel could be a good way of bring down the prices of most things which could be implemented by a brand new inexperienced government. Perhaps to correct actions that caused monetary inflation previously.

Point 2, As someone else has also mentioned funding infrastructure can decrease transaction costs and make for a better market. However if you have just had a revolution and are not in a position to start building high speed rail then bunging a few quid at petrol producers could be a good way of encouraging trade.

Neither are good long term policies, and I think these are weak arguments, however if you crack an egg on a broken radiator it will usually seal the leak long enough for you to get to garage.

What do you think?

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Christy

I'm glad Mr Witzel mentioned Nigeria. That happens to be my country. It might seem ridiculous to fight a concept that makes sense (all things being equal), but most would agree that things are all but equal around here :)

You're talking about a country that's one of the world's top oil producers, but doesn't refine crude oil. We import them, an THEN the government pays marketers the subsidies to keep the prices down. If you've been following developments here, that hasn't gone too well, even.

My country is a complex one :)

I won't even get into accountability, (mysterious) oil theft, or insecurity. I quite agree that allowing market forces 'do their thing' would pay off in the long run, but an angle I think is missing in this debate from Nigeria's point of view would be the ability to truly have the fairest domestic marketplace possible, and get rid of importation. But then we also have IOCs in the picture, wh0 have had a grip on the market for decades. It would take, perhaps, an act of God to deal with these issues simultaneously...or perhaps a leader born of a virgin :)

A bill to make that effort has been underway for years now (stakeholders are still debating the details). Let's see what we end up with.

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Patrick

Fuel does not automatically mean transportation fuel, the report makes that clear and your post confuses this. What about cooking/heating fuels? What you describe as being a transportation subsidy has a large health, welfare, and environmental component. Why, even Chicago was an early advocate of the car on the basis of it being a hygienic alternative to the horse.

I know for a fact that scientific research has been used to determine optimal fuel subsidies as a deterrent to habitat destruction from the illegal harvest of firewood from public lands. I cant vouch for other regions, but don't assume the determinants are the arbitrary whim of inept governance.

QuicoT

Spare a thought for poor Venezuela, which spends almost 8% of GDP to keep the average gas tank (not gallon, TANK) at less than $1 ...

The best - indeed, only - argument for the subsidy isn't a policy argument at all, but instead political. People tend to riot when their bus-fare goes up. And our politicians live in constant fear of that.

kayode

I live in Nigeria where government has severally unsuccessfully made attempts at removing fuel subsidies often canvassing these same arguments.

Transportation in Nigeria is largely privately controlled, with individuals often owning a single car/bus and very few owning fleets. These often belong to trade unions who acts more like cartels in fixing bus fares. Rail transportation is almost non-existent. Fuel subsidy removal implying a 40% increase in fuel prices can lead to bus fare increases by as much as 200%. Bus fares are linked to prices of most commodities from basic food prices to those of construction materials and all see significant price increases.

This can cause sudden spikes in cost of living and often violently resisted by the populace. A better approach is a phased withdrawal of subsidies while at the same developing other transportation capabilities.

Faizal

It might well turn out to be the smartest policy -- at least on this side of region where austerity measures often identifies removal of petrol and diesel subsidies as topping their prime agenda, in which the ripple effects would be mass protest. Having said that, it doesn't undermine the ineffectiveness of fuel subsidies but only to strengthen and extrapolate the negative externalities to the smuggling and other associated cartel economics. It is clearly a smart socio-political tool for the ruling regimes. The real crux is the energy governance, a multi-level one from the sub-national, national, regional and global. After all, a museum of liberal economy in South East Asia would surely include a machine exhibit, toss a dime and you'll be punched in the face by an invisible hand. Hard.