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A 12-Step Program for Fuel Subsidy-aholics

(Photo: Brad.K)

(Photo: Brad.K)

Back when blog posts were composed with reed styluses on clay tablets, I put up a couple of posts (here and here) on fuel subsidies in the developing world. These are generally 1) fiscally ruinous; 2) terrible for the environment and traffic congestion;  3) highly regressive with regard to wealth distribution; and 4) market-distorting by artificially promoting fuel-guzzling industries. So I made the case that this is a pretty foolish public policy, in fact one of the worst I can think of. It’s up there with tobacco subsidies, the Concorde, pretty much everything the North Korean government has ever done, and our government’s failure in spending a paltry $615,000 taxpayer dollars for UC Santa Cruz students to digitize priceless Grateful Dead photographs, t-shirts and concert tickets.

Given the problems with fuel subsidies, I promised a third post on what to do to eliminate them. But since I have a day job, and being a professor is much more difficult than it looked when I was undergrad, I’ve procrastinated on putting this last post up. However, engineering student Kishore from India wrote asking where part three is, and customer satisfaction is a goal here at Freakonomics. Besides, no doubt governments around the world have been waiting impatiently for my post before they start dismantling their fuel subsidies, so here it is.

Given the damning case against fuel subsidies, and a rising swell of opinion that they are counterproductive on many levels, why don’t these policies go away? The IMF (see this) and I offer several reasons:

Here are some ideas:

1) Before fixing the problem, it would help to know what the problem is. This means a rigorous study of the current policy in all its dimensions. This should start with the direct costs, which is harder to know than it sounds given that in many cases the subsidies do not appear on government balance sheets and instead are concealed in places like the balance sheets of state-owned industries.

2) Moving further, all of the subsidies’ short- and long-term impacts on government finances, national macroeconomics, the environment, traffic congestion, and wealth distribution must be tallied up, and contrasted with projections of the potential effects of policy reform.

3) This information must be disseminated to the public transparently, making it clear to the people who is gaining and losing from the subsidy program, particularly in terms of income distribution.

4) Once the public at large understands the issues, there must be broad consultation with all affected stakeholders, not just the politically connected and highly motivated beneficiaries, about the costs of subsidies and the potential benefits of subsidies’ repeal.

5) One strategy to bring these issues home to the public might be taking the gains and losses out of the realm of abstract numbers on a piece of paper. Instead, governments and civil society could demonstrate how the size of the subsidies compare to other budgetary needs such as health and education, showing the good that the money saved could do if applied to other purposes.

6) This trade-off could be made an explicit part of the policy of eliminating subsidies, and the plan may well include measures that offset the immediate pain to losing groups. The most straightforward and perhaps effective measure might be simple means-tested direct cash transfers; an alternate strategy might be government spending on things such as health, nutrition, or education. The problem here is that many of these programs may be difficult to administer or even beyond the capacity of the governments altogether, particularly in less-developed nations. One alternative might be simply upping expenditure on easy-to-run pro-poor programs already in place, such as bread subsidies. These are also market distorting, but at least they are progressive.

7) Taking all of this into account, a set of clear long-term objectives must be formulated, and a reasonable, meaningful, comprehensive plan produced. This must tackle the problem in all its dimensions.

8) Repeal must have a hard timetable for implementation.

9) As part of this process, government should take on broader reform of the petroleum sector. This might include examining where state-owned oil companies wield disproportionate power, stifling innovation and reducing economic efficiency. It would also involve ensuring that the private fuel market functions efficiently. For example, it is crucial to limit the market power of any participant, promoting adequate competition. One step toward this might be cutting red tape to ease entry to and exit from the market.

10) Along those lines, government should also formulate ideas to improve efficiency in fuel-guzzling industries, par
ticularly state-owned ones, to cushion the blow when fuel prices rise.

11) Assuming a consensus for repeal can be achieved, the program must be designed to ensure a smooth and effective transition, with a minimum of public outcry and economic dislocation, like spikes in inflation. One step would be to reduce subsidies only gradually, for example by limiting the amount fuel prices can rise in a given time period. This would reduce sticker shock.

12) Government might deflect some potential opposition by depoliticizing the process of subsidy reduction. This could be done through the use of automatic pricing measures like formulas, or politically independent price-setting bodies.

All of these steps are easier said than done. But the good news is that the wind is now blowing against fuel subsidies, and courageous countries like the Philippines and Turkey have successfully addressed this issue, reducing fuel subsidies or eliminating them altogether. The bad news is that many have not, and even more depressingly other countries like Ghana, Sierra Leone and Togo have tried and failed, reinstating or even increasing fuel subsidies when oil prices rose dramatically — causing public outcry. Thanks to the strategies above, more countries can take the former path rather than the latter, hastening the day this policy runs out of gas.