By
Dr. Farrokh Zandi

February 2020

Governments around the world in general and governments of oil-producing nations of the Middle East and North Africa in particular have long been subsidizing energy prices for a variety of reasons including redistributing the nation’s wealth with the public, social security and safety net and ensuring access to energy. The government of the Islamic Republic of Iran not only belongs to this group of countries but is also the greatest energy subsidizing country in the world.

Notwithstanding the above, the recent 200% gasoline price hike in Iran appears to have produced a narrative advanced by uninformed non-economists who mix up facts with fictions. To sort out this confusion and shed light on the current uninformed conversation, two aspects of this initiative need to be distinguished: why to reform and how to reform and whether and when to reform. 

Why reform? This aspect needs a careful analysis of the general facts about energy subsidies as well as a thorough discussion of the rationale for a price reform that is grounded on economic principles.

How-to reform? This aspect should critically evaluate the method of execution of the price reform and discuss the required conditions for a successful execution.

 Whether and when to reform? To answer this question, one needs to consider the overall environment within which the reform takes place. A welfare- improving policy prescription to maximize national welfare cannot be implemented in vacuum and independent of other policy initiatives that together shape up such an environment.

It is my intention in this commentary to elucidate on these three aspects of this issue. 

 What is consumption subsidy?

Consumption subsidies come in many forms and shapes. They comprise implicit subsidies which is the mechanism of keeping prices for consumers below the market level (price subsidies) and explicit subsidies that are transfers from the government to the public that come in the form of in-kind subsidy, a subsidy in the form of credit or simply cash transfers such as yaraneh mostaghim as implemented in 2010 by the government of President Ahmadinejad or komak maieshati as recently introduced by President Rouhani government.

Both types of subsidies, implicit and explicit, have long been used in the Iranian economy. While explicit subsidies are registered on the government budget as subsidies, implicit subsidies are not. Iran extends implicit subsidies in the energy sector when the National Iranian Oil Company (NIOC) sells petroleum products for the domestic market at below-international prices. Here, NIOC does not incur financial losses and hence the government does not need to make an explicit transfer to compensate it for losses. However, even though such a transfer does not appear explicitly on the state oil companies’ records or in the government budget, there is still an implicit cost involved: the opportunity cost, which represents a sacrificed economic revenue (rent) caused by not selling gasoline at higher market prices.

Hence in comparison with explicit subsidies, this type of subsidy does not appear explicitly on NIOC’s records or in the government budget.

Why subsidies?

There can be many reasons (not necessarily sound economic reasons) for governments through subsidies to make energy consumption more affordable to energy users: companies (corporations) that use energy for their daily business as well as households that use energy for their personal consumption. Energy subsidies can benefit its users both directly and indirectly: for households for example; (a) direct benefits occur as subsidies lower prices of energy used for household chores and for passenger transportation; and (b) indirect benefits are earned through reduced prices of other goods and services- consumed by households- that use energy as an input. Historically, subsidized energy prices have been used by governments of oil and natural gas producing nations as a method of redistributing and sharing the country’s natural resource wealth with the public. Subsidies have also been utilized to spur economic growth.

How much subsidy?

According to various sources including the International Energy Agency (IEA), Iran was the largest fossil fuel subsidizer in 2018 and prior to the recent tripling of the gasoline price, Iran had the cheapest gasoline in the world. Having spent $69.2 billion on fossil energy consumption subsidies in 2018, Iran ranked first globally, ahead of Saudi Arabia with $44.72 billion and China with $44.44 billion.  To put this in perspective, the $69.2 subsidy equals 15.3% of Iran’s GDP and 16% of total global energy subsidies. It also amounts to an average subsidization rate of 79% as a proportion of the full cost of supply and $844 share of each person in fossil fuel subsidies in that year. 

Source: International Energy Association, “Energy subsidies: Tracking the impact of fossil-fuel subsidies”, 2019

Prior to the recent price hike, one liter of gasoline cost 1,000 Tomans, equivalent to $0.08 (8 cents) when measured at the average free market rate of $1 = T12,000, or US$0.11 or (11 cents) at NIMA rate of exchange of $1= T9000 at the pump inside Iran. The same sold on the Turkish side for $1.25 and in Pakistan for $0.75 leaving a whopping potential profit for smugglers. 

Why reform?

While the reform of energy subsidies in Iran, as in many other oil-producing Middle Eastern countries, proves to be an economically and politically delicate task, the need for the reform remains as strong as ever. The reasons are as follows:

First, in the short term, the energy subsidy reform agenda will likely be dominated by the issue of fiscal sustainability. The growing fiscal burden which has spiraled out of control has made it impossible for the government to continue with its current level of subsidies, especially under the growing sanctions’ pressure.

Second, low gasoline prices encourage overconsumption and waste of energy. At about a 95 million litre daily consumption rate, Iranian drivers have been encouraged to overuse their cars. Low prices also inflict environmental costs.

Third, by absorbing a huge chunk of the government’s annual budget expenditure, energy subsidies divert money from other important public projects. As such, energy reforms are expected to pay off dividends by redirecting expenditure and hence creating potential for investing in more efficient areas including education.

Source: Energy Subsidies in the Middle East and North Africa, IMF, 2014

Fourth, gasoline is a standardized, homogeneous and tradeable good, and when substantial differences in its price develop across nations’ boundaries, they foster opportunities for smuggling. In the case of Iran, the significantly lower gasoline price, as stated above, has given rise to outbound smuggling from Iran. According to some unofficial estimates, Iran is losing a significant volume of fuels to its neighbouring countries, primarily to Turkey, Iraq, and Pakistan daily.

Different estimates put the volume of smuggled fuel anywhere between 10 and 22 million litres per day. Iran’s Headquarters to Combat Smuggling put this at 11.5 million litres while members of the Iranian Parliament’s Energy Committee have quoted various sources, putting the gasoline smuggling figure at 10 to 22 litres per day. This means not only does Iran lose gasoline to smuggling, what it loses is a highly subsidized gasoline. The dollar figure of this loss to gasoline smuggling is estimated at $3.5 billion annually. To put this into perspective, this is equal to roughly 9 percent of Iran’s entire 2018 budgetary revenue from taxation (about $40.95 billion). It should also be mentioned that prior to last year, Iran imported some gasoline for which it had to pay higher international free market prices while it exported highly subsidized gasoline. 

Fifth, energy subsidies also create distortions, i.e. they provide a natural disincentive for investing in alternative and cleaner energy technologies, such as solar and wind power.

Sixth, according to an IMF study, the richest one-fifth of households receive almost half of all subsidies; the poorest fifth receive only 10%. As such, whereas price subsidies are costly, unhelpful to the poor, and harmful to the society in the form of inefficiency and overconsumption, the targeted subsidies have become a tool in the government’s hand to pick and choose to reward and punish by extending subsidized cheap inputs.

In light of the above, Iran, like many other energy-producing Middle Eastern countries, has been under pressure from the IMF to institute major economic reforms, including eliminating subsidies in phases. In Iran, the energy price reform, along with few other price reforms started in 2010 when the gasoline price increased from 100 Tomans to 400 Tomans per litre and a cash transfer, yaraneh mostaghim, accompanied it to offset rising cost of living.

Economic theory holds that when the price of an item (such as gasoline) rises in the marketplace it exerts two reinforcing negative effects on consumers’ demand for gasoline: a substitution effect, which makes consumers to cut back on their demand for gasoline in favour of a substitute good, say public transit; and an income effect, which represents a decrease in consumers’ purchasing power again reducing demand for gasoline. Applying this concept, governments often attempt to compensate the income effect of the rising cost of energy through a cash transfer initiative.

However, in the aftermath of the above price reform in Iran there appeared little improvement. In fact, contrary to the expectations: gasoline consumption continued to rise; there was no evidence of the necessary relative energy price adjustment to bring about efficiency gains; and the cash transfer (yaraneh mostaghim) failed to complete its mission of compensating the energy end users  for the rising cost of energy as the out-of-control inflation eroded the purchasing power of this transfer. As for the price reform to generate additional government revenue, the evidence points in the direction of revenue creation not through cost savings as it had been hoped, but through the inflation tax. History is filled with examples of developing countries using money printing as the usual method of financing their budget deficits. Iran, judging by its poor performance on the inflation front which has exceeded 10% every single year over the last 40 years, is a blatant example of such countries. 

Naturally, one can consider the most recent gasoline price hike as the continuation of the 2010 price reform with the same objective as outlined by the IMF. However, it is already becoming clear that the chance of this round of the price reform succeeding is no greater than the last one. For one, on the revenue front,  the government’s own estimates put the expected revenue from the price hike for the year at about T31000 billion ($2.4 billion measured at the free market rate of T13000 to $1) whereas the cost of financing the cash transfer (komak maieshati) for the same period is projected to exceed T55000 x 60 million x 12 = T39,600billion ($3 billion). 

Therefore, it appears that the government has, in the name of gasoline price reform, put itself in a no-win situation as this scheme will inevitably worsen the already growing budgetary shortfall that has been shaping up in light of the sanctions with little prospect of recovery. In view of the above, one can predict a not-so-bright future for this initiative as it leaves the government with one of two options: (i) to resort to its customary money-printing (monetizing) the shortfall which by creating inflation will deteriorate the purchasing power of komak maieshati and hence will defeat its purpose, or (ii) to default on its income- assistance commitment. Either way, the public will come out worse off. However, defaulting on its new cash transfer commitment does not seem to be a viable option given the strong possibility of a severe political backlash. As such, left with the option of financing its new commitment through money printing, option (i), the resulting inflation across all goods and services will wipe out the intended goal of increasing the price of energy (relative to other items) that is necessary for removing price distortions and restoring efficiency.

As it turns out, there are already signs of increasing strains on the government budget. Iran’s governmental budgetary sources are primarily revenue from oil, gas condensate, and taxation. With the revenue from oil and gas exports having almost vanished due to sanctions, the government, in its latest budget (2020), appears to be acknowledging this difficulty and hence proposing to overcome it by reducing the revenue dependency on petroleum exports to 23% – which is the lowest since Iran became a major oil exporter in the 1970s –and replacing it with higher revenue from taxation. According to the proposed budget figures, revenues from exporting oil, gas and gas condensate are estimated at 45.5 trillion Tomans (about $10.83 billion measured at the official rate of exchange), down 66 percent from 137 trillion Tomans (about $32.61 billion) in the current year’s budget, while the revenue from taxation is projected to increase by 27 percent.

This, however, should prove quite challenging as Iran has one of the lowest tax revenues -GDP ratios in the world, 6.5% (in comparison with 26% for South Korea, 24% for Turkey, 33% for England, 27% for USA, 32% for Canada, 46% for France, 43% for Sweden) which is primarily because 60 percent of organizations and 40 percent of individuals in Iran are exempted from paying taxes, a phenomenon that has inspired tax evasion at the national level. Therefore, against this backdrop and also in light of the fact that Iran’s economy is already grappling with a deep recession- negative 9 percent growth of GDP in 2019- the government’s claims that higher revenues from taxation will replace the dependency of the budget on oil and gas are farfetched and untrue.

In any case, the recent government’s unannounced gasoline price hike reflects, among other things, the fear of being forced to start re-importing gasoline at the substantially higher free market prices from outside.

How to reform?

Although price subsidies are quite popular – especially among the low-income people whose wellbeing depends almost entirely on subsidies – to economists, price subsidies are inefficient and are considered a regressive method of redistributing income. However, despite these drawbacks, once subsidies are entrenched in the way of life, removing them, or even replacing them by a reasonable amount of monthly cash transfer, could pose a serious political crisis that only a prudently planned and carefully executed price reform can avert. The public often prefers price subsidies to a cash transfer for concerns about the loss of purchasing power of the transfer due to the price volatility and for fear of the government suspending the transfer program. 

Therefore, given the sensitive nature of the price reform, the IMF has recommended a series of arduous conditions for a successful price reform: 

  • Transparency and prior government consultation with all stakeholders;
  • Public education about the importance of energy conservation and price reform: their benefits as well as the costs of inaction;
  • Gradual phased and sequenced (as opposed to abrupt and sudden) price increases towards market- based prices based on a scheduled reform plan and a specific timeline that will allow enough time for adjustment;
  • Meaningful price increases that can effectively reduce demand, since relatively small domestic price increases could be easily eaten up in real term by inflation, an increase in international prices, or exchange rate depreciation. 

It is interesting to note, however, that none of these conditions was met prior to the recent price reform in Iran. Instead, lack of transparency, non- existent communication, distrust, and a rushed and abrupt approach had dominated the environment within which the price hike took place.

Whether and when to reform?

Government policies are part of an integrated dynamic environment that consists of economic, political, legal, competitive, social, and global factors which collectively influence the way economic agents’ (consumers and firms) wellbeing shapes up, the way business is conducted, and the way income is generated and distributed. In such an environment, any government policy, whether it is in the form of a new initiative, an existing policy adjustment, or termination needs to be viewed in conjunction with existing policy measures and its impacts must be assessed in the general equilibrium setting of the economy where policies interact rather than in vacuum and in a partial equilibrium setting isolated from the rest of the economy.

Therefore, the effects of the gasoline price reform must be evaluated and critiqued not independently, but rather within a broadly-based economic system where its impact on the overall market efficiency and consumers’ welfare can be examined. In light of the above, it is a mistake for the IMF to prescribe an out- of-context subsidy reform for an economy which is government-run in almost all aspects- more than 80 percent- and is riddled with distortions caused by but not limited to high tariffs, quotas and export subsidies; multiple exchange rate systems; price control; international capital control; financial repression; as well as the presence of the semi- government and shadow- government entities that are empowered to function as monopolies and are in control of a large portion of the economy. Worse yet, it is irresponsible and opportunistic of the commentaries that have lent support to the government for adopting these recommendations on the false pretense of concerns about efficiency and environmental concerns in this environment.

Consequently, against this backdrop, the recent isolated gasoline price hike may not be claimed as efficiency-improving and welfare-enhancing, but rather the opposite. As a matter of fact, this hasty price hike, one can deduce, must have been executed with only the budgetary stress in mind, a goal which seems to have taken priority despite its potential adverse effects on the economy in the form of escalating an already out- of- control inflation and intensifying the prevailing recession.

Conclusion

There is a strong economic rationale for subsidy reform that goes beyond tackling its high budgetary cost.  Subsidies distort prices, encourage overconsumption, divert public funds from essential investment projects, accrue largely to the wealthy who spend a greater absolute amount on most goods, incentivize smuggling to neighboring nations, and damage the environment, etc. Furthermore, there is irrefutable evidence that Iran’s energy sector is one of the most heavily subsidized and the gasoline price the cheapest in the world. However, several factors must be present and many conditions need to be met before a subsidy reform is launched. In their absence, which is the case of Iran, the gasoline subsidy reform is bound to inflict short-term as well as long-term and irreversible damage to the economy. Moreover, the gasoline price reform should have taken place in congruence with other market efficiency-improving measures, and hence cannot be defended as it was implemented in vacuum and independent of other prevailing government interventions in the marketplace. The untimely execution of the reform, when the economy is already grappling with a deep recession, an out-of-control inflation, and the strangling economic sanctions is also highly questionable. Therefore, any serious and meaningful subsidy reform should have been postponed until such time that the sources of the market distortions and imperfections are removed. In short, Iran’s existing legal and economic structure must be upended to accommodate a thorough reconstruction and a major overhaul for any market reform.

 References: 

BBC ‘کمکهای معیشتی’؛ چه کسانی مشمول دریافت یارانه‌های جدید نمی‌شوند؟, 05 آذر 1398
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International Energy Association, “Energy subsidies: Tracking the impact of fossil-fuel subsidies”, 2019.
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OECD Economic Department, “Phasing Out Energy Subsidies in Indonesia”, 2010.
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