Subsidies -- Love Them or Hate Them, It's Better to Target Them

Like many things, there may be a time and a place for using subsidies. But they need to be better targeted. And, often, there will be better alternatives. Alternatives that do a better job of protecting the poor.
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For decades, countries in the Middle East and North Africa have relied heavily on food and fuel price subsidies as a form of social protection. And, understandably, governments have recently raised subsidies in response to hikes in global commodity prices and regional political developments.

Like many things, there may be a time and a place for using subsidies. But they need to be better targeted. And, often, there will be better alternatives. Alternatives that do a better job of protecting the poor.

High-cost endeavor

Countries in the region stand out because of their heavy reliance on subsidies. The region accounted for almost two-thirds of petroleum price subsidies worldwide in 2009, according to estimates by the International Energy Agency. Food subsidies are also widespread.

How much these subsidies cost is a bit of a guess, but we estimate it was around $200 billion in 2010 -- equivalent to almost 8 percent of regional production. About 15 percent of this reflected the cost of food subsidies, and the remainder subsidies on fuels and electricity.

Subsidies may be popular, but they have drawbacks, and not just in terms of the substantial costs. In particular, subsidies:

  • Are not cost-effective or do not target those most in need;
  • Encourage overconsumption and waste, particularly for subsidized energy;
  • May lead to damage to the environment, inefficient investment choices, and competitiveness problems;
  • Can strain public finances and worsen debt levels; and
  • Encourage socially wasteful activities, such as smuggling and black-market dealings.

For example, in the United Arab Emirates and Iran, energy consumption (adjusted for income differences) is more than 50 percent higher than in the United States. In Egypt, price subsidies have reportedly led to the use of bread as animal and fish feed.

Better as stop-gaps

Price subsidies enjoyed by all are typically poorly targeted, so they are not the most cost-effective way to provide social protection. They really should be regarded as stop-gap measures. Take the case of Jordan, where the poorest 40 percent of the population receives less than a quarter of total spending on fuel subsidies.

Attempts to phase out subsidy regimes have often proved challenging. Some subsidy reforms, especially in the 1980s and 1990s, reduced outlays, but attempts were often reversed after meeting resistance (sometimes violent) or rolled back in the face of large commodity price swings.

Some of the reasons why it's difficult are obvious. Subsidies often create vested interests and, in oil-producing countries, many consider cheap energy an entitlement.

Resistance to subsidy reform may also reflect -- in part -- broader weaknesses in public services. In many countries, middle-income households are squeezed because they cannot rely on publicly-provided healthcare, schooling or utilities. Whereas price subsidies are seen as one of few tangible benefits in return for tax payments, removing them is heavily resisted.

But, over the longer term, the objective should be to design and introduce more cost-effective social safety nets and replace price subsidies.

Cash transfers and other forms of income support can be better targeted. Well-designed cash transfer systems can typically result in about 50-75 percent of spending reaching the bottom 40 percent of the population.

And some better targeted measures can be expanded or introduced relatively quickly. Take, for example, school feeding programs, waiving fees for public services for the poor (such as health, education, or public transport), or labor-intensive public works.

Some success stories

Of course, none of this is easy. But, some countries have successfully introduced subsidy reforms.

  • Outside the region, Indonesia more than doubled fuel prices in 2005 and increased fuel product prices by 25-33 percent in 2008. The budgetary savings were used to finance a cash compensation program to 15.5 million poor families.
  • Jordan started reforms in 2005, gradually phased out fuel subsidies and, by February 2008, domestic fuel prices followed international prices via a monthly automatic pricing regime. Although automatic fuel adjustment was temporarily suspended in January of this year due to social pressures, a major factor in the reforms had been measures to ease the adjustment. This included, among others, cash transfers to low-income households and increased allocations to the National Aid Fund (the social assistance body).

Both experiences illustrate the importance of putting in place effective social safety nets as part of price subsidy reforms to reduce the odds of reform reversal in case of sudden shocks.

Need for buy-in

Better targeting subsidies or replacing them with more effective social safety nets is a complex process, both technically and politically. But buy-in from the public is crucial to success.

There are several ways to do this. It's particularly important to:

  • Develop a comprehensive communication strategy and build political support.
  • Tell the public how much subsidies really cost and who benefits.
  • Compensate those hardest hit, by introducing or strengthening measures to protect the poor, including those that are living slightly above the poverty line.
  • Strengthen public sector governance and accountability. Net savings from subsidy reforms should be transparently allocated to high priority projects.
  • Improve targeting gradually. Narrowing the scope of existing subsidies--say, for products that are most important for the poor--can deliver quick gains. Ultimately, the goal should be to replace price subsidies by price-indexed cash transfers.
  • Automatic pricing mechanisms can help depoliticize price setting.
  • Move regionally, if possible. A broader--even coordinated--regional effort to phase out subsidies and establish better social protection could also help ease resistance.

The key point is that better targeting subsidies is as much about fairness as it is about value for money in public spending.From iMFdirect blog

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