Should The Government Subsidize Fuel Prices? #GuestPost

A fuel shortage queuePetroleum products have become a major part of our everyday lives as humans. In as much as it is, it has become a necessity in our lives, coupled with its sky rocketing prices which tends to burden major economies all around the world hence government subsidies.

Government subsidies occur when the government directly controls prices and often impose price tags that keep domestic prices below border prices (world prices). Governments’ control of petroleum products’ prices is a common feature in developing countries. In some cases governments directly controls import levels, domestic distribution and domestic prices; in other cases alike, the private sectors freely import and distribute petroleum products but government sets domestic “price ceilings” and compensate private distributors to cover costs. This is particularly the case when international fuel prices increase sharply and governments are reluctant to pass these increases fully on the domestic prices on petroleum products.

Obviously, in a number of economies, “fuel subsidies have been projected to exceed 2 per cent of their annual Gross Domestic Product (G.D.P) even after recent substantial increases in domestic prices. Also, these expenditures (fuel subsidies) were as large as public education and health budgets: even in some case, e.g. Yemen, Indonesia, total subsidies were higher than health and education budgets combined”. – PetroStrategies, an O.E.C.D report by Charles Husky.

Although subsidies are politically popular, they have adverse consequences on both government finances and efficient use of energy which often results in shortage. Again, large subsidies tend to redirect public expenditure away from more productive spending or contribute to unsustainable budget deficit. Like a “rippling effect” subsidies tend to have a major effect on all aspects of the economy and the people (rich and poor) as a whole. Low fuel prices (subsidies) fail to provide the appropriate incentives to household to be more efficient in their energy usage, which will mitigate the overall adverse effect of higher world prices on the country’s economy.

The trouble with subsidies on energy products, however is that, poor consumers get a disproportionately small chunk of the benefit and a disproportionately large chunk of the hurt. The benefit comes because subsidies make fuel prices affordable; that not only reduces the cost of cooking and lighting, but indirectly holds prices down concurrently, e.g. Transportation costs for food hence for individual families, reductions can be most welcomed.

An International Monetary Fund (I.M.F) study by Azel Del Granada found that $25 per liter in the price of fuel would reduce the real purchasing power of a household by more than 5 per cent as a result; the average 20 percent of the richest population may get 6 times as much total benefit from fuel subsidies.

On the other hand, since poorer households are less likely to be connected to the electric grid, they’ll account for a larger share of kerosene consumption and get more from the subsidies of that fuel. The harm to the poor arises from the way that fuel subsidies tend to drain government budgets of funds that could benefit the poor in a more targeted way. In 2012, Indonesia and Saudi Arabia’s fuel subsidies amounted to some 14 per cent of their governments’ annual budget. The same funds now squandered on fuel subsidies could be used to bolster public spending on health and education or other programs more efficiently targeted at the poor.

As far as it is, contrary to general thoughts, subsidies tend to affect the rich as well: since upper- income consumers get the bulk of the benefits from the policies that hold fuel prices below global market prices, we might as think they should be net – beneficiaries of subsidies programs, but that is not necessarily true.

There exist several channels through which subsidies affect the rich just as they do the poor; taxes are one channel. In some exporting, countries including the Saudi, individual income taxes and Value Added Taxes (V.A.T) are insignificant. Elsewhere, including Egypt and Indonesia, wealthy citizens have to cover the budgetary costs of fuel subsidies through income taxes and consumption taxes. The progressiveness of the tax system in such countries offsets the regressive nature of fuel subsidies themselves. Where that is true, fuel subsidies policies constitute a net drain on the budgets of the rich.

Secondly, fuel subsidies have side effects that directly reduce the quality of life of the people of all income levels. Traffic congestion and air pollutions are two of the most striking effects on the people as a whole. e.g. A recent story reported of one of the largest city in the world Jakarta, a city without a rapid transit system: lower income commuters get to work aboard slow and crowded city buses or rickety private mini buses. Things are really no better for those able to afford cars, however the 9 mile 90 minutes’ drive to work that one office manager reports is apparently typical. Because cheap gasoline encourages tens of thousands of extra cars and motor bikes to join the fray, traffic spills over everywhere including supposedly designated bus lanes.

Apparently, higher fuel prices could free up funds that now serve as subsidies so that they could be used for investments in modern transit facilities. At the same time, they could reduce the number of cars on the road. Instead, the main thing that fuel subsidies seems to buy is transportation hell for the rich and poor alike; not to mention intolerable levels of air pollution.

Slower economic growth is the third channel through which energy subsidies harm the rich as well as the poor. In countries with entrenched subsidies, businesses often express concern that higher fuel prices would undermine their competitiveness on world markets. In the short run, that may be true. However studies suggest that the opposite is the case in the long run.

Generally, fuel subsidies inhibit growth by tying up budget resources that could otherwise go to investment in human capital or infrastructure. Another way is by distorting trade structures.

In fact, given that the demand for energy is inelastic and that there is negative consumption externalities linked with its usage, taxation of petroleum products is generally viewed as an efficient way to raise government revenue. Moreover, this paper argues that universal energy subsidies are not a cost – effective way to protect real incomes of poor households since they involve substantial leakage of benefits to higher income groups.

Edem Komla Egle.
November 2014

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