The Chronicles of Subsidy Reform

A paper recently authored by economists Roman J. Zytek and Mohammad Reza Farzin has reviewed the experience of Iran’s Targeted Subsidies Reform. 

The study addresses several popular criticisms of the key elements of the reform design, implementation record and broader economic and social impact, identifying and elaborating on the most critical design and implementation shortcomings. 

Zytek served as senior desk economist for Iran in the International Monetary Fund in 2006-11 and 2013-15. 

Farzin is a professor at the Allameh Tabatabaie University in Tehran. In 2008-11 he was Iran’s deputy minister of finance and was in charge of the subsidies’ reform headquarters.  

The paper has been divided into several pieces, the first of which was published in Thursday’s edition. The following is part 2 and the remaining will be out in the coming days.

   Reform Objectives, Controversies

The reform was controversial and faces several criticisms. Some of the controversies are due to poor understanding of the reform’s objectives. Some of the criticisms are misplaced, while others are justified.

The reform’s design was innovative and its implementation and impact were ambitious. Ambitious and innovative reforms tend to be controversial. Unchallenged and uncorrected, these criticisms could turn into popular myths. They could undermine future reforms in Iran and other oil and gas exporting countries. For this reason, we discuss each one of these criticisms.

   Innovative and Ambitious for a Reason

The reform had to be innovative. No other country has ever before attempted to substitute implicit subsidies with explicit cash transfers to the extent that Iran aimed to do. Most countries that tried eliminating energy price subsidies have been energy importers. These countries did not earn hydrocarbon rents. The subsidies they paid to support low domestic prices came from current and future fiscal revenues. The few large hydrocarbon exporters that managed to impose high energy prices in the domestic market did so at a large cost: reduced social welfare, when the hydrocarbon rent was saved; or economic inefficiencies, when the hydrocarbon rent was used to pay directly for in-kind social benefits, such as higher direct public spending on health care or education. Therefore, Iran as the reform leader had to come up with an innovative reform design. 

The reform had to be ambitious. Given the extremely low energy prices in Iran on the eve of the reform in 2010, the reform needed to be strongly front-loaded. 

The front-loading was needed to break the habit of energy waste and generate significant cash revenues to make the transfers to households meaningful to buy popular support.

A more gradual reform would have steadily pushed consumer prices higher, likely triggering widespread wage and price indexation. 

The international experience of past subsidy reformers, such as in East and Central European Transition countries in the 1990s, supported the need for strong front-loading of the reforms. 

Gradualism was out of the question, given the fact that some of the key primary energy sources (such as diesel) were priced at less than 2 US cents per liter, or about 2% of their international price. 

   Understanding the Reform Objectives

Critics of the reform design tend to misunderstand the fundamental economic idea that underpinned the design of the Iranian reform. Specifically, the reform’s sole objective was to raise broadly defined economic efficiency. 

This was to be accomplished by raising energy and overall economic efficiency by, to a large extent, increasing the share of the income from the national hydrocarbon rent available for use by the lower income households. 

Ensuring fairness of access to the hydrocarbon wealth by equalizing the per capita value of the hydrocarbon income accruing to each person would reverse the socioeconomic costs and inefficiencies attributable to widespread implicit subsidies that had benefited mostly the richest households in the past. The more equitable distribution of Iran’s hydrocarbon rent would have allowed poorer households to boost spending, including on improving human capital, and thus support long-term productivity growth and economic development. 

These two inseparable objectives were to be accomplished by making energy prices reflect their full opportunity cost, and empowering the Iranian consumer to determine what the Iranian economy should produce and what it should import. 

The reform offered Iran a choice between an inefficient, supply-driven delivery of many consumer goods and services, including social services, and an efficient, demand-driven supply that would respond to genuine individual consumer choice. Therefore, the reform did not envisage allocating hydrocarbon rents to producers. 

In an efficient economy, producers bid for financing in competitive credit and equity markets; they do not get grants to reduce their production costs. 

Similarly, the reform would not allocate the windfall from the price increase to the government budget beyond what the government needed to pay for its own higher energy and related bills after energy prices had been raised. 

   Impact on Lower Income Households

The removal of subsidies and introduction of equal in value cash transfers to all Iranian citizens disproportionately benefited poorer households. In fact, the reform initially hurt the richer households most, because the transfer payments compensated for only a fraction of the increase in energy costs borne by the more affluent households. 

The reform would make almost all Iranians better off in the longer term by improving economic and energy efficiency, stimulating faster economic growth, reducing time wasted in traffic (benefitting those with the highest opportunity cost of time), and reducing the environmental and health damage from energy-related pollution. 

The only group that would lose were those who derived disproportional benefits from low cost energy that could not be compensated by cash transfers, faster economic and income growth, and improving environmental and health conditions. 

This group was likely small. Its members included energy product smugglers to neighboring countries and investors into exporters of energy intensive products who were able to capture a large share of the hydrocarbon rents before the reform. 

The reform was never meant to engineer a permanent transfer of over 20% of GDP in annual hydrocarbon rents to the poor, or even the bottom 70% of the population. Such a transfer would be very unlikely to garner much political support. 

Moreover, administering the income-based transfer system would have posed a logistical nightmare. In a dynamic society, today’s poor and the middle class advance along the income and social status ladders. 

Engineering a targeted transfer of hydrocarbon rents would have required a massive government monitoring system to ensure that people moving between the top 30th percentile and bottom 70th percentile were added to and taken off the beneficiaries’ lists every time they advanced or fell below the threshold. 

The system would have introduced prohibitively high marginal tax rates on the people just below the 70th percentile threshold and large subsidies and negative income taxes for those just above the threshold.