Rising petroleum prices and the plight of the poor
The government must make policies that help in the equitable distribution of wealth.
“What improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable.”
These words were written back more than two centuries ago by Adam Smith in The Wealth of Nations, Book-I. Smith is the person regarded by many as the father of economics and these words sum up in unambiguous terms what is required of national governments. Policies that benefit the whole lot of a country’s population, policies that help in the equitable distribution of the economic pie, and policies that provide a safety net for the disadvantaged are not only the prerequisites of a flourishing and happy society but are also the rudimentary duties of any government. Providing subsidies on petroleum products is not one of these policies.
The recent spike in international oil prices and the decision of the government to subsidise the same for the local population in the face of relentless criticism from the opposition parties and civil society alike is a hotly debated topic. According to estimates and the prime minister himself, the cost to the government of this subsidy is around Rs5 billion per month. This will further exacerbate the fiscal deficit which according to a report has already spiralled to Rs510 billion for the six months to December 2010. To bridge this gap between income and expenditures, the government can either try and raise revenues or resort to borrowing. There is not much chance of the former happening, given our collective distaste for paying taxes. But even a cursory glance at the country’s borrowings to date raises further alarm bells. As per the State Bank of Pakistan, government borrowings for six months of the current fiscal year stood at over Rs438 billion, an increase of 104% compared to the same period last fiscal year when these borrowings were Rs215 billion. Of the Rs438 billion, the central bank lent Rs261 billion whereas scheduled banks lent Rs177 billion. To cater to such exorbitant demand for borrowings from the government, the State Bank is said to be printing Rs2 billion daily.
It is in the backdrop of such a bleak economic scenario that the government has taken upon itself to absorb the effect of rising oil prices in the international market. Now, I am not against the notion of the government intervention to ameliorate the plight of the poor. In fact, the provision of a social safety net for the poor is what a government is supposed to be doing in the first place. However, in the case of fuel subsidies, research has shown that there are unintended consequences which work to the detriment rather than the benefit of the poor.
The first unintended consequence of subsidies is that it benefits richer households. This is because richer households consume more energy than their poorer counterparts. A study conducted by the Ministry of Economic Affairs in Indonesia, for example, concluded that in 2008 that top 40 per cent of high-income families absorbed 70 per cent of the subsidies whereas the bottom 40 per cent of households consumed just 15 per cent of the subsidies.
A similar official study in Malaysia also stated that 71 per cent of the subsidy on fuel goes to the upper and middle classes and not to the poor. A study conducted for the G-20 countries’ summit in Toronto in 2010 also concluded the same. In Pakistan too, it is not uncommon to see elite households owning more than two, even three, cars whereas a majority of the lower, lower-middle and middle-class households resort to motorcycles or public transport.
Second, fuel subsidies encourage fuel adulteration. This is due to the relative sizes of subsidies for different petroleum products. As a rule of thumb, the bulk of the subsidy is to be provided to kerosene, as it is used for lighting and cooking by poorer households, and diesel, as it is used across a wide range of vital industries such as public transportation, fisheries, agriculture and even power generation. However, in most developing countries, including ours, diesel is primarily a transport fuel used more by the upper and upper-middle classes. This, therefore, results in the leakage of the diesel subsidy to upper-middle and upper class households. As for subsidised kerosene, there is an incentive to mix it with diesel and sell the concoction as diesel, resulting in the leakage of the kerosene subsidy.
Third, fuel subsidies have also been known to promote smuggling. Because petroleum products are easy to store and transport, dealers closer to border areas have been known to smuggle the goods across the border to fetch higher returns. The effect in the subsidising country is the transfer of financial incentives to smugglers while the recipient country loses out on the taxes and duties which would have been levied had the products been sold through legal channels. A report by Inter-Press Service (IPS) in 2008 highlighted this very fact. Petrol pumps in Khyber-Pakhtunkhwa did brisk business as jerry cans upon jerry cans of diesel were smuggled across the border into Afghanistan. Back then diesel was selling at $1.4 per litre in Afghanistan against $0.9 per litre in Pakistan. Summarily, the already cash-strapped government not only bears the burden of cheap fuel for Pakistanis but also for Afghans. Governments of Argentina, Malaysia, Venezuela, Iran, Iraq, Kazakhstan and Vietnam can also attest to this unintended effect of fuel subsidies.
Moreover, the provision of fuel subsidies also distorts demand. By providing subsidies to consumers, the government is, in other words, providing the consumer with an incentive to consume more than he or she otherwise would have consumed. When a commodity, any commodity, becomes expensive, a rational consumer adjusts his demand in relation to the price, consuming only as much as he can afford. Granted, petroleum products are not a luxury. But only for the poorer households that rely on cheap bus, rickshaw and train fares to commute, or those who use kerosene to make food, and even those who own cars but earn within a certain bracket. All efforts should be made to shield them from the impact of rising oil prices but there are other ways to do this, as will be shown later, than providing subsidies across the board. It is preposterous to provide subsidy to people who live in big houses and drive SUVs (and those too more than just one) and say, it’s ok drive them all as much as you want, the government will pay. According to a study by Keith Bradsher reported in The New York Times, many emerging economies consume much more fuel than they would be by keeping fuel prices artificially low. According to one estimate, countries that provided fuel subsidies accounted for the entire increase in worldwide oil consumption in 2007.
To be continued….
Published in The Express Tribune, January 31st, 2011.
These words were written back more than two centuries ago by Adam Smith in The Wealth of Nations, Book-I. Smith is the person regarded by many as the father of economics and these words sum up in unambiguous terms what is required of national governments. Policies that benefit the whole lot of a country’s population, policies that help in the equitable distribution of the economic pie, and policies that provide a safety net for the disadvantaged are not only the prerequisites of a flourishing and happy society but are also the rudimentary duties of any government. Providing subsidies on petroleum products is not one of these policies.
The recent spike in international oil prices and the decision of the government to subsidise the same for the local population in the face of relentless criticism from the opposition parties and civil society alike is a hotly debated topic. According to estimates and the prime minister himself, the cost to the government of this subsidy is around Rs5 billion per month. This will further exacerbate the fiscal deficit which according to a report has already spiralled to Rs510 billion for the six months to December 2010. To bridge this gap between income and expenditures, the government can either try and raise revenues or resort to borrowing. There is not much chance of the former happening, given our collective distaste for paying taxes. But even a cursory glance at the country’s borrowings to date raises further alarm bells. As per the State Bank of Pakistan, government borrowings for six months of the current fiscal year stood at over Rs438 billion, an increase of 104% compared to the same period last fiscal year when these borrowings were Rs215 billion. Of the Rs438 billion, the central bank lent Rs261 billion whereas scheduled banks lent Rs177 billion. To cater to such exorbitant demand for borrowings from the government, the State Bank is said to be printing Rs2 billion daily.
It is in the backdrop of such a bleak economic scenario that the government has taken upon itself to absorb the effect of rising oil prices in the international market. Now, I am not against the notion of the government intervention to ameliorate the plight of the poor. In fact, the provision of a social safety net for the poor is what a government is supposed to be doing in the first place. However, in the case of fuel subsidies, research has shown that there are unintended consequences which work to the detriment rather than the benefit of the poor.
The first unintended consequence of subsidies is that it benefits richer households. This is because richer households consume more energy than their poorer counterparts. A study conducted by the Ministry of Economic Affairs in Indonesia, for example, concluded that in 2008 that top 40 per cent of high-income families absorbed 70 per cent of the subsidies whereas the bottom 40 per cent of households consumed just 15 per cent of the subsidies.
A similar official study in Malaysia also stated that 71 per cent of the subsidy on fuel goes to the upper and middle classes and not to the poor. A study conducted for the G-20 countries’ summit in Toronto in 2010 also concluded the same. In Pakistan too, it is not uncommon to see elite households owning more than two, even three, cars whereas a majority of the lower, lower-middle and middle-class households resort to motorcycles or public transport.
Second, fuel subsidies encourage fuel adulteration. This is due to the relative sizes of subsidies for different petroleum products. As a rule of thumb, the bulk of the subsidy is to be provided to kerosene, as it is used for lighting and cooking by poorer households, and diesel, as it is used across a wide range of vital industries such as public transportation, fisheries, agriculture and even power generation. However, in most developing countries, including ours, diesel is primarily a transport fuel used more by the upper and upper-middle classes. This, therefore, results in the leakage of the diesel subsidy to upper-middle and upper class households. As for subsidised kerosene, there is an incentive to mix it with diesel and sell the concoction as diesel, resulting in the leakage of the kerosene subsidy.
Third, fuel subsidies have also been known to promote smuggling. Because petroleum products are easy to store and transport, dealers closer to border areas have been known to smuggle the goods across the border to fetch higher returns. The effect in the subsidising country is the transfer of financial incentives to smugglers while the recipient country loses out on the taxes and duties which would have been levied had the products been sold through legal channels. A report by Inter-Press Service (IPS) in 2008 highlighted this very fact. Petrol pumps in Khyber-Pakhtunkhwa did brisk business as jerry cans upon jerry cans of diesel were smuggled across the border into Afghanistan. Back then diesel was selling at $1.4 per litre in Afghanistan against $0.9 per litre in Pakistan. Summarily, the already cash-strapped government not only bears the burden of cheap fuel for Pakistanis but also for Afghans. Governments of Argentina, Malaysia, Venezuela, Iran, Iraq, Kazakhstan and Vietnam can also attest to this unintended effect of fuel subsidies.
Moreover, the provision of fuel subsidies also distorts demand. By providing subsidies to consumers, the government is, in other words, providing the consumer with an incentive to consume more than he or she otherwise would have consumed. When a commodity, any commodity, becomes expensive, a rational consumer adjusts his demand in relation to the price, consuming only as much as he can afford. Granted, petroleum products are not a luxury. But only for the poorer households that rely on cheap bus, rickshaw and train fares to commute, or those who use kerosene to make food, and even those who own cars but earn within a certain bracket. All efforts should be made to shield them from the impact of rising oil prices but there are other ways to do this, as will be shown later, than providing subsidies across the board. It is preposterous to provide subsidy to people who live in big houses and drive SUVs (and those too more than just one) and say, it’s ok drive them all as much as you want, the government will pay. According to a study by Keith Bradsher reported in The New York Times, many emerging economies consume much more fuel than they would be by keeping fuel prices artificially low. According to one estimate, countries that provided fuel subsidies accounted for the entire increase in worldwide oil consumption in 2007.
To be continued….
Published in The Express Tribune, January 31st, 2011.