Wednesday, August 20, 2014

Should Government Continue to Subsidise Fuel?

Kofi Buah, Energy Minister

Crude oil is an internationally traded commodity with prices determined by external forces of demand and supply. Governments of many developing countries attempt to cushion the effects of crude oil price fluctuations on their citizens particularly the poor by instituting social intervention measures common among which is the subsidisation of refined products.

A petroleum or fuel price subsidy is usually the variance between the reference price and the actual (selling) price of the product. Depending on the petroleum import/export position of the country, the reference price would usually be the world market price plus the transport cost to border (import price) or world price minus transport cost to border (export price) or the marginal cost of domestic production.

The actual or selling price refers to the ex-pump prices at which various products are sold to final consumers. The total amount of subsidies paid by government is estimated by a summation of the product of unit subsidy and total units consumed per product for all subsidised products. This essay seeks to evaluate the feasibility of continued subsidisation of fuel prices by the government of Ghana. Should fuel subsidies be removed?

Advocates of fuel subsidies cite several reasons in favour of the continuous application of subsidies predominantly in less developed economies. Key among these is the objective of curtailing the adverse consequences of fuel price hikes on poor households and promotion of social equity.

Research has revealed that although a significantly lower percentage of subsidies benefit the poor, withdrawal of subsidies in Ghana has witnessed a decline in real income for the poorest 20% of consumers by as much as 9.1%, the highest among five countries studied (Coady et al. 2006). It has also been argued that since evidence shows fuel price increases are followed by rising prices of most products and services, subsidies could be used to reduce inflationary pressures.

Fuel subsidy reforms have also been observed to encourage poor households to switch to fuel wood thereby depleting forests and other natural resources. Although not usually explicitly stated in the discourse on fuel subsidies, the avoidance of labour agitations and political unpopularity often underline the reluctance of governments to remove fuel subsidies. Many more reasons than outlined in support of subsidies make it more expedient for government to withdraw subsidies. The effectiveness of other social intervention policies relative to fuel subsidies, achieving fuel consumption efficiency, reducing government spending, mitigating the impact of climate change are some arguments in support of subsidy reforms.

A number of studies have proven that other mechanisms of achieving social equity are more effective (Coady et al. 2006; Bacon and Kojima 2006; Beaton and Lontoh 2010; Sumedh 2011). Alternatives that have been identified include cash transfers, coupons, smart cards, vouchers, removal or reduction of fees and charges on social services such as health, education and transport. Beaton and Lontoh (2010) for example observed significant successes with the implementation of cash transfer scheme in Indonesia in 2005.

In Ghana, the removal of subsidies has a potential to drive transfers aimed at improving the Community Health Improvement Services (CHIPS) and other healthcare services for the poor, „Capitation Grants and elimination of fees for government basic and secondary schools and mass transport systems. Such programmes have been proven to cover significantly larger proportions of the poor population in developing countries in comparison with fuel subsidies. Evidence from five countries including Ghana has suggested that between 75% and 85% of the total benefits from fuel subsidies accrue to the richest 60% of the population.

Ghanaians queuing to buy fuel
A separate simulation conducted for Ghana indicated that 65% of transfers would benefit the poorest 40% of households compared to a corresponding 40% for kerosene subsidies (IMF 2006; Coady et al. 2006). For such alternative programs to achieve significant success, however, they need to be underpinned by effective planning, organization and monitoring mechanisms and prevent leakage of benefits to non-targeted groups.

Removal of fuel subsidies have also been regarded as a means of attaining consumption efficiency. In cases where tax on products such as gasoline and diesel have been used to cross-subsidise other products like LPG and Kerosene, it has often resulted in inefficient substitution of kerosene to adulterate diesel and gasoline. Empirical studies have also revealed that households become less efficient in using subsidised petroleum products (Coady et al. 2006).

Smuggling of subsidised products to neighbouring countries where prices are relatively higher has tended to defeat the objectives of subsidies. Under extreme circumstances, subsidies have led to acute shortage of petroleum products as a result of the inability of government to reimburse Bulk Distribution Companies (BDCs) as recently witnessed in Ghana in June 2014. Such inefficiencies and buying of subsidised products for unintended purposes can be avoided through the elimination of subsidies. High subsidies divert government spending away from more productive and potentially more beneficial sectors. This has consistently resulted in substantial budget deficits which could have been financed by relatively effective petroleum taxes as demand for petroleum products is inelastic. Subsidies have imposed a major drain on Ghana’s economy as Tema Oil Refinery (TOR) debt reached 7% of GDP in 2002 whiles throughout 2004, 2.2 % of the country’s GDP was spent subsidising fuel in the run-up to the general elections (Laan et al. 2010).

Conclusions from the discussions: It is evident that fuel subsidies exert a huge burden on public expenditure but a greater chunk of the benefits accrue to high income groups, a situation which defeats the essence of subsidisation. Removal of petroleum subsidies would free the needed funds for social equity programmes in health, education and transport albeit proper planning, implementation and monitoring are essential prerequisites. These programmes not only capture large proportions of the poor at lesser costs but also address the inefficiencies associated with subsidisation and cross-subsidisation. An independent price-setting regime should replace fuel subsidies but as Laan et al. (2010) observed, this “can only be as robust as the political will behind it”.

Author: Gyeyir M. Denis 

BA Economics/Entrepreneurship, MA Oil/Gas Management

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