Iran: The Subsidies Dilemma

Since the 1979 revolution the removal of government subsidies has proved expensive. Subsidies have strained government funds and fostered inefficient energy use, leaving the current administration in a quandary, as to how to approach a fair and efficient subsidy reform plan.

By-Jahangir Amuzegar*

The Islamic Republic’s five-year-old subsidy program, designed to compensate consumers for increased prices of energy and public utilities, has now become a fiscal albatross around the government’s neck: it cannot be continued as it is; and it cannot be terminated outright. It symbolizes the Persian adage: “a fool may throw a rock into a well where a hundred wise men won’t be able to retrieve it.”

The misconceived, misconstrued, and mismanaged scheme, launched in late 2010 during the administration of former president Mahmoud Ahmadinejad has so far cost more than $60bn with huge losses for the treasury, and questionable tangible benefits to the recipients. The program’s cost so far has been equal to nine years of the annual economic development budget.

THE BACKGROUND

From the post-1979 revolution period until 2010, the Islamic Republic, proud of being a welfare state, has provided its citizens with various goods and services (food, fuel, power and water) at highly subsidized prices – often below costs. According to an International Monetary Fund (IMF) report in May 2015, the Islamic Republic is paying the highest energy subsidies in the Middle East – North Africa region – estimated to be equal to 5% of its gross domestic product. Along with Venezuela, Iran has the lowest energy prices in the world – and eight times higher energy consumption per capita than in European countries.

This generosity has produced two thorny problems: one of efficiency, and another of equity. Dirt cheap prices of some subsidized items gave rise to profligate waste – with people feeding their animals with cheap bread, rural people using natural gas to heat up their shacks with windows open, and industries replacing labor with cheap energy, using natural gas. Equity problem rose as the well-to-do, with larger houses and bigger cars, had more use of subsidized items, and enjoyed disproportionately larger shares of the subsidies.

Misunderstanding and misinterpreting Western economists’ dictum that public subsidies are more efficient if paid in cash rather than through price discounts, the Ahmadinejad government decided in December 2010 to raise prices of government supplied energy and utilities, and compensate the users with monthly cash pay.

The “Subsidies Targeting” bill submitted to the Iranian parliament (Majlis) in early 2010 proposed to raise prices of energy and utilities gradually to their world level in five years. Increased revenues from higher prices were to be shared by the needy consumers, energy-intensive industries, and the treasury. While the bill passed by the Majlis authorized the government to raise prices of subsidized items to their international levels gradually in five years, the government ignored the mandate and increased prices of gasoline, gasoil, natural gas, electricity and water by four to eight times.

MENA FUEL SUBSIDIES*: DOWN BUT FAR FROM OUT (% OF GDP)

*PRE-TAX. SOURCE: IMF OCT 2014 REGIONAL ECONOMIC OUTLOOK (REO), 5 MAY 2015 REO UPDATE.

THE FIRST PHASE

The program’s “first phase” of operation (2010-13) proved highly disappointing, due to its basic structural flaws. Underestimating the size of potential monthly cash recipients, and overestimating the magnitude of revenues from higher energy and utilities prices, the government faced a fiscal deficit almost from the beginning.

In the first three years of the subsidies program some IR14 trillion deficit of the monthly cash programs was financed by borrowing from the Central Bank of Iran (CBI) and using the treasury’s borrowing account – giving rise to enhanced liquidity and higher inflation.

Monthly cash payments that were supposed to absorb only 50% of the revenues from higher energy prices ended gobbling up 200% – with the shortfalls covered by borrowing. The shares of the industry and the treasury were totally neglected. Furthermore, while higher energy costs had to pay by energy intensive industries, they were not allowed to raise their prices. By failing to give the industrial enterprises their shares of revenues as prescribed by law, the government caused drastic fall in industrial output – leading to the worst recession in Iran’s post-revolution history.

THE SECOND PHASE

The program’s continued fiscal deficit and its growing burden on the treasury, along with reports about misuse of the scheme, and a rising chorus of criticism regarding the inequity and inefficiency of the uniform and universal cash payments to all, called for urgent reform.

All eyes were on the newly-elected President Hassan Rohani in June 2013, and his group of economic advisors to come up with a plan to salvage the deficit-ridden program, and create a sustainable basis for a solution. Yet, for the first nine months of the new administration, nothing was changed and the program continued as before.

Pressured by various forces, the Rohani team finally came up with a new plan. The subsidies “second phase” promised to start from the third month of Iran’s New Year (May 2014). Monthly cash payments were now to be given to the head of each family after (1) he or she answered a questionnaire regarding family income and wealth, and (2) eligibility for aid was confirmed after the questionnaire’s review by the authorities. Applications were distributed in mid-April 2014.

Public response to the government’s initiative was highly disappointing. While it was widely expected that some 7 or 8 million well-to-do families out of an estimated 76 million would respond to the government plea, no more than 2.4 million individuals (or only 3% of the total population) volunteered to forego the monthly subsidy. Altogether, some 73 million inhabitants continued to demand the bounty. Matched against other available data, it was also evident that the respondents were not always truthful in their applications.

Failing to find enough wealthy volunteer families to forego monthly cash receipts, the government was back to square one to find and eliminate well-to-do recipients. Yet, while it was generally expected that the government’s 2014-15 budget would delineate a new second phase of the subsidy program, the draft submitted to the Majlis lacked any new proposals or guidance, and left the decision to the assembly – the first sign that the “wise men” had no clue as to how to approach the subject.

The Majlis, in its part, reversing its unwise 2010 decision that no one should be left out of monthly cash payments, ordered the government to eliminate the top 30% of income earners from the bounty. Accordingly, every household receiving a monthly check was asked to fill out a form stating their income and assets. Payments of cash subsidies in the New Year (20 March 2014- 20 March 2015) were thus contingent upon the completion of the application form and income eligibility. False information on the forms would result in imposition of three times the subsidies received as a penalty.

But the task once again proved to be as difficult as ever. In the first month of the new Iranian year, 2015-16, the fiftieth tranche of the monthly cash subsidies was routinely paid out without mention of any changes. Private newspaper investigators, however, claimed that payments to some five major groups – recipients living abroad, owners of luxury automobiles, foreign-exchange dealers, board members of banks and private corporations, and high-income physicians – had been quietly eliminated.

A strong immediate denial of the reported cuts by the government spokesman showed how apprehensive the authorities were of a public backlash. While the government spokesman finally acknowledged that monthly cash payments to some 250,000 recipients had been stopped in the last two months of the 2014-15 Iranian year, the authorities still did not announce or mention the base criteria for such suspension.

In passing the 2015-16 budget, the Majlis, facing falling oil prices and other rising expenditures, finally cut the administration’s subsidy appropriation by IR30 trillion (from proposed IR420 trillion to IR390 trillion) requiring the government to eliminate 6 million wealthy recipients from the monthly dole.

Four criteria for the elimination were suggested: number of individuals in the family; city of residence, ownership of property, and the type of automobile owned. Excluded recipients had a chance to protest the government’s decision and ask for a review within a month. The government was also given three months to come up with concrete indicators for cutting the number of recipients.

THE THIRD PHASE

The third phase began on 25 May 2015 when the government ended gasoline rations and sales at different preferential prices. The price of a liter of gas was raised to IR10,000/liter – or 10 times that in 2010. Prices of natural gas and gasoil were raised 15%. As part of its inflation-fighting policy, the Rohani government also allowed only a relatively modest 30% price increase in some other subsidized items for the 2015 year, although the Majlis had authorized bigger increases.

Due to the government’s obvious reluctance to further raise energy prices, the receipts from already raised prices in the current Persian fiscal year (March 2015- March 2016), are expected once again to fall short of cash payments, even though the statutory shares of the health sector, the industrial enterprises, and jobs creation will still be neglected as in the past. The only way out has been to drastically cut the number of monthly cash recipients. Yet, it has been fairly evident that neither the administration nor the Majlis wished to take the responsibility for initiating the unpopular move. Each party wanted the other to be identified with the action.

Sizable declines in annual receipt from oil exports – from $118bn in 2011 to an estimated $24bn in 2015 – due to drastic declines in oil export volumes (from 2.5mn b/d to 1mn b/d) and oil prices falling (from $108/B to less than $40/B) – having cost Iran an estimated $100bn – finally forced the Majlis to take further action, and to cut the current fiscal year’s appropriation for cash subsidies from the government’s proposed IR420,000bn to IR390,000bn. As a result of IR30,000bn cut in the subsidies, some 6 million of the current monthly cash recipients had to be reduced. In addition to reducing the subsidies budget, the assembly gave the government three months to come up with a blueprint for recognizing and eliminating the well-to-do for monthly cash payments elimination. True to form, the Council of Ministers on 5 June, asked the Ministry of Cooperatives, Labor and Social Welfare to come up with the needed formula, but without giving the ministry any clue to identify and find the candidates for elimination.

Despite the end of the deadline set by the Majlis for the government to come up with the list of indicators identifying the “wealthy”, and despite Ali Rabii’s (Minister of Cooperatives, Labor and Social Welfare) repeated promises to announce them in a week or two, nothing was said by the government for another two months.

Then after another delay, Mr Rabii’s deputy on 12 August announced “possession of luxury vehicles, ownership of real estate properties, high paying occupation, and other signs of wealth” will be counted as the reasons for exclusion – again without mentioning the concrete monetary figures. In the meantime, and in the absence of formal government announcements, newspapers have been regularly reporting the number of people being excluded from the bounty – all the way from 50,000 to a million, without official confirmation or denial. There has only been official acknowledgment that the monthly payment to 17,000 eliminated recipients has been restored after investigation.

This admission must indicate that the initial elimination has indeed been considerable. On 2 August, Mr Rabii alluded to the expected elimination of two million recipients, and later hinted that in the August monthly payments, this was done – but again without specifying the criteria, the exact indicators, and the specific procedure by which the elimination was accomplished.

PAST AS THE FUTURE

According to the original subsidies legislation, on this fifth year of the program, gas prices were up to 90% of the Persian Gulf levels. But even with the latest hike in the third phase, gasoline prices are still half of the ones in the Persian Gulf. And, even with the upward price adjustments, the Islamic Republic remains one of the most subsidized countries – with the world’s average price of natural gas estimated to be 12.5 times higher than Iran’s, and that of electricity seven times. The country’s energy intensity is still four times the world average.

A close look at the outcome of the subsidies targeting law which was to remedy the situation, however, shows that the new scheme has been no different from the one it was supposed to replace.

First, the fundamental purpose of changing the existing, across-the-board, benefits to the rich and poor alike, to a targeting system of rewarding only the poor has been totally neglected, as the monthly cash payments have included the entire population. Second, domestic energy and utility prices have not been adjusted yet to world levels. Third, revenues from higher domestic energy and utilities rates have not only failed to pay the statutory shares of the energy intensive industries and that of the treasury, but have also fallen short of financing the consumers’ share – with mounting deficits that had to be covered by borrowing from the treasury and the CBI. Finally, instead of the program being successfully completed by the fifth year, there is no end in sight.

Various reports on the content of the present program have also been mostly negative. A study by the IMF in mid-2014 showed that the program was only “partially successful” as 40% of the population got about 38% of the subsidies, and that the huge sums devoted to subsidies was larger than the budget for health, education, and capital spending combined. According to a newspaper report, while a major objective of the program was to reduce energy consumption, not only was this objective unrealized, but the consumption of some such as gasoline and gas oil have actually increased.

Other reports showed that the total number of monthly cash recipients exceeded the country’s total population by 500, 000, as “dead people” were also receiving over IR 9 trillion. A report by the Ministry of Finance and Economy in mid-2014 claimed that during the first phase of the program, purchasing power of families had fallen by 5%, resulting in 31% of people under the poverty line.

Finally, a report by the Majlis Research Center in mid-2014 claims that equal monthly cash payments to all families did not reduce income disparities among various social strata, and actually helped higher categories more.

Lamenting these shortcomings, the Minister of Economic Affairs and Finance Ali Tayyebnia, has called the day of monthly payment one of “great calamity” for the government. And the Oil Minister Bijan Zanganeh has labeled the scheme a “vivid torture.”

AN ENDLESS TUNNEL

With the Rohani government beginning its third year in office, and despite much popular expectations and some vague official promises, no new subsidy program has been announced, and there are no indications that any such is on the cards. The government spokesman in fact announced that the program would continue this year and next. It seems that the new administration is satisfied with following the current, and much criticized scheme – with only some reduction in the number of wealthy recipients.

According to newspaper reports, the authorities are currently engaged in the immediate suspension of 2 million and ultimately 6 million recipients – as this year’s budget legislation requires. However, even if the 2 million claimants so far said to be excluded are permanently left out, and no potential protesters restored, the program would still be in deficit this year and beyond – unless and until the whole 6 million are permanently cut.

And, in the highly unlikely case of the government succeeds in dropping 6 million current recipients from the dole, the subsidies albatross would still hang on the government’s neck. It would still be facing, some 10 to 12 million people in need of aid (currently supported by various charity organizations), but on the whole 70 million or so citizens expecting to be paid more than a $1bn every month.

The program’s inability to pay this sum out of the program’s own revenues (ie higher energy and utility prices) would thus require tapping funds from other public revenues – most readily the oil export receipts. In this process, the government would be engaged in using an exhaustible resource – whose proceeds should be used to finish some 10,000 or more already unfinished development projects – to pay for needless mass consumption. Mr Rohani’s “wise men” know all this, but the rock still stays at the bottom of the well.