Consumer Subsidies in the Islamic Republic of Iran: Simulations of Further Reforms

Mohammad H. Mostafavi-Dehzooei and Djavad Salehi-Isfahani

Introduction

The Islamic Republic of Iran is a major producer of oil and gas, and therefore it is not surprising that the country subsidizes energy heavily. In 1995 energy subsidies were estimated at $5 billion or 6% of gross domestic product (GDP) (Salehi-Isfahani 1996), and with rising world prices in the following decades, the subsidies rose several times over to reach more than 15% of GDP (Jensen and Tarr 2003; Salehi-Isfahani 2014). During the oil boom of the 2000s, when the world price of energy trebled, the country’s domestic price failed to keep pace, and subsidies ballooned. Despite several small adjustments in the domestic price of oil and gas since 1995, energy prices in the Islamic Republic of Iran diverged from their opportunity cost.

In January 2010 a bold law was enacted that required the government to raise energy prices to a level equal to 90% of the free on board (FOB) price of energy in the Persian Gulf. The law also stipulated that the revenues from the price increases should be divided into three parts: 50% to compensate households, 20% to compensate firms, and the remaining 30% to be added to government revenues. In December 2010 prices of energy products were increased, by factors ranging from 2 (for bread) to 9 (for diesel), and monthly cash transfers of 455,000 rials (Rls), or about $90 (U.S. dollars) in purchasing power parity (PPP) per capita started reaching about 95% of the population.

Although the reform was successful in raising energy and bread prices several times over and the cash transfer scheme allowed the price shock to go forward without any protest, four years later much of the program’s initial gains have been lost to inflation, and opposition to further sharp price adjustments is strong. In the meantime, the collapse of the price of oil in the world markets has narrowed the gap

M.H. Mostafavi-Dehzooei (H) • D. Salehi-Isfahani Virginia Tech, Blacksburg, USA

© Springer International Publishing AG 2017 259

P. Verme and A. Araar (eds.), The Quest for Subsidy Reforms in the Middle East and North Africa Region, Natural Resource Management and Policy 42,

DOI 10.1007/978-3-319-52926-4_10

between prices in the Islamic Republic of Iran and the outside world, diminishing the urgency of further subsidy reform. President Hassan Rouhani, who took office in August 2013, introduced the second phase of price increases, raising the average price of energy and bread by about 30%. His administration appears determined to follow up with gradual increases in energy prices. This chapter examines the consequences of further price reforms for consumer welfare and the government budget. It presents simulation results that compare the effects of gradual price reform, which is the likely course of action, with a one-time increase that removes all the subsidies, similar to the 2010 reform.

Although energy subsidies are lower than they were in 2010, the logic of removing them is stronger, especially for the government. Lower world oil prices, which have ostensibly reduced the need to raise domestic prices, have at the same time made it more urgent for the government to seek more revenue from its domestic sale of energy, which is more than three times what it exports.

Besides budgetary concerns, energy subsidies raise equity issues because they distribute the national hydrocarbon wealth unequally. This chapter shows that subsidies for energy products accrue mainly to upper-income groups, who use more energy than the poor. Efficiency is another concern. Decades of cheap energy distorted Iranian production to be more dependent on energy and less efficient in its use. As shown in Fig. 10.1, before 1987 the Islamic Republic of Iran consumed less energy for each dollar of production compared to the world and Organisation for Co-operation and Development (OECD) countries. Since then the country has increased its use of energy per dollar of GDP, while the rest of the world has decreased it. In 2009 the Islamic Republic of Iran consumed 50% more energy per unit of GDP than the rest of the world. Moreover, subsidized energy is detrimental to the environment. The country produces more than its share of greenhouse gases,

Fig. 10.1 Energy consumption in the Islamic Republic of Iran, the world, and OECD countries. Source WDI various years, World Bank calculations. Note GDP gross domestic product; OECD Organisation for Economic Co-operation and Development and pollutants have made the air in its major urban centers unbearable. As with snow days in the United States, Tehran’s schoolchildren get days off from school because of pollution, which has become a part of normal life. Finally, low energy prices have also encouraged the use of capital-intensive technologies, which limit demand for labor at a time when youth are entering the labor force in record numbers.

There is a small literature on the Islamic Republic of Iran’s subsidy reform. Several papers describe the reform (Guillaume et al. (2011), Salehi-Isfahani et al. (2013), Salehi-Isfahani (2014)). Salehi-Isfahani and Dehzooei (2015) evaluate the impact of the cash transfer on household labor supply. Gahvari and Karimi (2013) use an Almost Ideal Demand System (AIDS) model to study the reform and find that cash transfers improve welfare, at least for poor deciles. Gahvari and Taheripour (2011) use prereform data and the Quadratic Almost Ideal Demand System (QAIDS) to predict the impacts of a price reform in the country. In their general equilibrium framework, they find that eliminating subsidies for utilities results in substantial welfare losses. Jensen and Tarr (2003) use a computable general equilibrium (CGE) model to simulate the effect of reform of subsidies and find that “even nontargeted direct income payments to all households (not just the poor) would enormously and progressively increase the incomes of the poor.”

The plan of this chapter is as follows. The next section offers a more detailed account of the evolution of subsidies and is followed by a section that explains our sources of data. The next sections derive the distribution of subsidies as they existed in 2013, present the simulations results, and discuss the political economy of subsidy reform.