The Political Economy of Reforms

The most important political economy aspect of subsidy reform in the Islamic Republic of Iran is that much of the subsidies are government forgone earnings rather than cash expenditures. The government delivers daily about 4 million equivalent barrels of oil and gas, about three times as much as it currently exports, to domestic consumers, enterprises, and power companies at very low prices.

When oil prices are high the government is flush with revenues and does not feel the need to raise domestic prices of energy in tandem with global prices. When the world price of oil is down, government revenues and household incomes are also down, and that is the worst possible time to raise domestic energy prices. Given such price fluctuations, divergence between local and world prices of energy seems a natural part of the country’s political economy.

Another political economy reason that energy subsidies are endemic in the Islamic Republic of Iran (and in other oil-rich countries) is that although energy subsidies are unevenly distributed, with most of it going to higher-income brackets, removing them hurts the poor more than rich. As shown in Fig. 10.4, as a share of household expenditures subsidies are larger for the poor than the rich. Moreover, the credibility of Iranian governments to remove energy subsidies and promise to spend the proceeds more equitably and efficiently is low, which explains why the large price reforms of 2010 had to include a generous cash transfer program.

The unhappy history of energy price reform since 2010 also complicates the political economy of further energy price reform. Since 2010, for reasons unrelated to subsidy reform—sanctions and mismanagement of the economy—Iranians have experienced four years of stagnation and inflation, making them apprehensive of any new government-initiated price reform. A good part of the inflation in the four years following the reform had little to do with energy and bread price increases, but the Iranian media and public opinion believe otherwise. One contributor to inflation was that cash transfers were too generous and as a result the program was not fully funded. The government filled that gap with borrowing from the Central Bank, which fueled inflation. Another contributor to inflation was the low-cost housing Maskan Mehr program. According to the government, 40% of the monetary base was created to cover the deficit in this program. In addition to social spending, the country suffered sizable supply shock during 2011-13, as international sanctions tightened and disrupted its oil sale and general trade. As Fig. 10.11 shows, monthly rates of inflation decreased a few months after the reform but jumped back up with sanctions and devaluation. The much smaller price hikes in 2014, which were not followed up by other shocks, raised the rate of inflation for a few months before declining.

An important solution to the political economy of reform has been the cash transfer scheme that started in December 2010. Unfortunately, it has come under criticism so that it may not be part of any future reform. There have been claims of negative effects of cash transfers on the incentives of the poor to work. Although

Rates of inflation and macroeconomic shocks from January 2010 to September 2014, 3-month moving averages with annualized rates

Fig. 10.11 Rates of inflation and macroeconomic shocks from January 2010 to September 2014, 3-month moving averages with annualized rates. Sources Central Bank of Iran, various years, and World Bank calculations the evidence does not support such claims, anecdotes of poor agricultural workers abandoning their farms continue to appear in the Iranian media (Salehi-Isfahani and Mostafavi-Dehzooei 2016). The cash transfer program has also been criticized for its unsound targeting because even the richest Iranians receive cash transfers every month. Several attempts have been made to limit cash transfers to poor families only. The 2014-15 budget law required the government to find a way to exclude the richest families from the transfer scheme, but so far the government has avoided the issue because it lacks the necessary mechanism to identify high-income families.

Despite setbacks in public support for the continuation of subsidy reform, the government has strong motivation to raise energy prices and replace lost revenues from oil exports with revenues from the domestic sale of energy. The proposed budget for fiscal 2015/16 projects revenues from oil exports to fall by 24% in real terms, forcing the government to cut real current expenditures by 3.3%. The increased motivation for raising energy prices is, however, tempered by at least two factors. First, the government itself is very apprehensive of rekindling high inflation. Second, its willingness to raise the price of domestic energy is closely related to the outcome of the current nuclear negotiations, which affect the level of oil exports, and the need for more revenues from other sources. Following the July 14, 2015, nuclear accord between Iran and the six world powers, international sanctions against Iran are expected to be gradually lifted, allowing Iran to export more oil. But this may not be enough to close the budget gap if oil prices continue to remain in the low $50 range per barrel. There is considerable uncertainty regarding the future of oil prices, which suggests that budgetary pressures to raise domestic energy prices could continue for the next several years. Furthermore, the pro-market Rouhani government has already demonstrated its willingness to raise energy prices to market levels, so we should expect further adjustments in energy prices in the near future.

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