Harvard Professor Jeffrey Frankel: The Subsidy Trap

 Few policies place good economics so directly at odds with good politics as subsidies for food and energy. The issue of unaffordable subsidies is now front and center for three of the world’s most important new leaders: Egyptian President Abdel Fattah el-Sisi, Indonesian President-elect Joko “Jokowi” Widodo, and Indian Prime Minister Narendra Modi.

Sisi is confronting the need to cut subsidies better than might have been expected. Modi, by contrast, is doing worse than expected – even torpedoing a long-anticipated Word Trade Organization agreement. With Jokowi, it is too soon to tell.

In July, Sisi accomplished what few leaders in North Africa or the Middle East have: he sharply cut longstanding fuel subsidies and allowed prices to rise by 41-78%. Surprisingly,  few protests materialized.

Egypt’s food subsidy program, which costs more than $5 billion a year, is in urgent need of reform as well. The price of bread has been kept so low that it is often fed to animals. Past attempts to reduce such subsidies in North African countries have brought unrest and even toppled governments. But the Sisi government appears to be making progress here as well. Bread subsidies have already been cut by 13%.

Sisi had little choice. Even with subsidy cuts, the current government is targeting a budget deficit of 10% of GDP in the coming fiscal year (compared to 14% otherwise). Still, few expected Sisi, who took office in a fragile political environment, to move faster than Modi, who was elected with a whopping democratic majority amid hopes for sweeping economic reform.

In Indonesia, when Jokowi takes office in October, he will inherit a long history of fuel subsidies that, at $21 billion a year (up to 20% of government spending), the country can no longer afford. Outgoing President Susilo Bambang Yudhoyono took a first courageous step byraising fuel prices a year ago. Jokowi’s advisers favor cutting the remaining subsidies, and he has already forthrightly said that he plans to do so gradually, over a four-year period.

Economists feel confident in opposing commodity subsidies because agricultural and energy markets tend to approach the ideal of perfect competition, with a large number of consumers on the demand side and producers on the supply side. Where competition is imperfect, government, not large private monopolies, is usually the reason.

Critics of the invisible hand point out that, left to themselves, private markets can fail in a number of ways. For example, income inequality and environmental externalities are two of the most prominent justifications for government intervention.

What is striking about food and fossil-fuel subsidies is that they are often promoted in the name of the environment or equity, but usually do little to achieve these goals, and often have the opposite effect. Less than 20% of Egyptian food subsidies benefit poor people. Gasoline subsidies in most countries benefit the middle class, while the poor walk or take public transportation. In India,  less than 0.1% of rural subsidies for Liquefied Petroleum Gas go to the poorest quintile, while 52.6% go to the wealthiest. Worldwide,  far less than 20% of fossil-fuel subsidies benefit the poorest 20% of the population.

Food and energy subsidies can also distort public policy, as Modi’s government, seeking to protect India’s agricultural subsidies, has shown. Indeed, its veto of a WTO compromise has derailed the most important progress in multilateral trade negotiations of the last ten years.

Agricultural subsidies sometimes seek to benefit consumers at the expense of producers, especially in poor countries, and sometimes seek to benefit producers at the expense of consumers, especially in rich countries. India’s policies try to do both. As a result, India has accomplished the extraordinary feat of rationing grain to consumers at artificially low prices, while simultaneously suffering excess supply, because farmers are paid high prices. (Farmers are also subsidized via agricultural inputs – electricity, water, and fertilizer – to the detriment of the environment.) The government has purchased huge stockpiles of rotting rice and wheat, while the limited amount available to consumers is allocated in ways that are corrupt and inconsistent with the stated goal of helping the poor.

The government would like to keep its subsidies and stockpiles. But it knows that this would violate WTO rules. Unable to obtain a permanent change in these rules, Modi vetoed the WTO’s eagerly anticipated Trade Facilitation Agreement.

Once subsidies are in place, they are extraordinarily difficult to remove. When world commodity prices rise, as they often have over the last decade, citizens who are accustomed to the domestic price being set in the market are more likely to accept the reality that officials cannot insulate them from the shock. But people who are accustomed to administratively established food and energy prices hold the government responsible.

That is a strong reason not to adopt such subsidies in the first place. But it does not necessarily mean that, once subsidies are in place, keeping them is a savvy politician’s best option. If the alternative to raising the price is shortages or rationing, angry protesters may mobilize anyway. Similarly, the procrastinating leader is unlikely to benefit if ever-widening gaps force an even bigger retail-price rise when the day of reckoning comes.

Ideally, other, more efficient means of supporting incomes at the bottom will be instituted at the same time that food and energy subsidies are cut. Developing countries have learned a lot about efficient transfer mechanisms, from policy innovations, such as the conditional cash transfers of Mexico’s Progresa-Oportunidades program or Brazil’s Bolsa Família, and from technological innovations such as India’s Unique Identification system. But in countries where the adjustment does not come until a budget crisis forces it, there may be no money for transfers to cushion the pain.

The savvy politician should probably announce the unpleasant adjustment as soon as he takes office. Jokowi and Sisi seem to have adopted this approach. Modi, despite his huge electoral mandate and hype about market reforms, has fallen short.