Subsidies Encourage Waste

April 17, 2014

Xavier Devictor Rzeczpospolita

The recent discussions about reforms in Ukraine have highlighted the detrimental impact energy subsidies can have from a social, fiscal, environmental, and governance perspective.

Poland has had its own experience with artificially set prices, which do not reflect any economic reality, and with widespread subsidies which end up fueling corruption.  Poles know firsthand about the deleterious effect of such policies.  Yet, in a number of countries, from Eastern Europe to the Middle East, from Latin America to East Asia, they remain in force.

In many instances, energy subsidies are probably well intentioned – it is about making it possible for the poorest to afford the gas or the fuel they need for their daily lives.  On the face of it, removing such subsidies may appear as unfair and heartless, a move that would further aggravate the situation of those who are already struggling.

Yet, this is one of those situations where well-intentioned policies can have a very negative impact.

Indeed, in many instances, energy subsidies do not mainly benefit the poor, not even the lower middle class.  Time and again, detailed analysis of “who gets what” reveals that the well-off are those who gain the most: since they tend to have larger homes to heat and more powerful cars, they use more energy...  What was designed as a scheme to protect the poor ends up being a transfer of public resources to the wealthier part of society.

Furthermore, subsidies encourage waste.  Subsidized energy is relatively cheap, and hence wasting it is cheap.  Countries with large energy subsidies tend to have a poor track record on conservation and energy efficiency.  And the numbers are huge.  For example, the energy wasted in the countries of the former socialist block (that is, the amounts that could be saved if energy systems were as efficient as in OECD) is equal to… the entire consumption of Latin America.  Less subsidies, and hence higher prices, would no doubt encourage a more efficient use.

Energy subsidies also often drain public resources.  Instead of investing in the future – of building schools, improving infrastructure, or modernizing hospitals – countries spend to fuel their immediate consumption.  Subsidies also reduce the resources available for other social expenditures (including those which would have really benefited the poorest).  Considering that in many countries energy subsidies still amount to 5 to 10 percent of GDP, they often account for a large share of the fiscal deficit, and are a primary cause of public indebtedness.    

And finally, subsidies foster corruption.  If energy prices differ across the economy (for example, if households consumption is subsidized while industries are not), profiteers will take advantage of the opportunity to buy in one market and resell on the other (or to smuggle across the border)… and they will pocket the subsidy.  Considering the amounts at stake, this can become an avenue for rapid enrichment by a few profiteers at the expense of society: typically several percent of GDP end up in such pockets, year after year !

The solution – as the Poles know well for having done it in the early 1990s – is to get the prices right.  That is, to remove the subsidies and sell energy at market prices.

So, why do so many countries not do it ?  Simply put, because they are afraid of the short-term political costs, as citizens will see their energy bills increase dramatically.  Experience across the world, from Central Europe to Latin America and the Middle East, provides important lessons for countries like Ukraine which are considering an in-depth reform.  In particular, it suggests that this political risk can be reduced through a combination of communication and compensation.

Communicate –explain to the people the reasons for change, the fact that what was designed as a genuine way to help the poorest actually helps the well-off, or even worse the corrupters, and show how the resources saved from the removal of subsidies will be redeployed. 

Compensate – and ensure that the poorest do not end up being worst off without the subsidies.  Where a social protection system is in place, this is relatively easy to do: the Government can increase social assistance payments by the amount corresponding to the forfeited subsidies.  Even if the poorest are integrally compensated, the savings for the Government will be very large, since the subsidies benefit mainly the well-off and are in part diverted into corrupt schemes.

There are of course voices calling for caution, and for taking time to implement such difficult reforms.  And indeed, haste can be counterproductive.  But caution can also easily become an excuse for procrastination, especially for those who would lose the most from a well-handled removal of subsidies: not the poorest, but the rapidly-enriched profiteers.  In fact, when a country is on the verge of economic collapse, there may not be any option but to act.

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