Iran’s Subsidy Reform: RIP

Published on Monday, 17 Dec 07:00 am

By Jahangir Amuzegar*

On 13 November 2012 the Islamic Republic’s Majlis (national assembly) voted to “suspend” the second phase of the Targeted Subsidies Reform Act of January 2010 – thereby halting further price increases in public utilities (food, fuel, water, electricity) and further rises in monthly welfare cash payments to households during the current Persian year (March 2012-March 2013). Thus a program that had been announced with the greatest fanfare in December 2010 as the center-piece of President Mahmoud Ahmadinejad’s “Great Economic Surgery” (MEES, 24 November 2008) came to an inglorious end with hardly a whisper.

Furthermore, alarmed by the widespread rumors that the government intended to raise cash subsidies by manipulating exchange rates, the Majlis passed further restraining legislation. According to a new law coming into effect on 7 December 2012, “all money received from the sales of oil and gas proceeds at new higher exchange rates is part of the government’s general revenue, and no part of it could be used to raise monthly cash payments.”

The Program: From Birth to Suspension
Since coming to power in 1979, Iran’s Islamic government has been subsidizing the production, consumption, distribution and export of various goods and services. By the end of the first decade of the 21st century, these public subsidies – both explicit (budgeted) and implicit (ie foregone opportunity values) – had reached 25% of the gross domestic product. While some of these subsidies (such as food and medicine) played a useful role in raising child nutrition and reducing infant mortality, as a whole they resulted in wasted resources, profligate consumption, air and water pollution, environmental decay and the continued use of outmoded technologies.
The urgent need for subsidy reforms was thus a matter of national consensus, because the status quo was intolerably costly, wasteful, unfair, counter-productive and altogether unsustainable. Iran’s national energy consumption was doubling every 10 years, or four times as fast as the world average. With only about 1% of the world’s population, Iran was consuming some 3% of global fossil fuels, with per capita energy consumption 1.6 times the world average. Iran’s energy intensity was eight times that of East Asian countries and six times that of Europe. The system was also highly regressive, since the benefits enjoyed by the top 10% of the population were 15 times those received by the bottom 10%. A good portion of the subsidized items was smuggled to neighboring countries in search of higher prices.

Finding the situation fiscally unbearable, President Ahmadinejad in late September 2008 submitted an omnibus bill to the Majlis adjusting the prices of domestic energy, public utilities and eventually other subsidized items. The bill’s objectives were: to rationalize consumption, reduce energy waste, ensure a fairer income distribution, improve industrial technology and reduce smuggling. The bill that was submitted to the Majlis with “urgency” was finally passed after 18 months on 5 January 2010 by a slim majority.  The 2010 statute authorized the government to gradually raise prices of subsidized items to their world levels within five years. One half of the revenues received from upward price adjustments had to be given to a targeted consuming public as compensation for higher prices. Some 30% of new revenues had to go to energy-intensive industries as an incentive to acquire new technologies and/or cover the higher costs of their (no longer subsidized) inputs. And the final 20% was the treasury’s share to cover the administrative costs of the program.

Despite the act’s acknowledged potential benefits, the precarious status of the Iranian economy at the time and clear flaws in the law itself led many concerned observers to call on President Ahmadinejad to postpone or revise the plan’s implementation. Rejecting these pessimistic predictions, however, the president on 15 October 2010 announced the start of the subsidy reform. The program thus began by depositing some IR810,000 ($80) in the bank accounts of all registered individuals as a cushion against pending price increases.  Shortly after, President Ahmadinejad announced in an impromptu late-night television address on 18 December 2010 the start of the program as of the approaching midnight. Disregarding the legislature’s recommendation of a gradual five-year approach, the government’s decision involved: (a) drastic price increases for energy, water, power and bread to go into effect immediately; and (b) the gift of IR455, 000 a month to every registered applicant as compensation to offset higher prices. The original plan that envisaged cash grants to individual consumers on the basis of need was found impractical, and everyone in a family was given the same amount of cash (MEES, 20 June 2011).

Unhappy about the government’s undue haste in raising prices much faster than provided for in the law, dissatisfied with uniform monthly cash payments even to the top 20% of income earners and noting emerging problems in implementing the reform, the eighth Majlis, in the course of approving the March 2011–March 2012 fiscal budget, made a number of specific changes in the initial subsidies reform act. First, the president’s request for $62bn revenue from new price rises during the year was reduced to $54bn. Second, the government was allowed to increase prices by no more than 20% during the course of the year. Third, the consumers’ share was increased to 80% of total receipts from the previous 50% in order to maintain monthly cash payments. The share of production units was reduced to 20% and the 20% share of the Treasury was totally eliminated. The budget document projected some $54bn (at the prevailing dollar/rial rate) to be received from adjusted prices during the year, out of which some $40bn was earmarked as welfare payments; $4bn was appropriated as aid to state power companies; $6bn had to go to urban transport means; and the rest had to be used for administrative expenses. (MEES, 30 January)

The Second Phase
Claiming that 70% of subsidies still remained to be “reformed,” President Ahmadinejad told the press corps in early January 2012 that the second phase of the program would start before the end of the Iranian year on 20 March 2012.  There were other signs that the government intended to launch the second phase with even greater vigor. The Price Monitoring Board intensified its surveillance of the market, and some $24bn was set aside by the government to be used for stockpiling essential goods during the year. In the first week of Iran’s new year (late March 2012), a sum of IR280,000 was also deposited in the bank accounts of some families for each of its individual members—reminiscent of the same gesture before the first phase. Responding to widespread complaints by the Iran Chamber of Commerce regarding the neglect of the production sector, government officials promised to remedy the situation through direct financial assistance, low-cost loans and price rise allowances.

For unknown reasons, however, the day-to-day administration of the program turned out to be chaotic and confused. In late December 2011 the head of the Subsidies Reform Organization announced that some 10mn well-to-do individuals in the top 20% of the population – those with monthly incomes 10-20 times the current monthly cash receipts (ie individuals earning $445-890 a month) – would be excluded from monthly welfare handouts. Wealthy families would first be asked to forego these payments voluntarily, and if they did not, “more precise methods” would be employed. When the Majlis deputies found the exclusion to be against the subsidy law’s provisions, the “wealthy” households were asked through emails to voluntarily opt out. Receiving no favorable response, the matter was then quietly dropped. There was no explanation as to the purpose of IR280,000 deposits, the criteria for selection of the recipient families or the duration of the program. And, once again with no explanation, it was announced that the IR280,000 deposits should be considered as compensation for new higher bread prices.

In the meantime, President Ahmadinejad, still convinced of the superiority of the “shock therapy” and intent on finishing the subsidy reform program during the last year of his administration, asked the ninth Majlis to let him raise some IR1,350 trillion  ($135bn at the prevailing exchange rate) through higher prices of food, fuel, and public utilities. Such an authorization would have meant raising prices of those items again by more than three to four times.  Majlis deputies, already unhappy with the highly inflationary outcome of the first phase and the government’s numerous violations of the original statute, cut the president’s request by half. The approved subsidy reform budget for the current fiscal year (March 2012-March 2013) was reduced to IR66,000 trillion – of which IR56,000 trillion was to be obtained from higher energy prices, and IR10,000 trillion from higher prices for bread and  electricity. Of the IR66,000 trillion receipts, some IR48,000 trillion would go for monthly cash payments, IR10,000 trillion for grants to industrial enterprises, IR6,000 trillion for health and IR2,000 trillion for unemployment insurance.

The president found the approved budget insufficient and continuation of the program “impossible.” According to the subsidy reform spokesman, energy and other subsidized prices under the approved budget were to be raised by about as much as in the first phase – with the cost burden on consumers being the same – while the appropriated IR48,000 trillion would have allowed an increase in the monthly welfare checks by no more than IR80,000, compared to IR455,000 compensation in the first phase. This was unacceptable to the administration, and the president himself declared that “every time I want to put money in the people’s pockets, my enemies would block it.” There were no further talks about the second phase.

The November 2012 move by the ninth Majlis to “suspend” the second phase was thus an empty and inconsequential gesture. Eight months into the current fiscal year, the government had not moved to implement the program and had shown no intention of doing so. In fact, once the Majlis drastically cut the government’s budget request, President Ahmadinejad decided to put a halt to the program altogether (except for the monthly cash handouts). As the tug-of-war between the Majlis and the government continued, the case was referred to a special Arbitration Board (already set up by the Supreme Leader to resolve disputes between the two branches of the government) for settlement.  With no clear verdict from the board, the case was finally overtaken by emerging events—ie, the collapse of the Iranian rial, rapidly escalating food and housing inflation and tightening economic sanctions.

While the Majlis deputies tended to justify their decision to ”suspend” the second phase as a response to the government’s clear violations of the original statute and the resulting inflationary pressures, their true reason might have been more subtle and complex. The overtly cited breaches of the law pointed to: (1) the haste in implementing the reform in two instead of five years; (2) the miscalculation of the amount of monthly cash handouts available for distribution (ie IR455,000 instead of only IR260,000), resulting in a deficit; (3) payments of equal amounts to all recipients regardless of needs; (4) non-payment of the producers’ share as prescribed by the law, resulting in unemployment and bankruptcies; (5) spending more money than the receipts from higher price adjustments, resulting in debt to the Central Bank of Iran (CBI); (6) non-payment of the shares of the oil and energy ministries; (7) the use of unauthorized budget sources to pay for monthly welfare checks; and (8) a number of other procedural violations.  Yet the real reason for the haste in suspending the program might have been a genuine fear on the part of the Majlis members that President Ahmadinejad might try to collect the entire IR 66 trillion allowed by the law in the remaining four months of the current fiscal year through drastically higher energy and other prices—thus triggering a social upheaval.

The Report Card
A balanced assessment of the subsidy reform program is virtually impossible due to: (1) the absence of a comprehensive official report regarding the program’s operations, its sources and use of funds and its achievements and failings; (2) a dearth of reliable independent data on the actual consumption and use of subsidized items before and after the reform; and (3) most significantly, the coincidence of the program with escalating international sanctions on Iran’s frail economy and a steep decline in the rial’s value, making  cause and effect on major economic indicators difficult if not impossible to determine. Complicating the assessment process further are the irreconcilable differences between highly positive claims by reform officials and equally strong denials by the program’s critics.

With these caveats in mind, a quick look at the available information leads to some provisional observations.  To begin with, it is interesting to note that the only piece of information regarding the program’s financial status is a televised statement by the Reform Organization’s official spokesman on 9 October 2012. Accordingly, from December 2010 to October 2012, the reform program spent a total of IR71,200 trillion, of which IR45,500 trillion was received from higher price adjustments, IR18,000 trillion from regular budgetary appropriations and the rest from a provisional loan from the CBI.

Information regarding the program’s operation and achievements is also provided by an article written by the finance minister in April 2012 in which he unequivocally claims that:

  • The three principal objectives of the law—an improvement in consumption patterns, more equitable income distribution and the reduction of smuggling—have all been achieved. That is, despite a rising population, larger annual GDP and increased exports, the growth rates of gas, electricity, bread and water consumption were all stopped or became negative—resulting in savings of $15bn.
  • The national consumption pattern shows that some 80% of the population had their welfare improved.
  • Due to the reduced difference between domestic and foreign prices, flour and gasoline smuggling out of the country has nearly stopped. At the same time, contrary to dire predictions, the rise in the consumer price index resulting from higher price adjustments has been less than 10%

While no independently verifiable data in support of these statements were offered by the minister, it would not be implausible to assume that (1) there has been some reduction in waste and profligate consumption of bread, water, electricity and natural gas in response to higher prices; (2) the income status of perhaps the lowest two or three deciles of the population might have somewhat improved through monthly cash payments; and (3) smuggling  of some previously low-price items might have stopped.  But this is far from being the whole story. A glaringly disappointing aspect of the reform exercise has been the nearly total absence of improvement in energy-saving industrial technology— the single most sought after goal of “the great economic surgery.” In fact, anecdotal evidence shows that higher energy prices, instead of inducing industrial enterprises to renovate, have resulted in bankruptcies and factory closures.

There have been lapses in other aspects of the claimed success. Recently published records, for example, show that between December 2010 and April 2012, higher prices of just 14 consumer items alone absorbed some IR1,620,000 of the IR1,820,000 received in monthly checks by a four-member family, leaving only IR200,000 for tens of other urgent needs. Other reports indicate that the smuggling of gasoil, which had never stopped altogether, has increased again due to new price differences caused by the devalued rial.  Gasoline consumption has also reportedly reverted to the old ways.  And despite repeated official denials, Central Bank data show that producer prices to have been on the rise since December 2010 and are visibly traceable to the consequences of subsidy reform.

Offsetting the scant benefits of the program to the Iranian economy are three thorny problems which the initiative now poses for the government.  First, since the scheme is admittedly not self-financing, continued monthly cash payments to nearly the entire population impose a considerable financial burden on the already deficit-ridden fiscal budget. Second, since monthly welfare checks rely on borrowings from the Central Bank, they stoke the already troublesome inflationary fire. The third, and by far the most formidable task, is how to wrap up the program.  Current regular monthly compensation checks are now regarded as a permanent “entitlement” whose cancellation or even reduction poses a frightening challenge to the government.

What Next?
The Majlis’ November 2012 act only “suspends” the program’s second phase and presumably does not terminate the reform initiative.  In fact, the head of the Subsidies Reform Headquarters has told the press that the government will shortly propose the resumption of the new phase in the context of the forthcoming (2012-2013) fiscal budget, and hopes to reach a satisfactory compromise with the legislature. Yet under the current circumstances, the Subsidies Targeting scheme-- in its January 2010 form – is to all intents and purposes dead. Given the current official inflation rate of nearly 25% (caused mainly by excess domestic liquidity as well as international sanctions), the banking system’s latest record of non-performing loans and the growing current budget deficit, no prudent legislature would dare allow further drastic increases in the price of basic consumer staples. And given the rial’s dramatic devaluation (MEES, 6 August, 2012), the original statute would be nearly impossible to carry out.  Under this act, the prices of gasoline and other subsidized items were to be gradually raised to international levels (ie no less than 90% of their fob prices on the Persian Gulf). With the dollar/rial rate at the time of the legislation hovering around $1=IR10,000, the five-year price adjustments required a four to five times increase in the price of most items. Now, with the exchange rate nearing $1=IR30,000, compliance with the act’s original provisions would require a further threefold increase, which would be well-nigh prohibitive. Any new subsidies reform initiative would therefore have to start from scratch.

*Dr Amuzegar is a distinguished economist and former member of the IMF Executive Board.

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