An Analysis of Consumption Subsidies


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Executive Summary

·   The Government of Jordan introduced a new system where substantial reforms to eliminate or reduce traditional subsidies (wheat, barley, gas, gasoline, water and electricity) were introduced in addition to providing tax breaks and exemptions to a large number of intermediate and consumption products

·   The costs and benefits of the new system are quite unclear leading to further studies on the current system and the identification of alternatives for reform

Key Findings

·   Various options for subsidy removal are reviewed and their effects on household welfare are highlighted

o   Consumption cash subsidies

o   Tax subsidies

o   Improved Targeting of Cash Transfers (National Aid Fund)

o   Effects in other Sectors of the economy

·   Five key options for policy choices and reform of consumption subsidies in Jordan are highlighted

o   100% cut in food subsidy

o   100% cut in gas cylinders subsidy

o   100% cut in water subsidy

o   100% cut in all subsidies – considered the most drastic of the reforms

o   100% cut in tax subsidy

·   These options can be easily adjusted to take into account reforms that imply only partial cuts in subsidies

·   Three key lessons from past experiences are also highlighted for consideration:

o   A transition that includes phase-out of price distortions and phase-in of compensation mechanisms generates better results and is less prone to causing instability and altering social order

o   A widely cast and well-designed communication strategy plays a crucial role in addressing uncertainties and managing expectations

o   A clear and strategic vision on poverty reduction, equity improvement and commitment to change are essential to the reform’s success

 

Consumption Cash Subsidies

·   This option studies the incidence of subsidy cuts on household welfare assuming that changes in subsidies would be fully transmitted on to households and that subsidies for each household would be proportional to household consumption on subsidized products

·   Removing consumption subsidies for food, gas cylinders and water implies very significant price increases in subsidized products in addition to reducing household expenditure and increasing poverty

·   This option has sizeable consequences for the poor (in terms of reduced expenditure and increased poverty), relatively small consequences for the middle and rich classes despite the fact that these two groups receive the largest share of consumption subsidies

Tax Subsidies

·   This option studies the incidence of tax subsidy cuts of ten final consumption products exempted by the General Sales Tax (GST)

·   Cuts in tax subsidies implies the reintroduction of GST and amount to an increase in consumption prices of an amount equivalent to the sales tax

·   Similar to other subsidies, richer households benefit from a larger share of subsidies as compared to poorer households

·   The incidence of tax subsidies on household expenditure results in an overall increase in the poverty rate and smaller increases in the poverty gap and severity of poverty measures

·   The removal of tax subsidies would increase poverty while it would not have much impact on inequality

·   If tax exemptions were lifted, the government would benefit from an increase in revenues and would need a small percentage of revenues to compensate the poor

 

Improved Targeting of Cash Transfers (NAF)

·   Alternative uses of the subsidies budget were assessed by shifting attention to the National Aid Fund (NAF) system to see how subsidies budget can be used in a more targeted fashion

·   The current National Aid Fund (NAF) system for targeting poor households is not optimal

o   NAF’s targeting mechanism results in exclusion of many poor families in addition to other application disparities

o   It is still considered better than spreading transfers over the whole population as done with the current system of consumption subsidies

·   By using proxy-means testing (PMT), it is possible to reach more households and PMT is a more cost efficient targeting mechanism than the current one 

·   By adopting the PMT targeting mechanism, the objectives of reducing government expenditure and reducing poverty can be achieved simultaneously by redistributing part of the budget for consumption subsidies to the poor directly via a renewed system of targeting in the NAF

 

Effects in other Sectors of the Economy

·   Second-order effects are addressed through price increases of goods and services that use the subsidized good as an input

·   The case of water subsidy elimination (increase in price of water) is studied further

·   Overall, the magnitude of second-order effects is rather small and so focusing on the first-order is what counts when understanding welfare consequences of removing water subsidies

Recommended Actions and Initiatives

·   Aggressive implementation of the NAF renewal program (which adopts the PMT targeting method) is necessary to compensate the poor for cuts in consumption subsidies

·   Product targeting is a good approach to the extent that cuts in subsidies concern products not consumed and not needed by the poor. Howeverit would be difficult for Jordan to follow as it is hard to find any such products

·   The re-introduction of sales tax on exempted products would be a simple and less risky option for reform

 

Report Name

Date

Timeline

An Analysis of Consumption Subsidies

(Confidential Draft)

August 2011

Not Applicable

Author

Supporting Donor

The World Bank

The World Bank

Sector

Lead Ministry

Monetary Policy

Ministry of Planning & International Cooperation (MoPIC)

Key Topics

Cash –Exemptions – General sales tax – Household expenditure – Inequality – National Aid Fund (NAF) – Poverty – Proxy-means testing (PMT) – Sales Tax – Subsidies – Tax subsidies – Water

 

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