State capacity and the social impact of energy subsidies reforms in Jordan and Iran

Rania AbdelNaeem Mahmoud, University of Oxford

*This memo is part of POMEPS Studies 31, Social Policy in the Middle East and North Africa. Download the full PDF here.

Energy subsidies have long been used as a social policy instrument to alleviate poverty and facilitate easy access to energy products. However, despite providing direct benefits for the poor, energy subsidies are generally considered an inequitable redistribution tool that disproportionally benefit the better off. Nonetheless, the phasing out of energy subsidies is usually expected to have its greatest adverse impact on low-income households. This is largely due to the consequential inflationary increase in prices that these reforms bring in their wake and the inability of poorer households to adjust their consumption of basic food and energy products in the face of inflation. Typically, an increase in the price of energy products is predicted to have a two-fold effect: a direct effect, caused by the increase in energy prices and an indirect effect, as a result of the inflationary increase in the prices of other goods and services, for which energy is used as a production input (Allenyne, 2013).

In this memo, I compare the cases of Jordan and Iran, which have each embarked on recent energy subsidies reform plans. I argue that the elimination of energy subsidies in countries of weak-to-average institutional capacity can have unexpected, long-term socio-economic repercussions. This is especially the case in the Middle East and North Africa (MENA), where about 48 percent of the global energy subsidies exist (IMF, 2014). This is, in part, due to the scale of existing social safety nets (SSNs), that cannot buffer the immediate social cost of higher tariffs imposed on low-income households as a result of increasing energy prices. Silva et al. (2013) report that non-subsidy SSN transfers in the Middle East constitute less than a quarter of the bottom income quintile’s welfare. In addition, the cost of social protection programs is significant, especially in countries of low administrative capacity and high poverty incidence where identifying the poor in any bureaucratically effective way would be challenging.

The cases: Jordan and Iran

Jordan and Iran belong to different political regime types, but they share a number of similarities, which allow for an intriguing comparative analysis. Prior to reforms, the two countries scored relatively similarly in measures of government effectiveness and fiscal capacity, the key explanatory variables of interest. This enables us to examine whether or not a lack of state capacity, measured in that context, would limit governments’ ability to reform energy subsidies in a socially compensatory way, one that can simultaneously protect the economic interest of low and middle-income households.

The Jordanian and Iranian governments were each characterized as having average administrative capacity at the outset of their individual subsidy reforms, which began in 2005 and 2010 respectively. According to World Governance Indicators (WGI), Jordan scored 57 percent in measures of government effectiveness in 2005 and Iran scored an average of 41 percent in 2011[1]. These rankings indicate public officials limited capacity to implement and commit to reforms. In the economic sphere, both countries had to phase out subsidies on energy products in order to deal with a series of financial pitfalls. Jordan does not have oil fields for domestic use and has to instead rely on sizeable imported subsidized energy from Saudi Arabia and Iraq (Lasensky 2006). Since the 2003 toppling of Saddam Hussein in Iraq, Gulf countries started to replace Iraq in delivering cheap – if irregular – energy to Jordan (Schenker and Henderson, 2014). Being highly dependent on the Gulf increased Jordan’s energy bill from USD $60 million in 2002 to $711 million in 2005 (Vagliasindi 2013) and was projected to reach approximately $1 billion in 2008 if no corrective actions had taken place (Jaradat 2008). Iran, as a rentier state, heavily relies on income from oil and gas exports to finance generous social policies for a sizeable portion of the Iranian population. In 2009, according to International Energy agency (2010), Iran was the largest fuel subsidising country in the world, granting about $66 billions in fuel subsidies, around 20 percent of its GDP. However, the situation deteriorated after 2010 as a result of the UN-imposed sanctions that pushed newly elected President Mahmoud Ahmadinejad to propose the elimination of this huge unsustainable expenditure on energy subsidies.

Both states had limited fiscal capacity to expand social sector spending following the reform implementation. In Jordan, this low capacity was further exacerbated by the limited ability of the government to mobilize domestic resources and its reliance on local taxes to finance domestic expenditure. In 2003, tax revenues in Jordan amounted to 63.8 percent of total domestic revenues and only 15 percent of its GDP, whereas domestic expenditure has amounted to 36 percent of its GDP (ERF 2005). The tax administration system was also described as being weak and the extractive capacity of the Jordanian state as being underdeveloped (IMF 2005). Likewise, the Iranian state that largely draws on oil revenues to finance domestic expenditure was in a tight financial position owing to its weak extractive capacity. In 2011, the IMF reported that about 63.5 percent of the Iranian budget was financed by oil and gas export revenues whereas tax revenues only amounted to 5.5 percent of GDP in 2010 (Aghazadeh 2014; Dehghan and Nonejad 2015). This meant that when U.S. sanctions imposed on the Iranian oil supply in 2011 caused a reduction in the government’s revenue by around one-third, Iran was hardly able to meet its basic expenditure requirements.

The analysis in this memo contributes to a burgeoning body of scholarship on state capacity that emphasizes the significant correlation between a qualified and efficient bureaucracy and adequate fiscal with less poverty and higher social equality (Hau, et al 2013; Murshed et al. 2017; Ravallion, 2016). Nevertheless, this memo is not intended to establish any causal relation between energy subsidies reforms and the change in socio-economic indictors in Jordan and Iran. Other economic and political factors were also in play and could have impacted the outcomes of the reforms. In Jordan, subsidy reforms coincided with the international financial crisis of 2008, while reform in Iran coincided with the economic recession of 2009 and the political sanctions imposed on the Iranian government in 2011. However, by observing annual change in the Producer Price Index (PPI) and the Consumer Price Index (CPI) following the implementation of these reforms and taking into account the indirect effect of the increase in energy prices on households’ real income and consumption, we can adduce evidence for a correlation. In order to establish a causal relation, further technical simulations are required that would involve the use of counterfactuals to disaggregate the impact of the reform from other economic and social influences.

Energy subsidies reform in Jordan

In 2004, the Jordanian government announced its intention to gradually increase energy prices over a four-year period in order to be in line with the international market prices. Accordingly, in July 2005, energy prices increased by around 27 percent, resulting in a 10 percent increase in gasoline prices, 33 percent increase in the price of fuel used in power generation and 59 percent increase in the price of fuel used in industrial production (Coady et al 2006; Fattouh and El-Katiri 2012). Consequently, in February 2008, in association with the sharp increase in the international energy prices and the devaluation of the Jordanian dinar in face of the falling of the US dollar (to which it was pegged), the government removed most of its subsidies – causing the domestic gasoline price to jump by 16 percent, while fuel and kerosene prices increased by 76 percent overnight (Jones et al 2009). As a result, public expenditure on energy subsidies declined from 5.8 percent of GDP in 2005, to 2.6 per cent in 2006, and 0.4 percent in 2010. In association with the elimination of energy subsidies, Jordan’s PPI increased by 8 percent in July 2005, 7 percent in April 2006, and 9 percent in February 2008 – coupled with consequential increases in the CPI of 2 percent in July 2005, 2 percent in April 2006 and 6 percent in February 2008.

Mitigation measures in Jordan

Prior to the reforms, public expenditure on Jordan’s social safety net totalled around 1 percent of GDP and benefited about 8 to10 percent of the population (Vagliasindi 2013). There were three major facets to this: income support to the poor and vulnerable groups operated through National Aid Fund (NAF) and Zakat fund; social care service to vulnerable groups, including disabled and children; and economic empowerment programs to develop the skills of the Jordanian workers. Since the scale of these programs was not enough to mitigate the adverse impact of the reform on households’ welfare, and any upgrades would have required additional resources, the Jordanian government had to seek alternative immediate mitigation measures, in accordance with its institutional capacity, to protect poor households.

To this end, a more gradual price adjustment approach was adopted for energy products widely used by poor households and an electricity lifeline tariff was maintained for families whose consumption was less than 160 KWh per month (Vagliasindi 2013). Targeted national aid expenditures also increased by 43 percent from 2007 to 2008 to offset the predicted direct and indirect effects of increasing energy prices on low-income families. Furthermore, the average wage of civil servants as well as military and security personnel increased by 50JD for those with a base salary less than JD300, and increased by 45JD for those with a base salary more than JD300 (Yemtsov 2010). Likewise, the pensions of public-sector employees increased by an amount equal to USD $150 to USD $220 per month for families with an income less than USD $1000. The indexation of salaries also began to be linked to inflation and productivity. For private-sector employees, a separate compensation scheme was introduced for low-income families. Another alleviating measure was the sharp reduction of 5 percent tax that had been imposed on eleven of the most essential food commodities (including fish and meat). Mitigation measures remained a priority, and overall, the government was able to scale up its social protection expenditure to reach around 4.3 percent of GDP (around USD $552 million) in 2008, about one-third to half of the initial energy subsidies cost (Jaradat 2008).

These mitigation measures, however, were not enough to protect all income groups. Following the reforms, poverty incidence increased from 13 percent in 2006 to 14.4 percent in 2010 (HEIS 2006, 2010). Furthermore, the geographic “poverty pockets” – districts in which at least 25 percent of the population is poor – increased over the period (2006 to 2008) from 22 to 32 pockets. The inflationary increase in food prices (a 28.3 percent increase) coupled with energy price increases caused households to shift their consumption patterns; the average household expenditure on food items from 2006 to 2008 decreased by 2.6 percent. This reduction involved meat consumption falling by 41 percent and vegetables consumption by 20 percent. However, the bottom 20 percent (first quintile) did not experience any reduction in average food expenditure, but, instead, expenditure growth of 0.8 percent from 2006 to 2008. On the other hand, all income groups experienced a reduction in non-food expenditure by 8.2 percent as a result of the inflationary increase in the prices of non-food items (13.4 percent over the same period). This indicates that low-income households shifted their consumption pattern from non-food items to food items to offset the inflationary increase in the prices of both products. Generally, total expenditure on food and non-food items decreased by 6.2 percent from 2006 to 2008 for all income groups.

Table 1: Change in Jordanian households’ expenditures by percentage (2006-2008)

First Quintile (Lowest 20 percent) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest 20 percent) Total
Total Expenditure Growth -3 -4.8 -4.1 -6.1 -8.2 -6.2
Expenditure Growth for food items 0.8 -2.4 -1.1 -4.4 -3.4 -2.6
Expenditure Growth for non-food items -6.1 -6.7 -6.3 -7.2 -10.7 -8.2

Source: Household Expenditure and Income Reports (2006 & 2008)

Energy subsidies reform in Iran

In December 2010, the Iranian government announced its intention to liberalize energy prices to be adjusted to 90 percent of the prevailing prices in the Gulf area. Virtually overnight, gasoline prices increased by 400 percent, natural gas prices increased by 700 percent, diesel prices increased by 1000 percent and electricity prices increased by 300 percent (Fattouh & El-Katiri 2012). This reform aimed at saving the government around USD $70 billion per year (Salehi-Isfahani 2014). Due to the sudden substantial increase in energy prices, the first-round effect of the reform was reflected in an uncontrollable hike in inflation rates from 13.9 percent in 2010 to 26.4 percent in 2011 and to 28.6 percent by 2012. In analyzing the effect of the reform on inflation rates, it should be noted that the increase in energy prices is not the only factor that contributed to the unprecedentedly high level of inflation throughout this period (2010-2013). Other factors include the increase in money supply to finance households’ cash transfers through printing money (as explained below) as well as US sanctions imposed on the Iranian oil supply in 2011 that caused a currency devaluation in September 2012 (Salehi-Isfahani 2014).

Figure 2: Producer inflation

Figure 3: Consumer inflation

Source: IMF (2017)

Given the limited institutional capacity of the Iranian government and the unavailability of comprehensive, well-targeted safety nets to protect poor households from the negative impact of the reforms, the distribution of universal basic income to Iranian households was the only channel to ensure any measure of social acceptance for the government’s reforms. In order to ensure social and political stability, well before the initial implementation of the reform, the Iranian government electronically deposited around USD $45 per month per person into the Iranian citizens’ bank accounts that they were asked to open several months before the reform came into force. This amount was estimated to be around “28 percent of the median per capita expenditure for a household of four members, 10 percent of the monthly wage of unskilled worker and greater than the monthly expenditure of 2.8 million Iranian citizens,” and became available on the day of the reform (Salehi-Isfahani 2014: 8). Although the initial intent was to transfer the cash amount to the lowest seventh of income groups, the fear of social discontent provoked by excluding some families from the transfer forced the government into declaring all the Iranian families eligible for the transfer. Because of this, the reform eventually cost the government USD $30 million more than budgeted (Tabatabai, 2012). The percentage of cash recipients during the first four months of the reform, according to the government, was around 82 percent of the total population, increasing to 95 percent of the population very soon afterwards (Salehi-Isfahani, 2014).

On the social side, there is some evidence that the Iranian government’s crudely managed generous compensation measures did help reduce the incidence and magnitude of income poverty over the period 2009 to 2012. Yet this positive impact did not last long. The distribution of universal, rather than well-targeted, cash transfer cost the government more than the initial amount spent on energy subsidies at a time Iran had to run a deficit-ridden budget because of the sanctions. This eventually has resulted in a 25 percent budget deficit financed by printing money. The increase in money supply, along with other factors, caused inflation to record a high figure of 35 percent in 2013 and poverty rate, as seen in Figure (4), to go up again to 10.5 percent in 2014 (Salehi-Isfahani, 2017). Ultimately, the real value of cash benefits dropped by 38 percent between 2012 and 2014 in the face of inflation. In response, President Rouhani had to reduce the amount of cash transfers and increase energy prices to curb rising inflation, which in turn increased poverty incidence. On that point, Figure (5) shows the results of a World Bank study (2016), in which the erosion of cash transfer was identified as the main contributors to poverty changes during the 2012 to 2014 period.

Figure 4: Headcount poverty rates 2008-2014       

Source: IMF (2017)

Figure 5: Sources of income poverty changes 2012–2014

Source: World Bank (2016) using HEIS 2008–2014

Concluding remarks

There is no doubt that energy subsidies are inefficient forms of social expenditure that broaden the gap between the rich and the poor, crowd out productive public expenditure, and create economic distortions. Their elimination would likely help create a more efficient and equitable economy. For the MENA region, the rising costs of subsidies will eventually necessitate their elimination if governments are to reduce their fiscal deficits and target their limited financial resources towards more efficient social spending and towards activities that promote economic growth. Ultimately, the reforms considered here come at a social cost that needs to be addressed by governments before they embark on any comprehensive reform plan. As exemplified in the Jordanian and Iranian cases, this social cost is the expected adverse direct and indirect impact of the reform on households’ real income. Unless well cushioned by a combination of mitigation measures, this impact can increase poverty rates and reduce households’ consumption. Mitigation measures, however, require the presence of adequate institutional and fiscal capacities to be up to the task of fully protecting the poor and the economically vulnerable. In short, the social impact of energy subsidy reforms on households’ welfare is largely a factor of the comprehensiveness of the social safety nets in place prior to and following the reform’s implementation, the magnitude of the reform, the mode of its implementation, the capacity of government to estimate the impact on stakeholders, and its ability to design mitigation measures that can offset adverse effects of the reform.

[1] By contrast, Bahrain, Qatar, and OECD countries scored an average of 69, 73, and 88 percent in measures of government effectiveness in 2011.


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