Many countries seek to protect poorer households by subsidizing the consumption of fuel products. However, recent IMF research shows that fuel subsidies are both inefficient and inequitable, including in India.
But what about India? Are fuel subsidies also anti-poor? Sadly, yes. A new IMF working paper shows that India’s fuel subsidies are both fiscally costly and socially regressive.
Rich benefit much more than the poor
At a global level, a major cross-country study by the IMF showed that fuel subsidies generally crowd out high priority public spending, like health, education and infrastructure. They also put pressure on current account deficits, distort productive investment toward energy-intensive sectors and technologies, and contribute to global warming. Fuel subsidies are the opposite of carbon taxes, after all. But the study also showed that fuel subsidies are regressive, meaning that they actually benefit the rich much more than the poor.
Averaged across a large number of low-and middle-income countries, the study found that the top 20% of households capture six times more in benefits from fuel subsidies than the poorest 20%. Why? Because upper income households consume a lot more fuel products than poor ones, especially gasoline, which is the most regressive fuel product to subsidize. The image of a millionaire zooming by in his big SUV comes to mind. By contrast kerosene, which poor families are more likely to consume, is the least regressive product to subsidize.
Recognizing that fuel subsidies were reaching the neighborhood of 2% of GDP, and crowding out more productive public spending, India’s government has taken bold steps over the past nine months to reduce fuel subsidies. Diesel prices have systematically been rising, there are plans to cap the number of subsidized Liquefied Petroleum Gas cylinders per household, and state electricity boards have been encouraged to set more cost-reflective power tariffs. These measures are welcome, as they also help to take pressure off the worsening current account deficit.
But what less widely understood is that reducing fuel subsidies is a pro-poor measure. In per capita terms, the top 10% of Indian households spends more than 20 times as much on fuel as the poorest 10%. This includes both direct and indirect consumption – the latter being when producers transport food to market, for example, using subsidized fuel. Low-income households consume mainly kerosene, while upper income households predominantly use petrol and LPG. Visualize a crorepati (millionaire) cruising by in his brand new SUV.
What that means is that, if fuel products cost market prices, the top 20% of households would pay six times more for fuel, per person each month, than the poorest 20%. (See figure.) Put another way, the bottom 40% of families could be fully compensated for the move to market prices for less than a fifth of what government now spends on fuel subsidies, leaving significant savings to invest in roads, schools, and hospitals.
Of course, the example above assumes no leakage of benefits, and that’s a major challenge in India at this stage. But even if half of the efficiency gain were to be lost to leakage, fuel subsidy reform would still create a lot of fiscal space in India’s budget for high priority spending. In this respect, the Indian government’s plans to improve the targeting of fuel subsidies is particularly promising.
This piece is cross-posted from IMF Direct with permission.