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# Appendix 3 Examining the Short-Term Impact of Reducing Price Subsidies on Real Household Incomes: An Illustration

Juan Cordoba, Robert Gillingham, Sanjeev Gupta, Ali Mansoor, Christian Schiller, and Marijn Verhoeven
Published Date:
December 2000
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42. This appendix provides two competing pragmatic approaches to estimating the impact of price-subsidy reform on households in the short term.

• Estimate the loss of real household income as the arithmetic mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This amounts to the following:

where RL denotes the impact on real household income in percent, wi is the share of item in household expenditures, Pi(1) is the new (in most cases, higher) price of item i, and Pi(0) the price before the reform of price subsidies. This estimate of the loss of real household income can be illustrated with an example. Suppose the price of subsidized rice rises by 50 percent, and that the weight of rice in the expenditures of poor households averages 30 percent, and that of non-poor households, 10 percent.18 Using the above equation, the average impact on the real income of poor households can then be estimated at 15 percent. For nonpoor households, the corresponding loss in real income is smaller—5 percent, on average.

This estimate provides an upper boundary on the increase in living costs. If households respond to changes in relative prices by shifting away from the item for which the price has increased, the actual loss will be smaller. The loss will be close to the above estimate if the subsidized item is a basic commodity for which no ready substitutes are available. If there is a perfect substitute, households will react to even a small change in the price of the subsidized item by shifting completely out of that item and into the substitute, suffering no loss in real income. The procedure below recognizes the likelihood of a consumer response.

• Alternatively, estimate the real loss of household income as the geometric mean of the relative price change, using the shares of the consumption items in household expenditures as weights. This can be calculated as follows:

Using the same example as before, the estimated loss of poor house-holds from a rise in the price of rice by 50 percent can be calculated at 13 percent, and for nonpoor households, 4 percent. These estimates reflect the case when households are responsive—but not infinitely so—to changes in relative prices.19

43. Which estimate of real-income loss is more appropriate? The above approaches provide a reasonable range within which the correct answer is likely to fall. Which point in this range is most relevant for estimating the desirable level of compensation for price-subsidy reform depends on many factors, including whether the subsidized item is a basic commodity and some substitution possibilities exist. To be more precise, which estimate is more accurate depends on the size of the income effect of the price change versus the substitution effect. What is reassuring, however, is that the difference between the two estimates is typically small for poor households. In the above example, the estimates differ by only two percentage points.

## Index Guide to Concepts and Issues20

• Administrative capacity, 7, 14, 16, 23, 25, Box 1, and Table 1.

• Available financing, 7 and 26.

• Benefit incidence and equity, 19–20, 28, 31–32, 35, and 40.

• Cash transfers, 8–11, 15–16, 29, and Boxes 3–4.

• Delivery mechanism, 15, and Box 3.

• Exogenous factors, 29, 33, and Box 1.

• Efficiency of compensation mechanisms, 12–13 and 34.

• Fiscal savings, 1–2, 5–7, 26, 33, and Boxes 1–3.

• Mass information campaigns, 32, and 35.

• Middle class and other nonpoor groups, 7, 28–29, and 32.

• Political disruption, 28–32, and Box 4.

• Political support for price-subsidy reform, 6–7, 28–32, and Boxes 1 and 4.

• Price-subsidy reform in the longer term, 9, 32, and 34.

• Rationale for price-subsidy reform, 1, 4, 18, 20, and 41.

• Reversal of price-subsidy reform, 6–7, 33, and Box 1.

• Social impact and disruption, 2, 4–5, 20–21, and Boxes 1 and 3.

• Social safety nets and social compensation instruments, 5, 7–10, 15–16, 23, 25–26, 32, 34, Boxes 14, and Table 1.

• Speed of price-subsidy reform, 5–7, 33, and Box 1.

• Stakeholder approach, 32, 35, and Box 4.

• Subsidies by type,

• Consumer, 8, 22, 36–37, and 41.

• Explicit, 7, 18,26, 37, and 41. Food, 9, 15, 29–32, 39, Boxes 1 and 3, and Table 1.

• Implicit, 7, 18, 38, and 41.

• In-kind, 15 and 24.

• Petroleum product, 30, 32, 41, and Boxes 1 and 4.

• Producer, 10, 18, 36–37, and 41.

• Subsidies and environment, 27 and 41.

• Targeting, 8, 10–16, 25, 28, 34, Boxes 23, and Table 1.

• Targeting by type,

• Indirect targeting, 15, 34, and Table 1.

• Means testing, 13–15, 25, 34, Box 2, and Table 1.

• Self-targeting, 15, 34, and Table 1.

• Vouchers and food stamps, 15, 32, Box 3, and Table 1.

• Winners and losers of price-subsidy reform, 29, 32, and Box 4.

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Before 1994, generalized subsidies in Jordan covered many food items at an average cost to the budget of 2.2 percent of GDP. These subsidies took two forms: (1) coupons distributed to all households for buying rice, sugar, and milk; and (2) wheat price controls, which provided an implicit subsidy for bread. In 1995, the government also began issuing coupons for bread, but the price of bread remained extremely low, leading to wasteful consumption (bread was used for animal feed) and smuggling. In 1996, the price of wheat was increased and the government replaced coupons with a cash transfer for bread. This also led to an increase in prices of other foods like poultry and dairy products, which provoked food riots. In 1999, the fall in international wheat prices offered the opportunity to align the domestic price with its international level and integrate cash transfers into the targeted social assistance programs administered by the National Aid Fund. But the authorities set the domestic price of bread somewhat below its production cost, and a small subsidy reappeared. The domestic price of wheat continues to be controlled, and the bread subsidies may rise if wheat import prices increase.

In some instances, the government awarded wage increases at the time of price liberalization. This policy is tantamount to a cash compensation targeted to workers in the public sector and recipients of social security benefits.

Korea has been successful in phasing out safety nets after the effects of the 1998 financial crisis dissipated.

Based on a sample of 24 targeted-subsidy and cash-transfer programs in 11 countries in Latin America, Grosh (1994) finds that the administrative cost as a share of total program cost ranges from 3 percent to 10 percent for self-targeted programs, against 4 percent to 16 percent for geographically targeted programs, and 1/2percent to 29 percent for programs that assess eligibility individually for each participant. These wide differences in administrative cost are not reflected in the targeting efficiency; for all programs for which data were available, the share of benefits accruing to the poorest 40 percent was within or near the 70 percent to 75 percent range. This result can be attributed to the small share of screening cost of participants in the overall administrative cost of subsidy programs and disparity in the availability of existing mechanisms to channel benefits. Another reason might be that the administrative costs do not vary significantly with the level of the benefits; administration of a scheme that pays beneficiaries very little will thus tend to absorb a large share of the total program cost, independent of the targeting mechanism (see Foster, Gomez-Lobo, and Halpern, 2000).

See also Van de Walle (1998). Several studies have shown that the targeting of social safety nets tends to become more efficient over time; see Hammer, Nabi, and Cercone (1995) and Lanjouw and Ravallion (1999).

Targeted food supplements and nutrition interventions for women and children, including school feeding programs, are a special case of such targeting. The drawbacks of these programs are imperfect coverage of the poor and high administrative costs. On the other hand, they are not associated with labor market disincentive effects, and are subject to minimal leakage.

In Zambia, where cash-for-work road construction projects offered a relatively high wage rate, some beneficiaries subcontracted their jobs to others at a lower wage.

The principal factors that underlie self-targeting in the broader sense are the opportunity cost of time used for obtaining benefits in work programs, the attractiveness of products to the poor, and social stigma.

In practice, the design of price-subsidy reforms will be the outcome of a collaborative process involving the country authorities, the IMF, the World Bank, and other stakeholders, particularly if such reforms are part of a poverty reduction strategy paper.

If full information from existing sources is lacking, substantial resources would be required to take into account all relevant considerations set forth in the guide.

For a number of countries, World Bank staff carries out analyses of the impact of price subsidies in the context of the Poverty Assessments and Public Expenditure Reviews.

However, Pitt (1985) found that kerosene subsidies in Indonesia disproportionally benefited the nonpoor and that the elasticity of substitution between firewood and kerosene was very small.

Hausmann (1994) argues that entitlements, such as subsidies, imply a negative-sum game leading to a highly inefficient but stable political (Nash) equilibrium. Moving to a better, Pareto-efficient equilibrium, requires a package of policies that yields benefits over the medium term for all groups. Ravallion and Lokshin (2000) examine support for government redistribution in the Russian Federation in 1996. They find that support for redistribution not only depends on whether the population is poor or well-off, but also on whether it expects to suffer an income loss or gain.

An asterisk indicates that data on public spending on price subsidies before and after reform are available for the country.

Subsidies paid to consumers, as opposed to producers, are typically classified as transfers in the public sector accounts. Subsidies that are administered by extrabudgetary funds (such as agricultural subsidies in a number of countries) are sometimes not consolidated with the budget.

Data on subsidies are from the United Nation’s System of National Accounts (SNA), which defines subsidies as current unrequited government payments to enterprises on the basis of their production, sales, or imports. Thus, the SNA data on subsidies exclude payments to consumers, such as food stamps, which are recorded under transfers, as well as implicit subsidies. The IMF’s Government Finance Statistics (GFS) uses a similar definition of subsidies as the SNA; however, for most countries, the GFS does not report separately on subsidy payments but instead lumps these outlays together with government transfers.

Clements, Rodriguez, and Schwartz (1998) find that a large government, a large external current account deficit, and a relatively large manufacturing sector are associated with a higher level of explicit subsidies.

Data on household expenditures can be obtained from household surveys.

The estimate reflects households who respond to price changes in such a way that the shares of spending on different consumption items in their total expenditures remains constant. This behavior is consistent with preferences that can be described by (a monotonic transformation of) a Cobb Douglas function, which has unitary compensated own-price and cross-price elasticities. Preferences of this type also underlie calculation of the Consumer Price Index in a number of countries, including many components of the CPI for the United States.

The numbers refer to paragraphs, text boxes, and tables.