Chapter

VI. Policies Regarding Subsidies and State Enterprises and Their Relationship to the Pricing System

Author(s):
International Monetary Fund
Published Date:
September 1986
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Subsidies and Transfers

As described in Section II, the typical country undertaking a Fund-supported program subsidizes selected goods and services. These open-ended demands on government expenditure are a major cause of rising fiscal deficits and stimulate further inflationary finance. In some cases, the budgetary costs of these subsidies are a sizable share of government outlays. Nonetheless, the prices for the goods are often maintained at low levels, in part to symbolize the government’s commitment to protect the lower-income classes. The magnitude of the problem is such that in over half the programs surveyed (57 out of 94) subsidy control was a policy measure (Table 8). In 39 cases the issue was one of capping or reducing the subsidies of one of three major items (food, petroleum, or fertilizers) and in another 14 cases other subsidies were mentioned.

Table 8.Expenditure Policies for Transfers and Subsidies in Fund-Supported Adjustment Programs
Number

of

Programs
Percent
Transfers and subsidies5761
Capping or reduction in subsidies3941
Food2830
Petroleum2324
Fertilizers1516
Reduction in other subsidies1415
Curtailment of current transfers to nonpublic enterprises2628
Control of state enterprise operating expenditures1920
Source: Appendix III.
Source: Appendix III.

Few policies undertaken under Fund-supported programs receive as much critical attention as reductions in budgetary subsidies through increases in the prices of basic goods such as food, transportation, and petroleum. Any move to contain these subsidies is widely viewed as an adjustment policy that is regressive. Before accepting the widespread perception that these price increases are Fund inspired and, in particular, are “anti-poor,” it must be understood why, to achieve economic adjustment, prices of certain goods must be raised. Once understood, the question remains whether or not increases in these prices are, in fact, biased against the poor.

Administered Prices

Why does economic adjustment require increases in the prices of goods and services that are so directly associated with consumer well-being as those of food, petroleum, and public transportation? The answer is grounded in the political and historical circumstances which create prices for these goods that are far below their economic value and have serious, and often unrecognized, consequences in both the short and long run. Petroleum, for example, may be considered too strategically important for its use to be left to the decision of the private sector. Food price policy, on the other hand, may have been inherited from a colonial policy based on wartime shortages and price administration, or may have evolved from marketing boards’ policies originally intended to stabilize producer prices and improve food-marketing conditions.45 To some extent, the maintenance of low crop prices serves as a tax on output of the rural sector. Regardless of the origin of the government’s price-setting role, once the government is identified as responsible for the prices, every increase becomes a political issue. As a result, the prices of these goods often lag far behind the general rate of price increases in the economy; some-times, the strength of the government’s mandate can be measured by the extent of the lag.

Rural-Urban Terms of Trade: The General Problem

Problems created by the politicization of prices became acute with the rapid worsening in the commodity terms of trade associated with the inflation of food and petroleum costs that characterized the last decade. Attempts to protect the public from the effect of these increases by subsidizing consumer prices led to a loss of budgetary control and to deficit-induced inflationary pressures that, in numerous cases, pushed the rate of inflation in excess of 20–30 percent annually. In an environment of fixed exchange rates, this had a devastating effect on the real exchange rate and the rural-urban terms of trade in developing countries. As the purchasing power of receipts from agricultural exports diminished, farmers turned increasingly to the domestic market. Here, government policies such as the maintenance of an overvalued exchange rate held down the price of food, eroding incentives and threatening the economic base of market-oriented agriculture.46

The dynamics of today’s subsidy policies and the distributional implications of changes are intrinsically tied up with this deterioration of the rural-urban terms of trade. Subsidies on food and increased food imports were at least initially intended to put the price of basic staples within reach of urban residents. Over time, they encouraged the migration of those in rural areas to urban centers, as those still in agriculture faced diminishing real incomes because of price controls. This movement exacerbated the original imbalance, as it simultaneously increased the urban demand for cheap food and reduced the rural sector’s agricultural capacity. Large commercial farmers, increasingly aware of failing domestic food production and growing dependence on imports, successfully lobbied for subsidized irrigation water, fertilizer, diesel fuel, and agricultural credit. The small farmer suffered by the further erosion of his ability to obtain conditions which might make him competitive.

In these circumstances, improved price flexibility can serve to strengthen the overall adjustment program, transmitting exchange rate movements throughout the economy, restructuring incentives, and improving resource allocation. In recognition of this role, 37 (39 percent) of the programs surveyed focused on innovative pricing policies.

Price Policies

Food

A devaluation can establish appropriate agricultural incentives and incomes, but only if prices are sufficiently flexible to allow changes in the domestic currency value of foreign exchange to work their way to the producer. In turn, increases in prices of both export and domestic food crops that reflect the increased domestic currency value of both agricultural exports and of food imports are required. Often, however, these increases in producer prices for food result in higher levels of government expenditures and unsustainable budgetary deficits unless accompanied by increased domestic food prices. Of the 94 programs, 28 involved measures to reduce the cost of food subsidies. What are the distributional implications of the consequent price movements?

To answer this question, it is important to recognize that food is not only a consumer item but also an important source of income, particularly in rural areas.47 The poor lose in both respects when food policies are directed at maintaining low food prices.

Although much rhetoric has been voiced over the need for food subsidies to protect the poor, the fact is that most food subsidies are directed toward the urban sector, whereas the really poor tend to live in rural areas. Indeed, there is overwhelming evidence that severe hunger is a greater problem in the countryside than in the city. As Eberstadt (1981, pp. 42–43) observes:

  • To be sure, urban hunger is more visible, more dangerous politically, and more immediately influenced by the limited tools available to poor governments. Throughout the poor world, however, it is the villagers who are the more needy. The hunger which Western visitors encounter in the big cities of the poor world is shocking enough, but the fact of the matter is that children grow more slowly, and end up smaller and lighter, in the countryside. They also die earlier: in India, for example, a person born into the comparatively easy routine of city life can expect to live about ten years longer than one who must work and eat in the country.

Clearly, the use of administered prices to improve income distribution to the “ultra-poor” is severely limited by the objective conditions of poverty—to benefit from a subsidy; one must have the purchasing power to buy subsidized goods.48 This implies that only one type of food subsidy, that on the least expensive calorie source (which is the food of the poor), is likely to bring about the desired distributional effect, and then only if the food is perceived to be inferior by higher-income classes. In general, the poor buy foods that differ markedly from those consumed by the rest of the population, and while many of the malnourished are small farmers and their families, the majority are landless or nearly landless agricultural laborers, those in other low-paid, nonfarm rural employment, or the unemployed. Clearly, these groups benefit little, if at all, from income transferred through largely urban-oriented government subsidies on foods which, even at subsidized prices, are likely to be beyond the reach of the “ultra-poor.” Tarrant (1982, p. 108), for example, observes (in Bangladesh) that

  • [t]he ration system, as it is at present operated, is not intended to provide cheap food for the very poor. The really poor could not afford to purchase the food, at whatever price the government chose to provide it.

The emphasis on economic pricing, which is the rationale for the price and exchange rate policies in Fund-supported programs, will inevitably restore more appropriate rural-urban terms of trade, and, in conjunction with the redirection of resources to the rural sector, the income of rural residents will improve. These developments will normally have adverse implications for some, and perhaps many, urban dwellers, as discussed in Appendix II. The loss to the most vulnerable may be reduced or eliminated, through appropriate targeting measures.49 The overall effect is almost certain to reduce inequality, however, as the appropriate incentives are transmitted to the productive sectors and the rural poor receive a more appropriate reward for their labors.

Petroleum

If the full benefits of devaluation are to be achieved, the prices in domestic currency of other imported goods must also be increased. Petroleum products are the most important of these other goods, and their subsidies were adjusted in 23 (24 percent) of the programs.

The rationale for eliminating or at least reducing these subsidies is to eliminate inefficient energy use. In the case of petroleum, the pricing incentives not only affect consumers through their direct consumption of petroleum products, but also indirectly through their use as important inputs in production. As long as the use of petroleum is subsidized, firms using artificially cheap petroleum have less incentive to economize use of the scarce resource and a lower cost structure than the underlying market forces would warrant. If these firms were to pay the actual scarcity value of foreign exchange, their costs would rise, and many of them would encounter difficulty in continuing production. Clearly, the capital and labor employed in these industries are better off, in the near term, than if such a firm were to close owing to prohibitively high energy prices. For others not privileged to be employed in the formal sector, however, the subsidy is likely to reduce sharply the opportunity to participate in the benefits of economic growth.

In effect, the energy subsidy creates an impediment to further employment generation. Through its effect on relative prices, the subsidy encourages the flow of resources into energy-intensive, labor-saving technology (often replacing low-paid unskilled labor, e.g., road building, intensive agriculture) until the growth of industry based on such technology is limited by the cost of the subsidy burden. Either these subsidies are met through a diversion of resources from low energy users to high energy users through taxation, or the necessary financing is met through bank credit, with a consequent worsening of inflation and the balance of payments. In either case, potential economic growth and employment generation, and therefore the well-being of the unemployed and the underemployed, is sacrificed by the short-run commitment to those employed under the existing technology base.

State Enterprises

Distributional Concerns

State enterprises in many countries now have an important macroeconomic role and their operations have considerable impact on financial management.50 In 68 of the programs, nonfinancial state enterprises were included in the policy package (Appendix III). They are also often considered to be one of the instruments “to promote redistribution of income and wealth.”51 Notwithstanding the importance attached to this aspect by policymakers both in governments and enterprises, it has not received much attention in the literature on enterprises.52

Although recent experience indicates that most state enterprises owe their establishment more to pragmatic, organizational considerations (such as using foreign aid) than to ideological considerations, it is also true that considerations of social justice may encourage public ownership of strategic industries or “commanding heights of the economy.” Wealth is thus owned publicly and not privately which, in itself, can have a profound impact on its distribution. Consequently, the formation of new enterprises has become part of the development program in many developing countries.

The day-to-day operations of enterprises affect income distributions the most, as the prices of goods and services provided by the nonfinancial public enterprises have a direct impact on distribution. Very few of these subsidies are specifically compensated for by governments. They normally take the form of forgone returns on investment or additional borrowing, or both. The operational losses, however, are often financed through ex post facto transfers from the public budget. In practice the enterprises do not usually adopt dual or multiple pricing policies to provide goods and services to targeted income groups. Consequently, subsidized products are available to all income groups, not just to those below the poverty line.53 In addition, nonfinancial public enterprises also pursue vertical redistribution policies. These aspects are illustrated briefly in Table 9.

Table 9.Working of State Enterprises and Their Distributional Implications
Implications
PurposeNature of Action Taken or Instrument of DistributionDuring normal periodsIn the context of financial constraints
Fairness and social justice through ownership of productive resources.Establishment of new enterprises.Increases in public investment financed either by current savings or through borrowing.“Distressed” privatization.
Public interest promotion through help to the weaker sections of the community.Supply of subsidized goods and services provided by enterprises either in a general manner or through dual or multiple pricing practices (internal cross-subsidization); primarily applicable to trading, transport, and housing sectors.Transfers from government budget or adjustment in the surpluses to be paid by enterprises to governments.Reduced transfers and subsidies from government budget; adjustment of enterprise tariff t o cover increased costs.
Vertical distribution(a) Establishment of special enterprises to cater to the needs in specified sectors.Subsidized credit, marketing, and other facilities.Reduced subsidies and emphasis on recovery.
(b) Higher wages and increased employee benefits, including housing.Restrictions on wage increases or maintenance of wages at existing rates and reduced benefits.
(c) Price support systems that can be utilized for increasing or reducing commodity production.Responsive agricultural production systems with concomitant results on government finances.Adjustment in price supports in the light of overall fiscal policy; short-term impact on production, procurement, and storage of commodities.
(d) Greater employmentExpansive employment strategies through takeover of sick units, conversion of seasonal to regular employment, and maintaining or even expanding production even in a context of a deteriorating price situation.Defensive employment strategies for maintenance of highest manpower levels through early retirements, forced holidays, training of manpower for rehabilitation, and more selective takeover of sick units.
Horizontal distribution(a) Sectoral cross-subsidizationLow public utility prices to reduce input costs of strategic or basic industries.Upward movement in tariff to prevent further deterioration in utility finances.
(b) Relative changes in the price support systemsThe direction of these changes depends on the policy preferences of the government either to favor the rural sector or to cushion the impact on the urban consumer and on the overall financial status of the government.

While state enterprises may have a clearly defined set of policy goals, the actual progress toward these objectives, including redistributional concerns, is partly contingent on the financial stability of the enterprises. Financial constraints have often forced state enterprises to cut back on investment, to increase their tariffs to cover increased costs, to restrain costs, and to pursue defensive employment strategies; in more critical circumstances, employment has been reduced. These measures are taken by governments and enterprises even in the absence of Fund-supported programs. Indeed, the measures are commonly adopted by all enterprises regardless of their ownership. The distinguishing feature of state enterprises is that they are expected to pursue noncommercial objectives in the larger interests of the community. These noncommercial objectives, however, may not be financially feasible.

Actual experience with the operations of state enterprises reveals that many have not effectively served to redistribute income. Often employment opportunities were diminished by the enterprises’ choice of more capital-intensive technology in production, and selective wage increases actually contributed to wage rigidities and the establishment of favored classes.54 More-over, open-ended subsidy policies for these enterprises contributed to increased deficit financing. The impact of these unintended consequences cannot be measured precisely, however, but their directions are clear.55

Fund-Supported Programs and State Enterprises

Policy measures relating to state enterprises have always been an important component of Fund-supported programs, but this emphasis has increased in recent years, reflecting the growth of their financial demands and related issues. Many programs emphasized that state enterprises should attain financial solvency and not drain the budget; an aspect of this solution is that they should no longer be permitted to borrow abroad without government permission. “Solvency,” in this context, is interpreted as charging prices that will cover operating costs while at the same time making a reasonable contribution to capital maintenance and new investment. Some 27 of the programs curtailed current transfers to state enterprises, and 11 specified subceilings on credit to state enterprises either for the sector as a whole or for individual or small groups of enterprises.

Pricing policy provisions were a common feature of the programs, although in most cases they reflected prior actions; they constituted performance criteria in very few cases. In addition, many programs contained provisions relating to wages and general intentions to reduce overstaffing. Wage policies were generally geared to ensure that the enterprise policies were in accord with national policies to contain cost-push pressures. Moreover, some programs contained one or several of a variety of measures that could conveniently be labeled as administrative measures and included intentions to improve managerial efficiency, autonomy, and governmental control of operating expenditures (25 programs), as well as intentions for divestiture of enterprises to the private sector (26 programs); such measures are usually undertaken in collaboration with the World Bank.

In Fund-supported programs, therefore, the focus on state enterprises has been essentially concerned with selected enterprises, over a short period, and with financial solvency. The impact of the programs on distributional objectives is difficult to quantify and can only be surmised even in the best of circumstances. Furthermore, due weight has to be given to counter-factual aspects. It is possible that the enterprises directly affected by programs were not the ones specifically undertaken for distributional goals. Even if they were, the effects of these adjustments could be compensated for by other enterprises that had not previously been assigned a distributional role, and distributional goals could still be attained in the medium or long term. Although Fund-supported programs emphasize price revisions, their adverse impact on the distribution patterns is not likely to be significant unless the rate of subsidy, rather than the absolute amount of subsidy, is reduced. Although no details are available in this respect, it would appear that most price revisions are intended to allow industries to catch up with cost increases that have already taken place or to validate prices which the populace already paid in the parallel markets. Although intended to improve efficiency, the pricing actions are likely to improve income distribution as they transfer profits and incomes from the unofficial, untaxed sectors to individuals and companies liable to taxation (both direct and indirect).

Conclusions

The preceding arguments support the conclusion that the pricing policies typically encouraged under Fund-supported programs do not worsen the income distributions in developing countries. They can act to improve income distribution, mainly because the rural poor do not participate effectively in most subsidy programs. Moreover, in certain cases where producer prices are restrained, the poor in effect bear the burden of providing the subsidy. The following points, in particular, can be drawn from the section.

(1) The price policies followed under Fund-supported adjustment programs are typically oriented toward correcting distortions in the rural-urban terms of trade that are a major cause of both rural and urban poverty and unemployment.

(2) Both the allocational and the macroeconomic effect of energy subsidies may have employment-reducing effects that are likely to hurt the poor the most (as unskilled labor is replaced by machines).

(3) Unless subsidy programs are very carefully targeted, most of the benefits will “leak” to those who are well-off. Thus many subsidy programs actually promote rather than redress income inequality, at least insofar as the lowest income groups are concerned.

(4) Open-ended subsidies to state enterprises from the budget lead to unintended and unmeasured consequences, but if unofficial incomes and sales can be transferred to official ones, taxed markets equity should be improved.

With respect to public enterprises, Fund-supported programs try to ensure that operating costs are covered and that a contribution is made to maintain and to expand the enterprises’ capital. The pricing policies to achieve this may sometimes appear regressive but frequently the redistributive effect of state enterprises is ill-defined to begin with, often invalidated by shortages which lead to the development of parallel markets and vitiated by deficit budget financing.

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