Subsidising or taxing

While commonly it is thought that the poor benefit from fuel subsidies, reality points to the contrary, writes Samer Atallah

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There is often a deep divide between what is considered sound economics and what is pursued in public policy. In Europe and North America, environmental taxation appears the favourite policy instrument of academics in efforts to curb fossil fuel emissions and deal with growing concern over global warming. Yet in practice special interests from industry and their lobbyists often succeed in influencing the politicians' choice of what policy instruments to use. Cap and trade regimes, alternatively known as "carbon markets", are advocated widely across political platforms.

Egypt is no exception to this ideal/real divide. The only difference is that the people who pay the steep price for misguided economic policies are voiceless. The point is all too evident when it comes to the policy of subsidising fossil fuels, a policy Egypt adopted several decades ago with regard not only to domestic but also to industrial energy usage. What is of concern now is that this policy is not sustainable. Its harm in the long term far outweighs its short-term benefits, if there are any.

Fossil fuels such as gasoline and diesel are crucial to numerous sectors of our economy, from transportation to bread baking. Removing price subsidies would inflate the price level of practically all necessities, leading to a substantial drop in the purchasing power of the great majority of Egyptian households whose income has been rigid for decades. Given the high risk of consequent social unrest, past governments chose to keep energy subsidies intact, while exacerbating their negative long-term effects. As observed all too often, a common and frequently used approach to solving a given problem is to create a much bigger one for someone else.

Fuel subsidies consume a substantial portion of government income and contribute to a great extent to its chronic budget deficit. This affects the sustainability of economic growth in two ways. First, this deficit has to be financed either through higher taxes or through issuing more debt; either way, future generations end up paying the enormous bill. Extensive government borrowing additionally increases interest rates, which raises the cost of credit thereby crowding out investment, the main engine of growth. Alternatively, these resources could be redirected towards other priorities for development, such as improving failing public education and healthcare systems. Furthermore, these subsidies increase the consumption of fossil fuels, and that has well known negative consequences on the environment.

One must admit that the current government has taken a courageous decision to phase out subsidies in industrial usage. Given the exceptional influence of industry on the decision making process in Egypt, this step has to be applauded. A bolder action would be to tax energy usage; especially in export driven industries such as the cement industry. These industries have for long enjoyed substantial profits due to the fact that they sell at international prices while paying low domestic wages and enjoy a subsidised energy bill. There is no doubt in my mind that, even after taxing their energy usage, their profit margins would remain conducive, and their products would still be competitive in export markets. In parallel to proposed energy taxation, it is important to also lessen the burden of employment taxation paid by firms, which would eventually encourage the expansion of labour intensive industries.

Energy taxation should not be limited to industrial energy use only. The largest portion of fuel subsidies goes to the top and middle income brackets that own private cars. The willingness of this segment of society to pay for fuel has not yet been fully exhausted. It is incomprehensible that someone willing to pay over 150,000LE to buy a fancy 2008 car with a two-litre engine pays just 1.30LE for a litre of gasoline! What is even more ridiculous is how meagre the annual registration fee for a private vehicle is. Ironically, it is the poor who subsidise the rich in this country.

Further, I am surprised how people spend time and resources trying to improve traffic conditions in Cairo, whereas the solution lies at the source of the problem. Congestion is mostly blamed on the lack of reliable public transport, a market flooded with cheap cars bought on credit, and the extremely low price of gasoline. All these factors make the decision to own a car very rational. The solution, therefore, is to tax car ownership depending on the size of the engine and the number of cars owned by each household and each person. A key complementary adjunct to this policy is to invest heavily in clean and reliable public transport.

Yet the above solutions are not enough. Heavy subsidisation policies have to be brought to an end. It is a delicate matter; so delicate that no one wants to be in the shoes of the politician who would take such a daring decision. However, the only consolation is that delaying the decision exacerbates the problem. The question is not if, but rather how to do it. If any lesson is to be learned from the experience of 1977, it is that a sudden removal of subsidies has catastrophic consequences, and that a transparent and staged process needs to be adopted.

First, prices need to remain at their current level for a period ranging from a year to 18 months. For the following two years, fuel prices would be adjusted by an annual increase of 25 to 35 per cent. In the third stage, which should last two to three years, fuel prices would be a fixed proportion of their cost; say 70 per cent. Finally, after nearly six years, fuel prices should reflect at least their cost of production (currently the price of one litre of gasoline is less than 20 per cent of its production cost). One key element to the success of this plan is transparency. Consumers and firms alike need to be able to project the cost of energy to determine the allocation of their resources in the present and in the future.

Subsidies are essential for the poor. But when the benefits go to the rich rather than the poor it is imperative to take corrective action that is economically sound rather than sustaining the status quo for political reasons.

Samer Atallah has his BSc in Mechanical Engineering, AUC, 1997. He holds a MSc in Engineering, University of California at Berkeley, 2002, and a MA in Economics, McGill University, 2006. He is currently a PhD Candidate in the Economics Department at McGill University.