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La Trobe University

A General Equilibrium Analysis of Alternative Scenarios for Food and

Energy Subsidy Reforms in Iran

Submitted by

Mohammad Reza Gharibnavaz

A thesis submitted in total fulfilment of the requirements for the degree of

Doctor of Philosophy

School of Economics

Faculty of Business, Economics and Law

Supervisors: Dr. Robert Waschik

Prof. Harry Clarke

La Trobe University

Bundoora, Victoria 3086

Australia

February 2013

http://www.latrobe.edu.au/fbel

i

Abstract

The economy of Iran was characterized by distortions such as a dual exchange rate

system, non-tariff barriers and heavily subsidized petroleum products. From the

beginning of 2002, the Iranian government committed itself to implementing subsidy

policy reform intended to adjust distortions and structural imbalances. However, the

impact of the reform on needy and vulnerable households was a source of concern.

The main goal of this study is to evaluate a number of policy alternatives for

consumption subsidy reform in Iran. For this purpose, three main policy scenarios

ranging from eliminating food and agricultural subsidies to removing energy

commodity subsidies are analyzed in this research. To simulate the welfare impacts

of subsidy policy reform in Iran, we use the GTAP7inGAMS static CGE model with

20 household types in rural and urban areas, grouped according to income. The static

GTAP7inGAMS model is calibrated using the GTAP 7 database representing the

world economy for 2004. Subsidy rates were adjusted by incorporating protection

data prepared by Iranian statistical centers, and the Petroleum and Coal Products (p-

c) sector in the GTAP7 database was disaggregated into four energy commodities:

gasoline, diesel, kerosene and fuel oil, since the initial level of subsidies on these

energy commodities reported by Iranian statistical centers are quite different from

each other. Results indicate that removing food subsidies and introducing

compensating direct income payments to all income groups would make lower

income households in both rural and urban areas better off. Findings from the second

scenario suggest that reforming energy subsidies would significantly increase the

welfare levels of both rural and urban households, reflecting the high level of

distortions. Finally, counterfactual results in the third scenario reveal that the

removal of food and energy subsidies together with government compensation

would yield welfare gains in all income households. Finally, providing cash

compensation to all households after eliminating energy subsidies, as expected, will

make households wealthier compared to the situation when the energy subsidy

reform is implemented without cash compensation.

ii

Acknowledgments

I would like to express my appreciation for my advisor, Dr. Robert Waschik, who

not only introduced me to the world of general equilibrium models, but also has

consistently steered me in the right direction. I also thank him sincerely for his kind

and cheerful attitude in his capacity as advisor while performing this research. I am

thankful to Professor Harry Clarke for his role as my co-advisor. In particular, I have

been fortune enough to work with Dr. László Kónya, and I would like to thank him

for his assistance and guidance in developing this study. I am forever indebted to all

of my colleagues and friends for their support and encouragements throughout.

Finally, I would like to thank my parents for their love through all of my graduate

school years.

This dissertation is dedicated to my lovely wife, Aida, for her continuous sacrifices,

support, and encouragement not only through my doctoral program but throughout

our life together. I love you with all my heart and hope that our life together will be

filled with love and success.

http://www.latrobe.edu.au/economics/about/staff/profile?uname=lkonya

iii

Statement of Originality

I hereby certify that all of the work described within this thesis is the original work

of the author. Any published (or unpublished) ideas and/or techniques from the work

of others are fully acknowledged in accordance with the standard referencing

practices.

Except where reference is made in the text of the thesis, this thesis contains no

material published elsewhere or extracted in whole or in part from a thesis submitted

for the award of any other degree or diploma.

The thesis has not been submitted for the award of any degree of diploma in any

other tertiary institution.

Mohammad Reza Gharibnavaz

(February 2013)

iv

Table of Contents

Abstract ......................................................................................................................... i

Acknowledgments ........................................................................................................ ii

Statement of Originality ............................................................................................. iii

Table of Contents ........................................................................................................ iv

List of Tables.............................................................................................................. vii

List of Figures .............................................................................................................. x

Chapter 1. Introduction ............................................................................................ 1

1.1. Introduction ....................................................................................................... 1

1.2. The Research Questions .................................................................................... 2

1.3. The Basic Approach .......................................................................................... 3

1.4. The Outline of Dissertation ............................................................................... 4

1.5. Summary of Principal Results ........................................................................... 5

Chapter 2. Literature Review ................................................................................... 7

2.1. Introduction ....................................................................................................... 7

2.2. Defining and Classifying Subsidies: Basic Concepts ........................................ 7

2.2.1. The Definition of Subsidies: Conceptual Issues ......................................... 7

2.2.2. Characteristics of Subsidy Definitions ....................................................... 9

2.2.3. Summary of Recent Definitions ............................................................... 10

2.3. Subsidies: Types and Measurements ............................................................... 12

2.3.1. Subsidy Types ........................................................................................... 13

2.3.2. Measuring Subsidies ................................................................................. 14

2.4. Background of Government Paid Subsidies in Iran ........................................ 16

2.4.1. An Overview of the Trend and Size of Subsidies in Iran ......................... 17

2.4.2. Classification of subsidies in Iran ............................................................. 19

2.5. The Socio-Economic Debates over Government Subsidies ............................ 26

2.5.1. The Economic Issues over Subsidies ........................................................ 26

2.5.2. Rationale for Reform ................................................................................ 29

2.5.3 Subsidy Reform: Issues and Obstacles ...................................................... 33

2.6. Overview of International Experience in Subsidy Reform ............................. 36

2.6.1. International Experience in Consumer Food Subsidy Reform ................. 37

2.6.2. International Experience in Consumer Energy Subsidy Reform .............. 42

Chapter 3. Economic Policies and Reform Efforts in Iran .................................... 48

3.1. Introduction ..................................................................................................... 48

3.2. General Background of Iran’s Economy ......................................................... 48

3.2.1. Economic Growth ..................................................................................... 49

v

3.2.2. Inflation ..................................................................................................... 50

3.2.3. Unemployment.......................................................................................... 51

3.3. Key Economic Sectors .................................................................................... 51

3.3.1. Hydrocarbons ............................................................................................ 52

3.3.2. Agriculture and Fisheries .......................................................................... 52

3.3.3. Manufacturing ........................................................................................... 53

3.3.4. Services ..................................................................................................... 54

3.4. Economic Policy and Reform Efforts in Iran .................................................. 54

3.4.1. Iran’s Development Planning from the Perspective of Subsidy Reform .. 55

3.5. Previous Studies on Iran’s Subsidy Reform .................................................... 59

3.6. Application of CGE Model for Iran ................................................................ 63

Chapter 4. Theoretical Framework and Methodology ........................................... 69

4.1. Introduction ..................................................................................................... 69

4.2. Introduction to Computable General Equilibrium Models ............................ 70

4.2.1. Justification for Employing CGE Modelling Technique ........................ 71

4.2.2. Overview of Structure of a Standard CGE Model .................................. 72

Chapter 5. The Model ............................................................................................ 76

5.1. Introduction ..................................................................................................... 76

5.2. Structure of GTAP7inGAMS Model .............................................................. 76

5.3. The Model Formulation and Behavioural Equations ...................................... 82

Chapter 6. Benchmark Data ................................................................................... 91

6.1. Introduction ..................................................................................................... 91

6.2. Urban and Rural Households Income and Expenditure Survey ...................... 91

6.2.1. Background of Survey .............................................................................. 91

6.2.2. Classification of Individual Consumption According to Purpose

(COICOP); Basic Principles ............................................................................... 93

6.2.3. Detailed Objectives and Components of the Survey of 2004 ................... 95

6.3. Overview of the GTAP7 Database ................................................................ 101

6.4. Incorporating the Iranian Input-Output Table in the GTAP7 Database ........ 102

6.5. Data Aggregation and Modifications ............................................................ 103

6.5.1. Data Aggregation .................................................................................... 103

6.5.2. Extensions to the Basic Model................................................................ 106

6.5.3. Adjusting Tax Rates in the GTAP7 Data Base ....................................... 122

6.6. Deriving the 2004 SAM for Iran from the GTAP7 Database ....................... 125

Chapter 7. Estimating the Behavioural Parameters Used in the Calibration Process

132

7.1. Introduction ................................................................................................... 132

vi

7.2. Popular Functional Forms for Modelling Consumption Behaviour .............. 133

7.3. The LES Functional Form with Household Types ........................................ 136

7.4. Seemingly Unrelated Regression Equations (SURE).................................... 138

7.5. Estimating LES Parameters and Elasticities across Iranian Households ...... 140

Chapter 8. Counterfactual Simulations and Results ............................................ 152

8.1. Introduction ................................................................................................... 152

8.2. Targeted Subsidies Reform ........................................................................... 152

8.3. Policy Reform Scenarios and Model Simulation Results ............................. 153

8.3.1. Simulation Results for Scenario 1 .......................................................... 154



8.4. Sensitivity of the Simulation Results to Key Hypotheses ............................. 185

8.4.1. The Elasticity of Substitution between Domestic and Imported Goods

(Armington Elasticity) ...................................................................................... 185

8.4.2. The Elasticity of Substitution between Primary Factors (Labour and

Capital).............................................................................................................. 187

8.4.3. The Elasticity of Transformation between Outputs for Domestic Sale and

Export................................................................................................................ 188

8.4.4. Specification of the Utility Function ...................................................... 191

Chapter 9. Conclusions ........................................................................................ 193

9.1. Introduction ................................................................................................... 193

9.2. Summary of Findings .................................................................................... 194

9.3. Future Study .................................................................................................. 197

References ................................................................................................................ 199

Appendix A .............................................................................................................. 213

A.1. Equilibrium Conditions ................................................................................ 213

A.1.1. Zero Profit (Arbitrage) Conditions ........................................................ 213

Appendix B .............................................................................................................. 217

Appendix C .............................................................................................................. 221

Appendix D .............................................................................................................. 224

vii

List of Tables

Table 2.1: The Trend of Paid Subsidies and the Ratio of Subsidies to Some Macro

Economic Variables within Iran’s Economy (1973-2003). ................................ 18

Table 2.2: Consumption, Production and Services Subsidies during 1976-2002 in

Iran (in billions of rials) ...................................................................................... 20

Table 2.3: Subsidies Paid through the Consumer and Producer Protection

Organization, 1999-2004/05 (in billions of rials) ............................................... 22

Table 2.4: Explicit Subsidies Paid Through the Consumer and Producer Protection

Organization, and Other Subsidies, as Share of GDP, 2000/01–2006/07. ......... 23

Table 2.5: Rates and Amounts of Energy Subsidies by Fuels in Iran (in million rials

per year) .............................................................................................................. 25

Table 2.6: The Share of Iran’s Socio-Economic Sectors from .................................. 26

Table 5.1: Set Indices ................................................................................................. 77

Table 5.2: The Primal Variables (Activity Levels) .................................................... 78

Table 5.3: Benchmark Prices ..................................................................................... 78

Table 5.4: Tax and Subsidy Rates .............................................................................. 79

Table 5.5: Behavioral Parameters in the GTAP7inGAMS Model ............................. 83

Table 6.1: Sample Households’ Distribution According to the Size of Household

across Different Expenditure Deciles in Urban and Rural Areas (2004) ........... 97

Table 6.2: The Expenditure Shares of Food, Energy and Other Commodities across

Different Expenditure Deciles of Rural and Urban Households ........................ 99

Table 6.3: The Income Shares of Factor Endowments Including Labour, Land and

Capital across Different Income Deciles of Rural and Urban Households ...... 100

Table 6.4: Sectors in Aggregated GTAP7 Dataset................................................... 105

Table 6.5: Factor Shares in GTAP7 Sectors ............................................................ 108

Table 6.6: The Final Demand, Import and Export Shares of Energy ...................... 109

Table 6.7: The COICOP-GTAP Transition Matrix.................................................. 111

Table 6.8: COICOP Consumption Shares by Purpose for Expenditure Deciles of

Rural Households .............................................................................................. 113

Table 6.9: COICOP Consumption Shares by Purpose for Expenditure Deciles of

Urban Households............................................................................................. 114

Table 6.10: Shares of Total Household Expenditure on the GTAP7 Aggregated

Commodities by Rural Households .................................................................. 115

Table 6.11: Shares of Total Household Expenditure on the GTAP7 Aggregated

Commodities by Urban Households ................................................................. 116

Table 6.12: Income Shares at Different Income Deciles of Rural Households by

Source of Income (COICOP) ............................................................................ 119

Table 6.13: Income Shares at Different Income Deciles of Urban Households by

Source of Income (COICOP) ............................................................................ 120

viii

Table 6.14: Shares of GTAP7 Endowments Based on both Rural and Urban

Households in Deciles ...................................................................................... 121

Table 6.15: GTAP7 and Iranian Consumption Subsidies (% ad valorem rate) ....... 123

Table 6.16: Pre-Shock and Post-Shock Values of Major GTAP7 Accounts ........... 124

Table 6.17: The Account of Production Activities in the 2004 SAM for Iran......... 126

Table 6.18: Primary Factors of Production in the GTAP7 Aggregated Commodities

.......................................................................................................................... 129

Table 6.19: Demand of the GTAP7 Aggregated Commodities by Domestic Agents

.......................................................................................................................... 130

Table 6.20: Government Income and Expenditure .................................................. 131

Table 7.1: Estimation of the Subsistence Consumption of Each Commodity by

Household Type in Rural Areas........................................................................ 143

Table 7.2: Estimation of the Subsistence Consumption of Each Commodity by

Household Type in Urban Areas ...................................................................... 144

Table 7.3: Estimation of the Marginal Expenditure Share of Each Commodity by


Table 7.4: Estimation of the Marginal Expenditure Share of Each Commodity by


Table 7.5: Income and Own Price Elasticities of the LES Demand by Rural

Household Type ................................................................................................ 150

Table 7.6: Income and Own Price Elasticities of the LES Demand by Urban

Household Type ................................................................................................ 151

Table 8.1: Subsidy Rates and Expenditure Shares of .............................................. 155

Table 8.2: Aggregate Effects of the Food Subsidy Reform ..................................... 156

Table 8.3: Real Return to Factors with Reforming .................................................. 158

Table 8.4: Change in Government Revenue ............................................................ 159

Table 8.5: Private Consumption Impacts of Food Subsidy Reform by Rural

Households in Deciles (% change in volume) .................................................. 162

Table 8.6: Private Consumption Impacts of Food Subsidy Reform by Urban


Table 8.7: Welfare Impacts of Food Subsidy Reform by Rural and Urban

Households in Deciles (Real % Change) .......................................................... 165

Table 8.8: Subsidy Rates and Consumption Shares of ............................................ 167

Table 8.9: Aggregate Effects of the Energy Subsidy Reform .................................. 168

Table 8.10: Real Return to Factors with Reforming ................................................ 169

Table 8.11: Change in Government Revenue .......................................................... 170

Table 8.12: Private Consumption Impacts of Energy Subsidy Reform by Rural


Table 8.13: Private Consumption Impacts of Energy Subsidy Reform by Urban


Table 8.14: Welfare Impacts of Energy Subsidy Reform by Rural and Urban

Households in Deciles (% change) ................................................................... 175

Table 8.15: Aggregate Effects of the Combined Subsidy Reform........................... 177

Table 8.16: Real Return to Factors with Reforming ................................................ 178

ix

Table 8.17: Change in Government Revenue .......................................................... 179

Table 8.18: Private Consumption Impacts of Subsidy Reform by Rural Households

in Deciles (% change in volume) ...................................................................... 181

Table 8.19: Private Consumption Impacts of Subsidy Reform by Urban Households

in Deciles (% change in volume) ...................................................................... 182

Table 8.20: Welfare Impacts of Combined Subsidy Reform by Rural and Urban

Households in Deciles (% change) ................................................................... 184

Table 8.21: Sensitivity Analysis of Welfare Change to Elasticities of Substitution

between Imported and Domestic Goods ........................................................... 186

Table 8.22: Sensitivity Analysis of Welfare Change to Elasticities of Substitution

between Primary Factors (Labour and Capital) ................................................ 188

Table 8.23: Sensitivity Analysis of Welfare Change to transformation between

outputs for domestic sale and export ................................................................ 190

Table 8.24: Sensitivity Analysis of Income Elasticities, % Changes in Households’

Welfare.............................................................................................................. 192

Table B.1: The average Gross Expenditure of Food and Non-Food Commodities

between Different Expenditure Deciles of rural households (COICOP), (rials)

.......................................................................................................................... 217

Table B.2: The Average Gross Expenditure of Food and Non-Food Commodities

between Different Expenditure Deciles of Urban Households (COICOP), (rials)

.......................................................................................................................... 218

Table B.3: Average Annual Income in 10 Income Groups of Rural Households by

Source of Income (rials) ................................................................................... 219

Table B.4: Average Annual Income in 10 Income Groups of Urban Households by

Source of Income (rials) ................................................................................... 220

Table C.1: Factor Income by Household Types (2004 US$ million) ...................... 221

Table C.2: Household Consumption Expenditures on the GTAP7 Aggregated

Commodities by ................................................................................................ 222

Table C.3: Household Consumption Expenditures on the GTAP7 Aggregated

Commodities by ................................................................................................ 223

Table D.1: Descriptive Data for Expenditure Shares of the Commodities by


Table D.2: Descriptive Data for Expenditure Shares of the Commodities by


x

List of Figures

Figure 4-1: Flow chart outlining steps in CGE modeling (Sánchez, 2004a) ............. 75

Figure 5-1: Regional Economic Structure (Rutherford, 2010) .................................. 81

Figure 5-2: The Production Function ......................................................................... 85

Figure 5-3: Armington Aggregation .......................................................................... 87

Figure 5-4: International Transportation Services ..................................................... 88

Figure 5-5: Private Consumption ............................................................................... 89

Figure 5-6: Public Consumption ................................................................................ 90

file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356361file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356362file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356363file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356364file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356365file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356366file:///C:/Users/mgharibnavaz/Desktop/Dissertation%20(Final%20Draft).docx%23_Toc348356367

1

Chapter 1. Introduction

1.1. Introduction

Almost every country, independent of its level of development, has government

plans to reallocate income, goods and services to the most vulnerable members of

society. Subsidizing the components of households’ basic basket of consumption

such as basic foodstuffs and energy commodities, leads to a deviation of prices paid

by consumers from market prices, a pervasive feature of developing and low-income

nations (International Monetary Fund, 2008a). However, consumption subsidy

schemes in many developing countries have been economically inefficient since their

benefits mostly leak to high-income households. In the case of food subsidy

programs, for instance, Adams (1998), Dutta and Ramaswami (2004) and,

Farajzadeh and Najafi (2004) argue that a large proportion of food subsidies in

developing countries accrue to rich people due to the lack of targeting. In addition,

energy subsidy programs result in an unnecessary burden on the public budget and

often benefit mainly higher income households.

Subsidy reform of agricultural commodities and key energy items has frequently

been one of the key policy recommendations proposed by some international

financial institutions, such as the World Bank, to developing and transition

economies. If the main purpose of food and energy subsidy programs in developing

countries is to improve the welfare levels of low-income households, there may be

more appropriate policies to protect them than consumption subsidies. For instance,

income transfers to the poor which are not as distortionary as consumption subsidies

can be considered as one alternative policy for food and energy subsidy reform in

these countries. In this context, most of developing countries have turned their

attention to the removal or reform of subsidy schemes in recent years in that these

alternative scenarios for subsidy schemes are presumably supposed to improve

economic efficiency.

Since Iran is abundantly endowed with large deposits of hydrocarbon fuels and

natural resources, the government has distributed a major portion of natural resource

assets through food and energy subsidies to the Iranian citizens. In 1996 the

government of Iran submitted its application to join the World Trade Organization

2

(WTO). To meet WTO obligations, the government has launched several market-

oriented reforms to deal with existing distortions such as heavily subsidized food and

petroleum products. Despite taking many socio-economic issues into consideration,

the topic of reforming food and energy subsidies in Iran has received a great deal of

attention during the last two decades. Generally, the government of Iran has put in

place socio-economic policies through five-year socio-economic development plans

so as to put the economic sectors on an appropriate growth path. The government of

Iran has committed itself to reforming public subsidies and continuing down the path

of targeting public subsidies on basic necessities and energy commodities termed the

most sweeping economic surgery in Iran.

However, the impacts of the elimination of food and energy subsidies on needy and

vulnerable households were a source of concern. In this respect, the government was

obliged to research and measure the socio-economic effects of targeting subsidies on

wheat, milk, rice, vegetable oil and cheese, sugar, medicine, fertilizer and energy

commodities including gas, electricity, gasoline, diesel, kerosene and fuel oil. This

chapter firstly points out critical research questions arising from food and energy

subsidy reform in Iran. Secondly, it illustrates the basic method used in this study to

evaluate the socio-economic effects of eliminating food and energy subsidies in Iran.

Finally, it provides an outline of the research to deal with the research questions.

1.2. The Research Questions

While many studies have employed partial and general equilibrium models to

evaluate the socio-economic impacts of consumption subsidy reform in Iran, no

studies have fairly analysed nationwide economic impacts of food and energy

subsidy reform in Iran on each economic agent in general, and on different income

groups of rural and urban households in particular. Since the impact of the

consumption subsidy reform on vulnerable households is a source of concern, this

study specifically attempts to evaluate the welfare impacts of subsidy policy reform

in Iran on 20 household types in rural and urban areas, grouped according to income.

It is anticipated that this study will identify both negative and positive outcomes of

the consumption subsidy reform on consumers, producers and the government in

3

Iran. Therefore, the core research questions that are expected to be answered in this

study are as follows:

1. What are the aggregate effects of the food and energy subsidy reform on

Iran’s economy?

2. How are returns to factors of production affected by the food and energy

subsidy reform in Iran?

3. How does the food and energy subsidy reform affect government revenue?

4. How does the food and energy subsidy reform affect households’ income and

expenditure?

1.3. The Basic Approach

To answer the main research questions, it is required first to analyse the existing

government policies related to consumption subsidy programs, and then offer

alternative scenarios for subsidy policy reform in Iran. Given the main research

objectives, alternative scenarios ranging from removing food and agricultural

subsidies to eliminating energy commodity subsidies are considered in this study. In

this research, the existing subsidy policy and its implementation in Iran is viewed as

a benchmark. Counterfactual results derived from alternative policy scenarios in this

study will be compared to the benchmark equilibrium. In this case, we analyse and

use the differences between the benchmark equilibrium activity of production

sectors, private households, government, and traded goods sectors, and their

counterparts in a counterfactual equilibrium so as to describe the simulation results.

For these purposes, this research uses the GTAP7inGAMS1 static Computable

General Equilibrium (CGE) model with 20 household types in rural and urban areas

as the core of its empirical framework to simulate the major effects of subsidy policy

reform on the (macro) economy of Iran in general and on households’ income

deciles in particular. Although a number of alternative methods, such as input-output

model, social accounting matrix and multi-market models can be employed to

evaluate this problem, the static CGE model used in this study has comprehensive

modelling features for analysing the welfare impacts of subsidy policy reform in

1- Thomas Rutherford (2010).

4

Iran. The model is calibrated using the GTAP data base version 72 which is a fully

documented and a consistent global data base representing the world economy for

2004. The 2001 input-output table, provided by the Statistical Centre of Iran (SCI),

along with some complementary tables were utilized to construct the Iranian input-

output table under the GTAP classification.

1.4. The Outline of Dissertation

The remainder of the dissertation which includes eight separate chapters proceeds as

follows. Chapter 2 reviews literature of basic concepts and details related to

definitions, types and measurements of subsidies. Chapter 2 also provides

background of government paid subsidies in Iran and the socio-economic debates

over government subsidies, along with a review of international experiences in

subsidy reform. Chapter 3 describes a general background of Iran’s economy,

including a brief history of Iran’s Five-Year development plans from the perspective

of reforming basic necessities and energy commodities’ subsidies, and reviews a

series of studies on the subject of structural reform in Iran, stressing generalized

subsidy reform. Chapter 4 provides the theoretical framework, methodology and

major justifications for employing the static CGE model in this research. This

chapter also reviews a number of important studies in Iran that have employed CGE

models so as to facilitate the development of an appropriate CGE model in this

study.

The structure of the GTAP7inGAMS static CGE model along with its equations and

equilibrium conditions as the core of the empirical framework to simulate the

welfare impacts of subsidy policy reform in Iran is presented in Chapter 5. Given the

main research goals, Chapter 6 provides a comprehensive description of the

necessary data employed in this research as well as their aggregations and

modifications. Chapter 7 focuses on the application of the most commonly used

functional forms in estimating own-price and income elasticities for modelling the

consumption block of the CGE model. This chapter also contains the estimation of

own-price and income elasticities across Iranian households by using the Urban and 2

- Hertel, T., R. McDougall, et al. (2009). "GTAP 7 Data Base Documentation-Chapter 14:

Behavioral parameters." access at https://www. gtap. agecon. purdue. edu/resources/download/4184.

pdf.

5

Rural Households Income and Expenditure Survey of 2004. Chapter 8 includes the

presentation of the effects of targeted subsidies reform on all economic agents in

general, and on different income groups of rural and urban households in particular.

Finally, the major findings are summarized and discussed in Chapter 9.

1.5. Summary of Principal Results

Since the main objective of this study is to evaluate a number of policy alternatives

for consumption subsidy reform in Iran, three main policy scenarios ranging from

eliminating food and agricultural subsidies to removing energy commodity subsidies

are analyzed here. The main findings of the model simulation show that consumption

subsidy reform causes a decrease in the private consumption and production of

subsidized commodities in Iran. The counterfactual results in the first scenario reveal

that the food subsidy reform leads to a decrease in the real return to mobile factors of

production. While results show that owners of Land specific to production of

subsidized food and agricultural commodities will experience a decrease in rents

after the removal of food subsidies, overall welfare rises by around 0.99 percent. The

food subsidy reform is found to be beneficial for all rural and urban household

deciles. In general, rural consumers experience larger welfare gains than urban

consumers, and poor consumers in both rural and urban areas gain relatively more

than wealthy consumers from the food subsidy reform.

In this study, the welfare effects of the elimination of energy subsidies are also

evaluated. Energy subsidies in Iran are much higher than food subsidies, and energy

goods account for a large share of consumption expenditures. While overall effects

are similar, welfare gains due to energy subsidy reform are much larger than from

food subsidy reform, almost 45 percent of base period welfare. In addition, rural

households gain relatively more than urban households from the energy subsidy

reform, and poor households in both rural and urban areas benefit relatively more

than rich households from energy subsidy reform. In all cases, income compensation

plays an important role in insulating consumers from the increase in food and energy

prices which accompany the subsidy reform programmes, particularly poor

consumers. Another important outcome of the counterfactual simulations in this

study is the government revenue effects of the consumption subsidy reform in Iran.

Findings suggest that the consumption subsidy reform leads to an increase in the

6

government tax revenue from private consumption. But since energy subsidy reform

leads to a large decrease in production of energy commodities, government rents

earned from ownership of natural resources specific to production of these energy

goods falls.

7

Chapter 2. Literature Review

2.1. Introduction

Throughout recent decades, the burden of food and energy subsidies on the public

budget in developing and transition economies has led economists and policy makers

to criticize subsidy programmes in these countries and to consider some reform in

food and energy subsidy schemes. Given that the main goal of this study is to

determine the effects of alternative consumption subsidy reforms on welfare of

different income groups of households in Iran, highlighting the socio-economic

debates and issues over government subsidies and reviewing international

experiences in subsidy reform is of high importance. Thus, the first section of this

chapter is devoted to a discussion of basic concepts and details related to definitions,

types and measurements of subsidies. This is followed by a description of

government paid subsidies in Iran, and the socio-economic debates over government

subsidies. Finally, this chapter closes with a review of international experiences in

subsidy reform.

2.2. Defining and Classifying Subsidies: Basic Concepts

2.2.1. The Definition of Subsidies: Conceptual Issues

Even though the term “subsidy” is extensively employed in economics, it is rarely

defined accurately (Alan O. Sykes, 2003). The more comprehensive definitions vary

between countries and organizations, and occasionally, between sectors and analysts

for given sectors. Thus, there is no explicit definition of a subsidy that is accepted

across the world. At the most basic level, a subsidy is a form of assistance resulting

from a government action that grants a benefit to consumers or producers, with the

intention of enhancing their income or lowering their costs, and where the benefits of

that support do not accrue to the whole population.

Subsidy is frequently applied as an antonym to a tax. It signifies a government

transfer of money to an entity in the private sector. It can be argued that tax

concessions are a form of subsidization. Indeed, for the relevant recipients it may not

make much difference whether they are made wealthier by receiving money or

8

through the reduction of their tax bill (World Trade Organization, 2006).

Furthermore, both forms of assistance correspond to fiscal transfers by the

government. On the other hand, border protection, such as tariffs, does not cause any

such financial transfer from the government, and instead brings about fiscal revenue.

Nevertheless, the enforcement of a tariff corresponds to a form of subsidization for

the import-competing sectors that are thus protected from foreign competition.

Defining subsidies in terms of government transfers or fiscal expenditure is thus not

complete. Principally, the basic difference between a subsidy and a transfer is the

consequence on prices. Fischer and Toman (1998) note that, unless they come in an

unconditional lump sum form that does not impact marginal production costs (such

as a start-up grant for a new company), subsidies vary the effective cost of a good. In

contrast, transfers are allocated without exchange of goods and services and, hence,

cannot directly have an impact on price levels.

An alternative procedure is to consider that a “subsidy” arises any time a government

programme benefits private actors. The major complexity with this method is that

recipients of, for example, a cash transfer or a tax concession, are not inevitably the

final beneficiaries of the policy. In their last effect, however, they are not different

from direct payments to construction companies. Correspondingly, the major

beneficiaries of subsidized intermediate goods might not be the recipients of the

subsidies, but rather downstream firms consuming these products as inputs in their

own production. Such indirect effects may or may not be intended by the

government. The more specifically designed a scheme, the more it is expected that

the intended recipient (objective) and the actual beneficiary (effect) coincide. But it

is not easy to propose well targeted programs (World Trade Organization, 2006).

The literature presents several examples of subsidy schemes that have unintended

side effects. Swaroop and Devarajan (1998) demonstrate how official development

assistance (ODA), although targeted at a specific project, might indirectly finance

other activities in cases where the government would have executed the related

project anyway. ODA has the effect of releasing government resources that can be

spent elsewhere. For example, Adams (2000) analyzes the likelihood that owing to

inappropriate targeting of inferior goods in the case of food subsidies to assist the

poor households, some part may be leaked to wealthier people, where they free up

9

funds for other uses. Numerous governmental services, such as road infrastructure,

are tax-financed by users, in this case through such levies as excise duties on cars

and road tolls. The provision of road infrastructure should thus not be reflected as a

subsidy in its entirety; however, it may include a factor of subsidization that is in

most cases complex to measure. A number of subsidy schemes even appear to be

planned in order to counterbalance distortions generated through other government

interventions. In several countries, for example, savings beneath a certain threshold

are exempt from taxes (World Trade Organization, 2006).

2.2.2. Characteristics of Subsidy Definitions

Rather than trying to pin down one explicit definition of subsidies, this section

reviews various characteristics of subsidy definitions employed in the literature or in

policy documents and analyses how various subsidy definitions make reference to

these characteristics. A large number of government schemes may be considered

subsidies in order to achieve their protectionist objectives, such as to increase

welfare of the lowest income rural and urban households. As World Trade

Organization (2006) noted, for simplicity, these plans can be classified into at least

three categories.

First, the government may transfer funds to producers or consumers, leading to direct

or potential budgetary expenditure. Direct transfers would fall into this category. An

example of a potential expenditure is the provision of loan guarantees. If a

government instructs a private institute to provide loans at preferential interest rates

to certain private entities, this would not result in government expenditure. Thus far,

this can be considered to be a government transfer as it would not have taken place

without the intervention of the government and it has similar consequences as if the

government itself had provided the loan at preferential rates.

Second, the government can supply goods or services below prevailing market price,

such as public transport, university education or key food items. Such transfers, in

addition, comprise costs for the government, with the difference being that recipients

receive in-kind grants as opposed to funds they can freely dispose of. Furthermore,

the public provision of goods or services like electricity can have intended or

10

unintended indirect effects. It can influence competition in industries that utilize the

relevant goods or services as an input, as it affects producers in a different way

depending on how intensively they employ the input.

Third, regulatory policies can be identified as subsidies if they cause transfers from

one entity to another. For instance, border protection allows for price discrimination

and the pooling of revenues to producers that are implicitly financed by domestic

consumers (Schluep & de Gorter, 2000). In this context, Cadot, Estevadeordal, and

Suwa-Eisenmann (2005) reveals that the regulatory instrument can circumvent forms

of direct subsidization, resulting in the same effects at higher welfare costs. This

category of transfers caused but not paid for by the government may also include

implicit subsidies due to the failure by governments to internalize externalities, such

as air pollution by industry, or rents associated with untaxed exploitation by private

parties of publicly-owned or managed resources.

2.2.3. Summary of Recent Definitions

There has been considerable controversy over how to describe a subsidy. In spite of

this debate, most recent theoretical definitions of subsidies closely have the same

view, such as that provided by De Moor, Calamai, and Council (1997) and restated

by Moor (2001, p. 168) as:

“Subsidies comprise all measures that keep prices for consumers below market

level or keep prices for producers above market level or that reduce costs for

consumers and producers by giving direct or indirect support”.

This is basically the same as the definition applied by the International Energy

Agency and the United Nations Environment Programme (United Nations

Environment Programme-Division of Technology, Industry and Economics, &

International Energy Agency, 2002). The most prevalent information on “subsidies”

is gathered in the UN National Accounts Statistics for which country data are

accessible worldwide. National Accounts Statistics (NACC) defines subsidies as

follows:

11

“Subsidies are current unrequited payments that government units make to

enterprises on the basis of the level of their production activities or the

quantities or values of the services which they produce, sell or import. They are

receivable by resident producers or importers” (Commission of the European

Communities - Eurostat, 1993 p. 214).

As World Trade Organization (2006) has argued, this subsidy definition is confined

to the first category of subsidies classified above and merely to one specific form of

intervention within this category. It exclusively comprises direct payments in its

definition and thus ignores transfers through tax breaks or soft loans. Moreover, this

definition is exceptionally explicit about the beneficiaries of subsidies. Transfers are

purely considered to be subsidies if they are allotted to producers, while transfers

made directly to households are identified as social benefits. Furthermore, recipients

of transfers are required to be inhabitants in the country whose government is

providing the transfer, in order for the transfer to be considered a subsidy.

The Eurostat (1979) reports the following definition in paragraph 421:

“Subsidies are current transfers which general government or the Institutions of

the European Community make as a matter of economic and social policy to

resident units producing or importing goods and market services with the

objective of influencing their prices and/or making it possible for factors of

production to receive an adequate remuneration”.

The United Nations (1968, p. 237) gives the following definition of subsidies:

“All grants on current account made by government to private industries and

public corporations, and grants made by the public authorities to government

enterprises in compensation for operating losses when these losses are clearly

the consequence of the policy of the government to maintain prices at a level

below costs of production”.

Most definitions of subsidies in statistical sources are rather explicit as to whether or

not they include each of the three subsidy categories distinguished above. However,

12

within these categories, an impressive range of various instruments are accessible to

governments to confer subsidies. Many subsidy definitions do not comprise all of the

feasible instruments within one category because they define the term subsidy along

other lines. In reality, subsidy definitions have a propensity to make reference to one

of the following characteristics of government interventions in order to confine the

concept of subsidies: the beneficiaries of subsidies, the form of subsidies, their

objectives and their effect (World Trade Organization, 2006).

As a general rule, subsidy definitions have often distinguished between two

categories of recipients: producers and consumers. Moreover, they create explicit

reference to the nationality of individuals, namely, by distinguishing between

domestic and foreign beneficiaries. As Guiyang (2007) has argued, a subsidy is a

widely-used technique for governments to put forth policy intervention. By applying

subsidy policies the government ensures that consumers face a lower commodity

price than the market level, or that producers realize a higher production price than

the market level. In other words, the nature of a subsidy is that the government gives

a benefit to consumers or producers by direct or indirect means to curtail cost and

enhance income, so as to realize various policy objectives.

2.3. Subsidies: Types and Measurements

There are at least three convincing arguments for analyzing various types and

behaviours of government subsidies. First, subsidies are a major existing mechanism

for implementing government expenditure policy. Second, subsidies can influence

domestic resource allocation decisions, expenditure productivity, income

distribution, and by decreasing the flexibility of the domestic economy, they possibly

have an effect on structural and sectoral adjustment. Third, subsidies are very likely

to be a major instrument resulting in the proliferation of multilateral and bilateral

arrangements and increased international cooperation, through trade, that creates

issues concerning the extent to which resource allocation, on an international level, is

distorted by government subsidies, since they are affecting competitiveness

(Schwartz & Clements, 1999).

13

2.3.1. Subsidy Types

Subsidies can be classified according to various criteria. Government subsidies can

be separated into funds and policy subsidies, consistent with the difference of

subsidy modality. Government subsidies, in terms of transparency of policy, also can

be sorted into explicit and implicit subsidies. Government subsidies relying on

explicit expenditure of government funds can be identified as explicit subsidies. For

instance, a government may sell a production factor to producers at less than their

cost of production or offer credit for purchasing an input at below-market interest

rates. In both cases government funds are being employed to decrease the cost of the

production factors for producers. Furthermore, the cost of production of factors to

producers can be reduced by allowing of imports at preferential exchange rates.

These subsidies which indirectly contribute to reducing the cost of factors of

production are called implicit subsidies (Guiyang, 2007).

Riedy (2003) believes that there is a difference between financial subsidies and

subsidies related to externalities. Financial subsidies generally arise within the

existing economic structure and have a tendency to reduce the cost of production

and/or consumption, thereby enhancing the activity level of individuals involved in

the activities that are subsidized by government. By definition, externalities are the

uncompensated impact of entities’ actions resulting in costs and benefits that are not

clearly included by the market. Subsidies associated with externalities result from the

historical development of the economic system, whereas financial subsidies appear

from government intervention.

Moor (2001) suggests a pragmatic pattern for identifying subsidies that breaks up

subsidies into the following categories derived from the form of implementation:

i. Budgetary subsidies, including direct expenditure and tax expenditure;

ii. Public provision of goods and services below cost;

iii. Capital cost subsidies; and

iv. Policies that create transfers through the market mechanism.

14

Schwartz and Clements (1999, p. 120) present a classification of government

subsidies according to the following seven types:

1. “Direct government payments to producers or consumers (cash subsidies

or cash grants);

2. Government guarantees, interest subsidies to enterprises, or soft loans, it

signifies, low-interest government loans (credit subsidies);

3. Reduction of specific tax liabilities (tax subsidies);

4. Government equity participations (equity subsidies);

5. Government provision of goods and services at below prevailing market

prices (in-kind subsidies);

6. Government purchases of goods and services at above-market prices

(procurement subsidies);

7. Implicit payments through government regulatory actions that alter

market prices or access (regulatory subsidies)”.

2.3.2. Measuring Subsidies

As already argued, defining and measuring consumers’ and producers’ subsidies is

quite challenging. The prime objective of measuring subsidies is to understand the

scope of the government subsidy implied by a particular user charge. Theoretically,

there are numerous approaches by which subsidies can be measured, depending on

the objective for which the measurement is being conducted, each having its

advantages and weak points. Even though the most evident starting point in the

measurement of subsidies would be an analysis of gross budgetary outlays, fiscal

reports only reveal direct subsidies. In reality, most support is transmitted off-budget

(Schwartz & Clements, 1999).

Revealing the comprehensive scope of indirect subsidy policies is encumbered by

the fact that governments habitually do not maintain records of off-budget support.

Even when such statistics associated with government subsidies are accessible,

divergences in different governments’ views of what counts as a subsidy and should,

hence, be included in subsidy measurement methodologies are widespread,

15

weakening comparisons of international or sub-national subsidy statistics (Moor,

2001).

Subsidies conceptually can be measured in projected current prices or at constant

prices. When subsidy measurement is combined with the economic analysis of a

project, it can most easily be undertaken in constant prices, integrating any changes

in relative prices that the economic analysis embraces.

A conventional technique to measure different types of subsidies is Producer or

Consumer Subsidy Equivalent (PSEs and CSEs). These can easily be measured

either on a gross or net basis, and grant equivalents. This method includes five

categories of support: market price support, direct payments, reduction in input costs,

general services and other indirect support (De Moor, et al., 1997). Despite the fact

that the PSE and CSE technique has several advantages, it does not measure all

forms of subsidy plans. The PSE method was derived from current levels of

production, consumption, trade and world prices, thereby excluding any government

support that would change output levels in the future.

Because of such exclusions and restrictions associated with the PSE and CSE

method, during 1998, substantial endeavours towards measurement uniformity were

made by the OECD that changed the PSE and CSE measurement, relabeling it the

“Producer or Consumer Support Estimate”. The name alteration reflected the fact

that the producer or consumer ‘subsidy equivalent’ was defined by the OECD as “the

lump sum payment which would leave producers or consumers as well off as they

are at present in the absence of current policies”. The OECD (2005, p. 18)

stocktaking of sectoral support established five principal procedures measuring

government subsidies which can be classified on the basis of the following types:

1. “Programme aggregation: adding up the budgetary transfers of relevant

government schemes; in most cases data are at the national rather than the

sub-national level.

2. Price-gap: measuring the difference between the world and domestic

market prices of the product in question.

16

3. Producer or consumer support estimate: measuring the budgetary

transfers and price gaps under relevant government programmes

influencing production and consumption equally.

4. Resource rent: measuring the resource rent predetermined for natural

resources.

5. Marginal social cost: measuring the difference between the price actually

charged and the marginal social cost.”

As a general rule, two fundamental organising schemes have been employed by

analysts in subsidy measurement: sectoral subsidy accounts, which have relevance to

a specific product, industry or sector; and comprehensive accounting systems

(exemplified by the System of National Accounts). National accounts can be

extremely advantageous for pursuing government expenditure. Moreover, national

accounts present gross data and are not appropriate when taking into account feasible

cost recovery through consumer charges or a different mechanism (OECD, 2005).

The inability of national accounts for providing analytical objectives would be a

paramount justification for the use of compound indices of support, and of sectoral

subsidy accounts. In fact, economic institutions and analysts take sectoral subsidy

accounts into consideration when they define and measure government subsidy data.

Sectoral subsidy accounts exclude non-specific subsidies, such as non-targeted tax

credits designed to stimulate investment, which may have a consequence on the

distribution of resources within an economy. This has come to be known as a major

limitation of sectoral subsidy accounts.

2.4. Background of Government Paid Subsidies in Iran

The Iranian citizens, as those of other oil-rich nations, have benefited from subsidy

policies by purchasing heavily subsidized food and energy commodities for decades.

Providing vulnerable households with appropriate living conditions, redressing

inequalities in income distribution as well as increasing public welfare have

generally been the main socio-economic objectives of subsidy policies. Thus, it is

necessary to highlight how government paid subsidies have been distributed among

socio-economic sectors in general, and different income levels of the rural and urban

17

households in particular. In this section, the classification as well as an overview of

the trend and size of government paid subsidies in Iran will be discussed.

2.4.1. An Overview of the Trend and Size of Subsidies in Iran

Since Iran is abundantly endowed with large deposits of hydrocarbon fuels and

natural resources, the government faces many choices to guarantee that all

households can benefit from government expenditures. Subsidy policies, which are a

major part of the social safety net programmes in the country, aim to distribute a

major portion of natural resource assets in the most direct way to the needy. Table

2.1 reports the trend of government paid subsidies and their share of some macro-

economic variables within Iran during 1973-2003.

As is evident from Table 2.1, subsidies paid for essential food and energy

commodities have progressively grown from 7.3 to 28,800 billion rials3 over the

period. Although, per capita subsidies at current prices have increased over the

period, real per capita subsidies have been less as a result of high inflation during the

period. In fact, subsidy policies have been less effective in achieving socio-economic

objectives since the government has been incapable of controlling the inflation rate.

Per capita subsidies under fixed prices have increased from 3377 rials to 33,642 rials

during 1973-2003 which means there has been a tenfold increase in the amount of

paid per capita subsidies at fixed prices (Shirkavand, 2004). Moreover, subsidies as a

share of GDP and the government budget have increased from 0.42 to 2.6 percent

and from 1.4 to 7.9 percent respectively. The ratio of subsidies to total taxes has

substantially increased from 5.5 to 44.4 percent over the period.

3- The rial is the currency of Iran. In 2004, the average exchange rate with the $U.S. was $1 = 8350

rials

http://en.wikipedia.org/wiki/Iran

18

Table 2.1: The Trend of Paid Subsidies and the Ratio of Subsidies to Some Macro

Economic Variables within Iran’s Economy (1973-2003).

Year Total Subsidies

(billion rials)

Government

Budget

(billion rials)

Ratio of

Subsidies to

Government

Budget (%)

Ratio of

Subsidies to

Tax Revenues

(%)

Ratio of

Subsidies to

GDP (%)

1973 7.3 531.4 1.4 5.5 0.7

1974 64.0 1174.4 5.4 40.7 2.2

1975 117.1 1496.2 7.8 43.3 3.6

1976 84.0 1675.4 5.0 24.5 1.9

1977 65.8 2174.9 3.0 14.8 1.3

1978 42.6 2044.2 2.1 9.1 0.9

1979 79.2 2018.2 3.9 21.5 1.3

1980 73.3 2249.3 1.7 11.0 0.6

1981 81.3 2707.1 3.0 14.7 1.1

1982 109.7 3166.3 4.1 17.9 1.1

1983 106.1 3671.7 3.5 13.3 0.9

1984 102.2 3353.6 2.9 13.4 0.9

1985 116.4 3313.6 3.6 11.3 0.8

1986 127.1 3156.8 4.0 12.4 0.9

1987 104.5 3640.6 2.9 10.2 0.6

1988 90.6 4210.6 2.2 9.2 0.5

1989 162.5 4316.7 3.8 13.7 0.7

1990 403.9 6051.1 6.7 23.8 1.2

1991 514.9 8090.9 6.4 18.6 1.1

1992 1063.8 10756.8 9.9 27.7 1.6

1993 2337.7 20886.9 11.2 52.3 2.1

1994 3686.1 28912.4 12.7 67.1 2.8

1995 4895.1 41330.9 11.8 66.9 2.6

1996 5506.0 56783.1 9.7 44.6 2.3

1997 5085.3 65438.0 7.8 29.3 1.7

1998 5806.1 7097.3 8.2 31.1 1.8

1999 7071.2 93160.8 7.6 27.4 1.6

2000 8898.1 108316.2 8.2 25.3 1.5

2001 10011.9 131883.0 7.6 23.9 1.5

2002 21527.3 229963.0 9.4 42.6 2.4

2003 28875.2 367261.0 7.9 44.4 2.6

Sources: Central Bank of Islamic Republic of Iran, the Consumers and Producers’ Protection

Organization, Iran’s annual budget.

19

2.4.2. Classification of subsidies in Iran

The classification of government paid subsidies can be helpful in analysing sources

and uses of the government budget for subsidy reform purposes. For the sake of

simplicity, in the following sections paid subsidies through governmental

organizations will be broken down into three major groups:

i. Consumption, production and services subsidies,

ii. Explicit subsidies

iii. Implicit subsidies

Table 2.2 reports consumption, production and services subsidies in Iran over the

period 1976-2002. The share of consumption subsidies has been more than 50

percent over the entire period and has grown to 92 percent during the period,

remaining above 90 percent over last 9 years of the period. Production subsidies in

Iran have been widespread. Although the share of production subsidies has dropped

considerably from 57 to 6 percent over the period, production sectors have been

protected by the government through tax concessions, the exemption of commercial

profits and customs duties, as well as the restriction of similar imported goods. The

government also paid services subsidies to public services in urban areas. However,

the share of services subsidies has fallen from 12.9 to 1.8 percent during this period.

Subsidies take two general forms: explicit subsidies which are referred to as direct or

fiscal subsidies and implicit subsidies which are often referred to as indirect or quasi-

fiscal subsidies (International Monetary Fund, 2008b). Explicit subsidies which are

provided from the government budget are typically apparent and uncomplicated to

either identify or estimate. Explicit subsidies provide suppliers of goods or services

with direct co-payments from the government’s budget and consequently increase

consumer purchasing power by decreasing real prices of subsidized goods and

services. Explicit subsidies in Iran consist of financial support to households for a

number of essential items such as wheat, sugar, milk and cheese, and medicines, as

well as imported staple foods. Both the Central Bank of Iran and the Consumers and

Producers’ Protection Organization reported that explicit subsidies, which amount to

20

about 6 percent of GDP4, have remained relatively steady in recent years, apart from

imported gasoline subsidies which have consistently grown. Table 2.35

shows

explicit subsidies paid through the Consumer and Producer Protection Organization

for the period of 1999–2004/05.

Table 2.2: Consumption, Production and Services Subsidies during 1976-2002 in

Iran (in billions of rials)

Year Production Subsidies

Consumption

Subsidies

Services

Subsidies

Total

Subsidies

Agriculture Industry Total Percent Sum Percent Sum Percent

1976 2.0 2.0 57.1 1.5 42.9 3.5

1977 10.0 10.0 15.2 55.8 84.8 65.8

1978 4.1 4.1 9.6 38.5 90.4 42.6

1979 7.6 7.6 9.6 71.7 90.4 79.3

1980 14.6 14.6 39.0 22.8 61.0 37.4

1981 27.6 27.6 33.9 53.7 66.1 81.3

1982 27.7 4.0 31.7 28.9 63.8 58.2 14.2 12.9 109.7

1983 29.7 29.7 28.0 63.6 59.9 12.8 12.1 106.1

1984 29.7 29.7 24.7 80.6 67.1 9.9 8.2 120.2

1985 23.7 0.5 24.2 20.8 82.3 70.7 9.9 8.5 116.4

1986 25.0 0.2 25.2 19.8 97.2 76.5 4.7 3.7 127.1

1987 24.8 3.0 27.8 26.6 75.0 71.8 1.7 1.6 104.5

1988 25.0 25.0 27.6 59.8 66.0 5.8 6.4 90.6

1989 41.1 20.0 61.1 37.6 96.3 59.3 5.1 3.1 162.5

1990 103.5 11.3 114.8 28.4 258.0 63.9 31.1 7.7 403.9

1991 116.9 11.3 128.2 24.9 361.2 70.1 25.5 5.0 514.9

1992 167.3 167.3 15.7 796.3 74.8 100.3 9.4 1063.9

1993 368.4 368.4 17.3 1562.2 73.5 194.0 9.1 2124.6

1994 553.2 553.2 15.0 3127.4 84.8 5.7 0.2 3686.3

1995 654.9 654.9 13.4 4222.0 86.2 18.3 0.4 4895.2

1996 597.5 597.5 10.7 4997.0 89.1 11.6 0.2 5606.1

1997 601.8 601.8 11.8 4466.0 87.8 17.5 0.3 5085.3

1998 516.7 516.7 8.9 5266.6 90.7 22.8 0.4 5806.1

1999 605.1 605.1 8.8 6232.6 90.6 43.6 0.6 6881.3

2000 780.0 780.0 9.8 7645.2 89.2 57.8 1.0 7920.0

2001 891.0 891.0 8.9 8922.4 89.1 198.4 2.0 10011.8

2002 784.8 784.8 6.2 11709.9 92.0 228.0 1.8 12722.7

Sources: The Consumers and Producers’ Protection Organization, Iran’s annual budget.

As is evident from Table 2.3, wheat has received the major proportion of explicit

subsidies, accounting for an estimated 51 percent of total explicit subsidies in 2004.

It is worth noting that since the country had been faced with high inflation during

2002-2003, the government made an effort to compensate consumers for the adverse

4- IMF Country Report No. 06/154, April 2006

5- The table obtained from Iran’s Balance Sheet (2004/05)

21

effects of the inflation through subsidizing some essential food commodities, such as

wheat, milk and sugar, aimed at providing lower income households with cheap and

affordable food. Milk subsidies grew steadily until 2004, as the government decided

to increase the share of milk subsidy in the government budget for nutritional

reasons, providing the truly needy with adequate rich dairy products in particular

(Permeh, 2005a). Thus, Iranian households have witnessed a considerable increase in

the size of milk subsidy, from 468 to 1743 billion rials over the period of 2002-2004,

and the government paid subsidy on cheese more than doubled from the late 1990s to

2004. While vegetable oil, rice and sugar had not received considerable subsidies

until 2002, the amount of government paid subsidies on these commodities jumped

to 3622.90 billion rials in 2004, representing 13.2 percent of total explicit subsidies,

of which 2438 billion rials accrued to sugar, and vegetable oil and rice received the

rest. Subsidies on medicine, powdered milk and hygienic products followed a similar

trend. The share of meat subsidy was not significant, amounted to 1.8 percent of total

explicit subsidies in 2004.

According to the World Bank (2008) , the government of Iran is ranked first among

Middle East and North African (MENA) nations in terms of subsidizing food

commodities as a share of GDP, followed by Syria, Egypt and Jordan. Looking at

food subsidies as a share of total government expenditure in MENA regions gives a

similar depiction compared to subsidies as a share of GDP. However food subsidies

as a share of government expenditure were much more significant for Iran,

attributable to the low government expenditure share by MENA standards. Table 2.4

shows how subsidies paid through the Consumer and Producer Protection

Organization, and the other subsidies, as share of GDP have changed over the period

2000-07 in Iran. According to the summary results, the share of fertilizer, sugar and

dairy subsidies have followed similar trends during 2000-2007. Wheat has received

the main share of explicit subsidies in comparison with other subsidized

commodities during 2000-07.

22

Table 2.3: Subsidies Paid through the Consumer and Producer Protection

Organization, 1999-2004/05 (in billions of rials)

Subsidy on

1999

2000

2001

2002

2003

2004

2004

%

Change

Share

of total

Chemical fertilizers 470.7 543.1 428.4 555.0 560.9 650.0 15.9 2.4

Purchase of wheat 5200.0 5835.0 6818.7 10060.5 11788.1 14048.8 19.2 51.0

Cheese 189.6 193.0 247.4 196.9 357.5 514.3 43.9 1.9

Milk 291.0 200.0 542.0 468.4 922.5 1743.2 89.0 6.3

Rice, oil, sugar and

cube sugar

118.5 160.0 439.0 4.5 806.3 3622.9 349.3 13.2

Meat 335.0 323.6 328.2 298.5 415.0 504.0 21.5 1.8

Foodstuff for armed

forces

100.0 100.0 110.0 121.0 10.0 0.4

Livestock drugs and

vaccine

13.5 12.5 20.0 21.1 17.0 38.6 127.2 0.1

Freight charges of

rural ration goods

21.4 31.8 41.0 185.4 301.0 320.0 6.3 1.2

Support for book

publishing

28.5 35.0 45.0 49.5 54.0 9.1 0.2

Detergents 45.2 71.0 69.9 61.0 214.1 318.3 48.7 1.2

Paper 15.3 16.6 30.0 0.0 121.5 479.1 294.3 1.7

Pesticides and seed 58.9 58.0 100.0 72.5 89.1 100.0 12.2 0.4

Exchange rate

differential for Hadj

pilgrims

348.7

Basij Committee

expenses

8.2 4.0

Special expenditures

of the Basij

Committee of

provinces

14.0 20.0

Insurance charges of

agricultural products

62.0 75.0

Tea 38.0

Medicine, powdered

milk and hygienic

products

231.2 259.0 213.0 201.7 2440.0 2261.6 -7.3 8.2

Rice, oil, tea,

cheese, poultry and

allowance to

theologians (3)

227.8 279.0 60.7 100.0 64.8 0.4

Sale of subway

tickets

28.5

Tuba Project 211.4 214.6 228.0 384.0 346.0 -9.9 1.3

Others 232.9 76.0 0.0 20.0 187.3 1660.2 6.0

Note 5 of Budget

Law for 1380 and

1381 and Article 46

of 3rd

Plan Law (4)

272.0 584.5 354.9 498.3 656.3 31.7 2.4

Total 7694.1 8390.5 10468.0 13152.4 19322.8 27538.4 42.5 100.0

Source: Ministry of Economic Affairs and Finance and Consumers and Producers Protection

Organization.

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Table 2.4: Explicit Subsidies Paid Through the Consumer and Producer Protection

Organization, and Other Subsidies, as Share of GDP, 2000/01–2006/07. 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07

Fertilizer 0.1 0.1 0.1 0.1 0.1 0.4 ……..

Sugar 0.1 0.1 0.1 0.1 0.2 0.2 ……...

Wheat 1.0 1.0 1.1 1,1 1.0 1.4 ……...

Milk and cheese 0.1 0.1 0.1 0.1 0.2 0.2 ……...

Rice and

vegetable oil 0.1 0.2 ……...

Other food

subsidies 0.1 0.2 0.1 0.2 0.2 0.4 ……...

Total food

subsidies 1.4 1.5 1.4 1.5 1.8 2.9 2.8

Other subsidies ……... ……... 1.4 1.5 1.2 0.3 0.1

Total subsidies ……... ……... 2.8 3.0 3.0 3.1 3.0

Sources: Central Bank of Islamic Republic of Iran; and the Consumer and Producer Protection

Organization.

Implicit subsidies (often referred to as indirect or quasi-fiscal subsidies) are defined

as the difference between a premium price charged to a specific group of households

for a particular benefit and the estimated price that would have to be applicable to

those households. According to International Monetary Fund (2008a), government

control of interest rates, prices and the exchange rate, in addition to specified

regulations such as production quotas, are the most widely employed methods giving

rise to implicit subsidies. Implicit subsidies which do not involve cash transfers are

typically less transparent, and hence highly complicated to estimate, and more

inflexible to remove than explicit subsidies. In general, implicit subsidies which

dwarf explicit subsidies in Iran are concentrated in the energy sector.

Iranian consumers of energy commodities rely heavily on implicit subsidies which

have been increased progressively in the past few decades. Petroleum products6, gas

and electricity have been subsidized implicitly through administrative controls in

Iran with the main purpose of protecting low-income households. According to

International Monetary Fund (2007b), implicit subsidies to energy commodities in

Iran are estimated at more than 15 percent of GDP, derived from border prices of

hydrocarbon fuels. In 2004, total energy subsidies stood at about 187761 billion

6- Petroleum products include gasoline, diesel, kerosene, and fuel oil.

24

rials, of which more than 70 percent was allocated to petroleum products. The

remaining 30 percent was equally shared between gas and electricity subsidies. Table

2.5 shows summary data on energy subsidies over 1995-2006, indicating that the

average domestic value of these commodities amounted to about 17 percent of their

market prices over the period. More specifically, the domestic sales of energy

commodities in 2004 accounted for an estimated 19 percent of the market values.

While government subsidies on petroleum products have increased steadily from

1995 to 2003, the amount of subsidies increased dramatically in 2004, to 151768

billion rials, and doubled again from 2004 to 2006. Trends in gas and electricity

subsidies followed a similar pattern, particularly over 2002- 2006.

Energy subsidies have been distributed disproportionately among Iran’s socio-

economic sectors. Table 2.6 provides the data on the share of support derived by

each sector from energy subsidies. Residential and transport sectors has received

significant shares of energy subsidies over 2003-2006. For instance the average share

of residential and transport sectors from total energy subsidies stood at about 30 and

38 percent respectively over the period. In contrast, agriculture, commercial and

public sectors have received small shares of the subsidies, accounted for an averaged

7, 3.7 and 5 percent respectively. Although the major objective of providing energy

commodities at lower prices to the residential sector is to increase the purchasing

power of households’ disposal income and to retain a minimum level of welfare for

the truly needy segment of the population, the existing subsidies on energy

commodities in Iran do not differentiate between low and high income groups.

25

Table 2.5: Rates and Amounts of Energy Subsidies by Fuels in Iran (in million rials per year)

Subsidy

Rate (%) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Liquid

Gas 0.90 0.94 0.95 0.97 0.98 0.98 0.98 0.98 0.98 0.98 0.99 0.99

Gasoline 0.62 0.73 0.60 0.76 0.74 0.79 0.70 0.93 0.62 0.69 0.77 0.79

Kerosene 0.92 0.95 0.93 0.92 0.92 0.93 0.90 0.91 0.90 0.94 0.96 0.96

Diesel 0.92 0.94 0.93 0.92 0.91 0.93 0.90 0.91 0.90 0.94 0.96 0.96

Fuel Oil 0.90 0.95 0.94 0.94 0.96 0.96 0.95 0.95 0.95 0.95 0.97 0.98

Natural

Gas 0.82 0.87 0.86 0.91 0.87 0.87 0.85 0.83 0.83 0.83 0.83 0.87

Electricity 0.48 0.65 0.72 0.81 0.77 0.75 0.72 0.67 0.64 0.62 0.62 0.72

Paid

Subsidies 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Liquid

Gas 395978 813212 1263913 2037943 3507817 5409593 4054551 5075152 4964232 6472060 8395299 10168008

Gasoline 1814177 4178327 5862657 8560538 13739641 22211245 14317114 17576242 21982177 40109998 66584830 82370823

Kerosene 2413776 5752161 5554200 6703909 10488302 13953195 10151823 11547990 11452309 19991383 28242230 30708362

Diesel 4834649 10704706 11992477 14220365 22468950 33798327 27455074 33761375 37083895 66609572 101815288 128524307

Fuel Oil 1361589 4347079 5415026 6116967 10935620 14969198 13275987 15729592 15288321 18584739 32329213 40095698

Natural

Gas 2579653 5322237 8856528 17683628 19383725 20483219 21606434 24077357 27818547 32590404 34734024 53271324

Electricity 2463442 6123301 10785645 22643165 23434132 24331521 25107782 25458515 27561831 31267614 33115613 57246798

Sum 15863264 37241023 49730446 77966515 103958187 135156298 115968765 133226223 146151312 215625770 305216497 402385320

Source: IIEA (Institute for International Energy Studies) Statistical Data Bank, Affiliated to Ministry of Petroleum and thesis calculations.

26

Table 2.6: The Share of Iran’s Socio-Economic Sectors from

Energy Subsidies (%)

Sectors 2003 2004 2005 2006

Residential 31.64 29.9 33.7 25.7

Industrial 15.72 13 19.1 16

Agriculture 7.8 7.7 6.3 7.3

Transport 35.5 41.8 31.7 42.7

Commercial 4.22 3.3 4.2 3

Public 5.03 4.4 4.9 5.2

Sum 100 100 100 100

Source: Ministry of Energy, Energy Balance Sheet for different years.

2.5. The Socio-Economic Debates over Government Subsidies

2.5.1. The Economic Issues over Subsidies

A detailed analysis of the economic debate over state subsidies must address theoretical

issues surrounding generalized subsidies offered by governments to assist consumers,

producers and other socio-economic activities. As a general rule, the initial point in

economic research is a benchmark economy where markets are characterized as

perfectly competitive.7 Theoretically, no government intervention can be offered as a

subsidy based on the assumptions of a perfectly competitive market. As stated in “The

Economics of Subsidies”, with perfectly competitive markets, offering a government

support or specifically planning a subsidy will be inefficient and also welfare-

diminishing (World Trade Organization, 2006, p. 55). However, under any

circumstances where the assumption of perfectly competitive markets is relaxed,

situations may exist where government interference like a generalized subsidy improves

the level of welfare between the most vulnerable members of society. An efficient

7- According to World Trade Report (2006, p. 55), “perfectly competitive markets exist with costless and

free entry and exit by firms, homogenous products, constant returns to scale, the absence of any

possibility for individual producers or consumers to affect prices, and the possession of full information

on the part of consumers and producers. In practice, of course, these conditions rarely, if ever, exist.”

27

subsidy scheme would also be capable of rectifying a market failure, bring

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