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The Price of Petrol: Getting It Right
Thorvaldur Gylfason[*]
Subsidized energy is not an efficient form of social protection, for two main reasons. First, selling domestically produced energy at home at a lower price than could be fetched in foreign markets deprives the producers of the energy of revenues they could earn abroad and expend at home, and thereby reduces national income below potential. Second, artificially inexpensive energy discourages enterprises and people from conserving energy, thereby inviting waste. A tax on petrol aimed at bringing its price at the pump closer to world market prices could be used to raise revenue to finance more efficient forms of social protection by improving education, health care, and infrastructure. Nigeria would benefit from such a tax, as would the United States.
It is understandably tempting for oil-producing countries to supply their citizens with inexpensive fuel. So this is actually what most of them choose to do. Even so, this is an expensive practice because the fuel that is sold at cost price at home could alternatively be sold abroad at the usually much higher world market price. This means that selling fuel at cost price at home rather than at the world market price is tantamount to a subsidy on fuel.
The problem with such a subsidy is that it is arbitrary and discriminatory, and thus invites waste: it leads to excessive burning of fuel, too much traffic, and so forth, thereby discriminating against other things which the recipients of the subsidy might have preferred had the subsidy been paid out in cash rather than in kind in the form of cheap fuel. This is why Russia, for example, has made great strides to bring the domestic price of petrol, which was only one-seventh of the world market price a few years ago, closer to the world market price. This is also why Saudi-Arabia some time ago decided to double the domestic price of petrol. And this is also why the Nigerian government has, reluctantly, taken steps in the same – right! – direction.
Allowing the price of fuel to follow the forces of demand and supply and adjust towards the world market price is equivalent to a reduction in the indirect subsidy on fuel. In practice, this may mean a local tax on petrol in order to bring its domestic price at the pump closer to the world market price. If the tax proceeds are returned to the public (for example, in the form of a lower general sales tax or value added tax), this means that the selective fuel subsidy has been replaced by an equivalent general cash subsidy. This is an ideal solution because it allows the recipients of the subsidy to decide for themselves how to make the most of the subsidy.
If the tax proceeds are instead used to bolster the education system, this means that the fuel subsidy is replaced by a subsidy to education. If they are used to improve health care and hospital services, then this means that the fuel subsidy is replaced by a subsidy to health services, and so on. In Nigeria, the proceeds from increased levies on petrol have been channeled through the Petroleum Trust Fund to finance infrastructure (water, electricity, etc.). The possibilities are endless.
A reasonable compromise solution would involve a combination of alternative uses of the proceeds from reducing and ultimately eliminating the indirect subsidy on fuel. Most people want the price of petrol to be as low as possible, it is true, but they also want more and better public services, including clean air and uncongested roads.
Selective consumption subsidies, especially when they are indirect or hidden, are generally not an effective form of social protection. There is almost always a better (that is, less costly) way to achieve the same social objectives – through taxes and transfers, for instance. Hidden subsidies tend to be especially costly from a social point of view precisely because their cost does not appear anywhere in the government budget. Like other aspects of economic policy, taxes and subsidies need to be transparent. A lack of transparency tends to perpetuate inefficiency.
In Nigeria, the social cost of the indirect fuel subsidy has been compounded by the breakdown of some of the country’s oil-refining capacity, which has led to persistent shortages of petrol. This means that for those patient, lucky, or well-connected enough to be able to fill the tank of their car, the price per litre is now65naira (roughly 50 US cents) plus the time and effort it takes to get the petrol. Others pay a higher price in the curb market. Still others do not drive at all for lack of petrol. As always when petrol is scarce, some drive too much while others drive too little.
This is not an efficient way of organizing the market for petrol, or any market for that matter. The government should not be in the business of fixing prices of individual commodities, for this is what free markets do best. Therein lies the superior efficiency of a market economy compared with alternative ways of organizing economic activity. The market for petrol is no exception from this general rule.
In Lagos, the social cost of the present arrangement of the petroleum product market seems especially high when traffic congestion and the time it takes from more useful activity are taken into account. It does not have to be that way. For example, in Accra – a smaller city, yes, but still – where petrol is somewhat more expensive than in Lagos, traffic congestion is much less severe. True, a higher price of petrol would impose increased hardship on some. Over the long haul, however, a higher price of petrol would induce people to work closer to home or live closer to work. And look at the bright side: less congestion means less waste, more efficiency, better business, and more rapid economic growth as time passes.
Social protection is an essential ingredient of growth-friendly policy reforms. For one thing, social insurance and health care reduce the need for population growth, thereby enabling families to offer each of their children better opportunities through better education and health care. Subsidization of energy, however, is an inefficient method of social protection because it deprives the national economy of necessary income and discourages conservation of energy. A tax on energy aimed at bringing local energy prices closer to world market levels could be used to finance more efficient means of social protection through more and better education, health care, and infrastructure.
[*] The author is Professor of Economics at the University of Iceland and has worked extensively in developing countries as a lecturerand consultant. He is the author of Principles of Economic Growth (Oxford University Press, 1999). Address: Faculty of Economics and Business Administration, University of Iceland, 101 Reykjavík, Iceland. Tel.: +354-525-4500. Fax: +354-552-6806. Email: