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Iran Primer: The Subsidies Conundrum

by SEMIRA NIKOU

26 Oct 2010 19:0511 Comments
gasriotsiran.jpg [ primer ] The 1979 Revolution was carried out in the name of "the oppressed," and the Islamic Republic has been a welfare state committed to "social justice" ever since. The government introduced rationing soon after Iraq's 1980 invasion generated new economic hardships. To appease a war-weary society after the conflict, the theocracy kept consumer prices for energy, basic foods, medicines, and utilities (water, power, and sewage) well below market prices. But the economic burden soared as the new theocracy initially encouraged population growth, which almost doubled the population from 34 million to 62 million in a mere decade. The cost of subsidies, in turn, also soared.

The Islamic Republic has long been vulnerable economically. Politicians in both the executive and legislative branches have been reluctant to take badly needed reforms for fear of political backlash. President Hashemi Rafsanjani's austerity plan in the early 1990s sparked riots across the country, forcing him to shelve free market reforms and subsidy cutbacks. President Mohammad Khatami was unable to mobilize support from conservatives in parliament for either subsidy reforms or a plan to gradually increase gasoline prices. Under Ahmadinejad, the announcement of gasoline rationing triggered unrest and attacks on gas stations in 2007.

Ahmadinejad proposed new subsidy reforms in 2008, but the plan was deferred until after the 2009 presidential election. He had to wage a heated political battle, and a compromise was eventually reached with the intervention of the supreme leader, in 2010. Yet for the first time, Iran's major political factions agreed that the burden of subsidies was unsustainable, despite fears of severe economic and political consequences.

The case for reform

Subsidies have been costly. They were estimated to eat up around 25 percent of Iran's gross domestic product (GDP) of $335 billion in 2009. Subsidies for energy products alone accounted for 10 percent of Iran's GDP in 2010, according to the World Bank. Iranians pay as little as 38 cents for a gallon of rationed gasoline, cheaper than bottled water. Gas costs 10 center per liter, while a liter of bottle water costs around 25 cents.

Without reforms, costs would only continue to grow as Iran's population increases -- even though innovative programs by previous presidents brought the population growth rate down, from a height of 3.9 percent in 1986 to 1.3 percent in 2008. In 2010, as he was simultaneously pushing subsidy reforms, Ahmadinejad also called for new population growth, including a $950 incentive for each new baby and a $95 annual stipend until the child turns 18. But a higher birth rate would be a further drain on the economy, and even conservatives moved to block institutionalizing his initiative.

The subsidies program has been plagued by two fundamental flaws. First, cheap prices have fostered wasteful behavior. Iran's energy consumption has increased five-fold in the past 30 years, while the population has only doubled, according to former International Monetary Fund economist Jahangir Amuzegar. Official Iranian figures claim energy consumption has actually increased nine-fold since 1976. Cheap gas has, in turn, contributed to chronic pollution, environmental decay, and massive traffic overload in urban areas.

Second, subsidies have helped everyone, not just the poor. Those benefiting the most from subsidies are middle and upper income Iranians. Iran's richest 30 percent have reaped the benefits of 70 percent of government subsidies, according to Iran's Ministry of Economics and Finance.

The plan

* Subsidies will be phased out over five years, ending in 2015.

* The government can cut back up to $20 billion of subsidies within the first year. In subsequent years, parliament will have to approve additional amounts through the annual budget process.

* Immediate cutbacks affect the price of petroleum products, wheat, rice, cooking oil, milk, sugar, and postage, as well as airline and railway services. The government has discretion over which subsidies to cut first.

* Medical services and products are not affected by the plan.

* In lieu of subsidies, the government will distribute small sums of cash to individuals.

* A new government body -- a subsidy reform organization -- will hold most of the funds that were once allocated for subsidies. It will plan and supervise the distribution of cash payments as a substitute for subsidies. Parliament insisted on making the organization subject to audit.

* The funds accrued from subsidy cuts will be divided:

-- 50 percent for direct cash payments to people who qualify for aid;

-- 30 percent to industries that rely heavily on subsidies, and to improve the energy sector and public transportation;

-- 20 percent directly to the Treasury to cover government costs of implementation and reduce dependence on oil revenues.

The politics

Ahmadinejad's reform plan is widely interpreted as a policy reversal. He won the presidency in 2005 on a platform of increased social services and aid to the poor -- and putting Iran's oil wealth on the dinner table. But his cash handouts did little to improve living standards or reduce growing income gaps. The purchasing power of Iranians, particularly the poor and middle classes, weakened as inflation spiked, hitting nearly 30 percent in 2008, according to the Central Bank of Iran. Critics argued that Ahmadinejad's profligate spending also drained the Treasury of billions from oil revenues, while contributing little to improve Iran's aged and ailing infrastructure.

Unlike his two predecessors, Ahmadinejad initially rebuffed proposals for reform by the World Bank and International Monetary Fund. But tough economic realities apparently changed his mind. His original proposal called for an even more drastic plan to eliminate subsidies within three years.

Many economists and members of parliament argued that Ahmadinejad's original shock-therapy strategy would have dire consequences. They urged a more gradual transition to avoid a dramatic spike in inflation for families and industries that relied on highly subsidized energy supplies and already faced a competitive disadvantage due to sanctions. Parliament also wanted supervisory power over distribution of funds, which Ahmadinejad rejected. After a year of intense debates, a compromise bill -- lengthening the transition and creating the subsidy reform organization (SRO), which will be subject to parliamentary oversight through its audit authority -- was passed in 2010.

Potential problems

The new scheme faces many dangers, especially in a fragile political climate following the disputed 2009 presidential election. First, the biggest danger is soaring inflation that could deepen poverty. Parliament's Research Center warned that Ahmadinejad's original plan could have produced inflation exceeding 60 percent, while the International Monetary Fund projected an increase of over 30 percent -- figures the government rejects. Ahmadinejad's administration contends that the negative side effects will be transient and that the projections are based on out-of-date models.

Poverty is already a key political issue, and one reason Ahmadinejad first won the presidency in 2005 on a populist political platform. Figures vary widely, but both Iranian and U.S. sources say at least nine million Iranians live in absolute poverty, with millions more living at the poverty line. Some economists say the plan's success will depend on gradual implementation to avoid too much economic disruption.

Second, Iran's industries could also suffer. Many have been able to compete with cheap imports -- despite outdated equipment, inefficient practices, and international sanctions -- courtesy of low energy costs. Economists contend that the 30 percent in new aid for domestic industries is not sufficient to compensate for higher production costs. Industries are already at a competitive disadvantage because of the high cost of labor and overvalued exchange rate. A further danger is a ripple effect that impacts workers in an already restive labor climate.

A 2010 report by parliament noted that Iran already has the world's 17th worst unemployment rate, out of 208 countries and territories surveyed, despite a change in the definition of a worker. In his first year, Ahmadinejad altered the legal definition of employment to include anyone who works two hours a week. Previously, employment meant a minimum of two days of work each week.

Third, the new system for providing individual aid is wracked with flaws.

The government originally decided to divide the population into three income brackets and distribute financial assistance to the bottom two. But Iran does not have an effective data-collection system on family income. Most data was gathered by self-reporting to Iran's Statistical Center, and many families do not want to disclose their assets for tax and other reasons. The government then revised its plan and indicated it would distribute cash payments to a wider segment of society. It also encouraged people with financial means to forgo cash subsidies, but over 90 percent of the population signed up for aid. Trying to remove them from the list -- now or later -- endangers a backlash.

Sanctions impact

The United Nations, the United States, and the European Union all imposed tough new sanctions on Iran in 2010. One big unknown is how they may intersect with or impact the new subsidies cutbacks.

The regime is calculating that reducing subsidies and increasing petroleum prices will force consumers to change excessive consumption habits, thereby mitigating the effects of sanctions. Iran could also try to blame new hardships on international sanctions to divert public attention from its own controversial cutbacks. But if sanctions begin to bite, either the president or parliament could also try to delay or reschedule the phased cutbacks.

The future

* Iran is cutting back subsidies at one of the most precarious moments, politically and economically, since the 1979 Revolution. To avoid a backlash, Tehran must avoid a further drop in unemployment, a slowdown in the economic growth rate, and a significant increase in inflation. The growth rate of Iran's gross domestic product is already at its lowest point since 1989, after the war with Iraq ended.

* Ahmadinejad's poor economic track record has spawned concern about his administration's ability to implement such extensive reform in ways that are not politically disruptive and economically harsh, particularly on the urban middle and working classes.

* The controversy over Iran's nuclear program could produce future setbacks. The Islamic Republic faces the danger of additional sanctions if there is no agreement with the international community to resolve growing tensions.

* Subsidy reform alone may not solve Iran's chronic economic problems. To improve Iran's overall fiscal health, the government also needs to pursue structural changes and other free market reforms to reduce inefficiencies plaguing state-owned or state-affiliated industries. The government otherwise may still be forced to support key sectors that depend on the state's protection or business.

Semira Nikou is a research assistant at the U.S. Institute of Peace. This article is presented by Tehran Bureau, the U.S. Institute of Peace, and the Woodrow Wilson International Center for Scholars as part of the Iran project at iranprimer.usip.org.

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11 Comments

Iran's corporations & industries, public or private are neither properly regulated nor legally formed in most cases.

Take the case of Iranian Telecommunications Company, ITC. This entity was formed and paid for by Iranian national wealth over a period of more than 75 years. It was originally part of PTT and was later separated & managed on its own. This year it was privatized & its shares were mostly bought by companies tied to the regime and its armed forces (IRGC). The Islamist regime in power has been essentially giving away much of Iranian NATIONAL industries and resources to those it favors for the last decade or more.

Therefore, describing the reduced rates on energy & utilities as SUBSIDY is MISLEADING. These utilities belong to the Iranian NATION who did not get anything out of their PRIVATIZATION.

Legally, the NATION has every right to be compensated for the sale of these corporations.

Paying a reduced rate for energy & utilities is the RIGHT of every Iranian whose wealth, mostly from oil income and partly taxes has gone into building these utilities and corporations.
The regime in power has no right to divide up and sell these entities to its cronies.

This should end in a REVOLUTION and the people shall get back what it is theirs by RE-NATIONALIZING these industries & utilities.

Maziar Irani / October 1, 2010 1:38 AM

Thanks for a very informative article.

Further to the comment by Maziar Irani, it does seem that equally problematic to the subsidies issue is the continued domination of industry by the state and quasi-state, and it's hard to see how cutting subsidies can, on its own, be positive for most Iranians unless prices can be driven down by a proper, competitive, free market system. I note this is basically what you're saying in your final paragraph. The situation seems reminiscent of Russia in the 1990s, with formerly state-run industries being handed over to favoured elites whilst at the same time these industries are protected from competition by pseudo-legal/tax diktats, which outside investors can't hope to contend with.

Undoubtedly this'll be a rocky road for Iran. I hope they take the advice of the IMF and World Bank seriously, since a lack of access to credit at all levels is going to make any reforms incredibly painful. However, it's very heartening to see Iran moving in this direction as it will inevitably lead to greater freedoms for the Iranian people as they become free of state support/control. I suspect, however, that under Ahmadinejad Iran is doing these things out of necessity rather than because of any true commitment to free market economics.

I note that a factor contending against Iran's reforms is the willingness of the US to heavily subsidize some of its own industries, particularly the military (which would of course be boosted by another war); so if Iran could pursue sensible foreign and economic policies and engage in d├ętente and free market reforms then this would help the US taxpayer to boot ;-)

I look forward to the primer on Iran in November, and in particular I would be interested to know more about Rafsanjani's previous efforts in this direction.

Thanks again.

Ian / October 1, 2010 4:32 AM

How does Khamenei sleep at night?! The economic situation looks like such a potential minefield!

Cy / October 1, 2010 5:54 AM

I completely agree with Maziar Irani. Well said. A re-nationalizing of industries is key, not 'reforming' subsidies. That is like putting a band-aid on a wound but letting it still rot internally. Cronyism will continue, no matter how 'liberal' the market becomes in Iran, that's just a part of the sociocultural fabric of a lot of nations that aren't a part of the West. And unfortunately further privatization only exacerbates and feeds into the pockets of these 'cronies' and their nouveau capitalist reform mentality. You write about structural reform but you don't give it any space in the article . In fact, structural reform is a paradox because any structural change isn't really reform--> it's REVOLUTION. So you might want to work on how you frame the 'subsidy' issue.

kash / October 1, 2010 9:48 PM

Very basic economics lesson for the day.....

There is no such thing as a "free lunch".

Subsidies, and nationalizing cost the consumer in other hidden ways. Subsidies are paid for by the government which is paid for by taxes from the consumers. Nationalizing industry is also paid for by the consumers in taxation. There is a net loss to the consumer due to enefficientcy in government administrating industry.

muhammad billy bob / October 2, 2010 1:05 AM

Naturally, Iran needs an update of the tax system and they have started the initiation if this in January http://en.wikipedia.org/wiki/Iranian_Economic_Reform_Plan

However, there are some strange issues, the biggest is that they still have the tax extempt Bonyads http://en.wikipedia.org/wiki/Bonyad that has to be taxed on the same conditions as other companies, this will reduce the waste of money and provide income that will make it possible to reduce the corporate tax that now is 25 % to a lower figure that as well would reduce the tax evasion.

With respect to VAT is this really correct:
http://www.irantradelaw.com/wp-content/uploads/2010/03/Irans-Foreign-Trade-Regime-Report.pdf

According to article 16 of this Act, the VAT rate is 1.5 percent, but the VAT rates of
certain goods such as "cigarettes and tobacco products" and "gasoline and jet fuel" are
respectively 12 and 20 percent.
In addition to the VAT rates just mentioned, article 38 of VATA levies the
following duties on goods and services which are subject to this Act:
a) 3 percent on all types of cigarettes and tobacco products;
b) 10 percent on all types of petrol (gasoline) and jet fuel;
c) 10 percent on kerosene and gas oil;
d) 5 percent on fuel oil; and
e) 1.5 percent on all other goods and services.

this means that they would have subsidies for petrol products and at the same time add extra value added tax. I would be better to skip this extra VAT rate and have a normal duty related to volume or weight in a few years time when the subsidies are removed.


Any comments on this?

Mike / October 3, 2010 4:09 PM

You mention a couple of times that Ahmedinejad won the Presidency in 2005. Did he?

Is it not likely, knowing what we do about the 2009 "election", that the votes were rigged in 2005 too?

But I think he is right to try to phase out subsidies, which badly distort the economy. However, an economy based heavily on resources (oil, gold, diamonds) will always be distorted, compared to one with a wide spread of industries.

Don Cox / October 3, 2010 4:48 PM

Don,

You're right about 2005. I think he should have been eliminated in the first round. They forced him through to the second round by fraud and eliminated Karoubi. In the second round things are not so clear. I think he probably beat Rafsanjani since a lot of people hated Rafsanjani so much that they preferred to vote for this unknown person whose main promise was to fight corruption. I remember Ahmadinejad was consistently 6th,7th, or 8th out of the 8 candidates in all of the official polls that were carried out by various institutes inside the country. When he made it to the second round it was a huge shock.

The nature of the fraud in 2005 was different from 2009 though. In 2009 it seems that the whole thing was engineered beforehand and the results were pulled out of a hat, so to speak. In 2005 it was mostly ballot-stuffing by the Basij and the Guards as well as discounting votes from certain polling stations etc. The Guardian Council also had a more direct hand in skewing the results in favor of AN in 2005, whereas in 2009 the Ministry of the Interior, which was under the control of AN, was directly responsible.

Cy / October 4, 2010 5:13 AM

billy bob,

You said: "Very basic economics lesson for the day.....

There is no such thing as a "free lunch".

Subsidies, and nationalizing cost the consumer in other hidden ways. Subsidies are paid for by the government which is paid for by taxes from the consumers."

That's the danger of applying our US-centered biases to other countries. Very little of Iranian government's revenue comes from taxing anyone let alone consumers.

IRI generates the vast majority of its income from selling the country's natural resources: oil and gas.

So as long as price of oil and gas remains high and IRI is able to sell them at high profits, they can subsidize many domestic products and imports without asking people to pay one penny more.

We must be careful about applying pre-conceived notions of how economy works to other countries. As we learned in 2008, there is no such thing as a free market system even in the west, nor is an extremist application of free market theories the right answer even in the west.

Most things are better in moderation...

Bahman / October 4, 2010 8:50 PM

Bahman,

It depends on what you consider taxation. Yes, alot of the Iranian government's revenue is from sells of oil and gas.

But, who works in these industries? Is it not Iranians? Where does this money come from to pay for the subsidies. Is it made out of thin air? It is mostly extracted from those that work in these industry. And others that are forced to contribute to the Iranian government.

When a government nationalizes an industry they "skim off the top" what they wish. This is very harmful to the average worker. The average worker is having his labor "skimmed off" to pay for government.

Regarless of what part of Earth it is. Giving up some to government in hopes of a better return after it comes out is not realistic.

muhammad billy bob / October 7, 2010 4:49 AM

Correction: the new state entity that will oversee the money released from the subsidy cuts will actually not be under the purview of the Parliament.

Roshanak / October 21, 2010 8:40 PM