The Subsidies Conundrum
Semira N. Nikou and Cameron Glenn
- Iran has subsidized petroleum products, basic foodstuffs, medical goods and utilities since 1980, first to manage hardships during the eight-year war with Iraq, and then to prevent political and economic challenges after the war.
- Since the 1990s, four presidents have tried to cut back subsidies that are estimated to cost Iran between $70 billion and $100 billion annually.
- In 2010, President Mahmoud Ahmadinejad won parliamentary approval for a controversial plan to phase out subsides. The cutbacks came at a time the government already faced serious economic troubles and tougher international sanctions.
- Under the plan, universal price controls were replaced with small cash payments to families and direct support of industries. From its onset, cash payments have been available to everyone–wealthy and poor alike–though the government has repeatedly asked the wealthy to refrain from signing up, albeit few have done so. With 95 percent of Iranians receiving the payments, the program has been much more costly than anticipated.
- Price increases in gasoline and other products along with more robust sanctions and loose monetary policies subsequently contributed to a dramatic rise in inflation, which reached 40 percent by 2013. Although by 2015 the inflation was reduced to around 15 percent, rising prices had dropped the value of cash payments–which have remained steady–to one third of their original value.
- President Hassan Rouhani pursued additional subsidy cuts after taking office in 2013. Despite raising energy prices twice, the government still faced a budget shortfall in funding the cash payments by 2015. The near universality of cash payments continues to drain the state budget.
- Energy prices remain below free market levels. If reform ultimately succeeds, however, the program could help reduce waste, shrink state outlays, enhance efficiency and productivity, and help redistribute income.
The first phase of subsidy reform began in December 2010, codified by the Targeted Subsidy Reform law. It included the following provisions.
- Subsidies would be phased out over five years, ending in 2015.
- The government could cut back up to $20 billion of subsidies within the first year. In subsequent years, parliament would have to approve additional amounts through the annual budget process.
- Immediate cutbacks could affect the price of petroleum products, wheat, rice, cooking oil, milk, sugar, postal services, as well as airline and railway services. The government had discretion on which subsidies to cut first.
- Medical services and products would not be affected by the plan.
- In lieu of subsidies, the government would distribute small sums of cash to individuals.
- A new government body—a subsidy reform organization—would hold most of the funds that were once allocated for subsidies. It would 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 would 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.
- Although President Rouhani has made some progress in reversing the economic damage of the Ahmadinejad years, subsidy reform is far from complete. The universality of cash payments remains problem, though the administration is slowly removing individuals from the program.
- Despite subsidy cuts, energy prices remain below market prices. Therefore, further price hikes may be necessary. To avoid a backlash, Tehran must avoid a further drop in employment, a slowdown in the economic growth rate and a significant increase in inflation.
- Iran is poised to regain access to billions of dollars in assets as part the final nuclear deal, which lifts sanctions in exchange for Iran scaling back its nuclear program. The funds could help Iran cover its deficit, but the additional cash may also reduce pressure to prioritize subsidy reforms.
- Subsidy reform alone will 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.
This chapter was originally published in 2010, and is updated as of August 2015.
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