Getting smart about

subsidies
Markus Goldstein
The World Bank

Subsidies are all around us

Obvious ones such as agriculture, urban

transport, fuel
But think about the air we breathe (e.g.
subsidies for pollution control), the
water we drink (subsidies for water
utilities)
Not all subsidies are bad, but in order to
tell the good from the bad we need to
think smart.

How do we think smart

about subsidies?
Think systematically
What are subsidies and why are
they important?
Why do we subsidize?
Who gets the subsidies?
How do we implement subsidies?

Why are subsidies

important?

Subsidies are political

Why are subsidies

important?

A lot of money is spent on subsidies

In 2005, the EU was spending 2 euros per cow,

per day (puts them above the poverty line)
Egypt spent an estimated 6.9% of GDP on fuel
subsidies and 1.6% on food subsidies in
2005/6

Subsidies can have big policy effects

Malawi removed all primary school fees,

enrollment went up by 1 million children over
6 years, and the enrollment gap between rich
and poor closed

We often view subsidies

too narrowly

The tendency is to think in terms of

producer subsidies (e.g. agriculture)
but they apply to both supply &
demand
A subsidy is when the price is lower
than the cost, where the
government provides the funds
And a tax is a negative subsidy

Why subsidize?

Do we know why we
subsidize?

Take the case for subsidizing primary health care:

Some would argue its a right, so we do it for equity

reasons
Others would argue market failure, e.g. incomplete
information
Still others would argue that it is an externality healthier
people are better able to participate in society

So the answer is both yes and no we can see a set of

justifications, maybe even more than one for a given
subsidy
To understand whether a subsidy is working or not, we
need to know why -- the main reason why -- we did it in
the first place
Understanding why a subsidy is in place, also provides
grounds for taking the debate into the political realm
and dealing with fiscal constraints

So why do we actually
subsidize?

Markets arent working right

efficiency
We care about the poor equity
There may (or may not) be tradeoffs
across these
These are tempered by the hard facts
of real constraints, in particular:

Fiscal constraints
Politics

Making markets work right

Externalities

e.g. government subsidies to identify and

treat tuberculosis
Special case of externalities is public goods

e.g. government funds (100% subsidy) national

defense

Market failures due to information

issues

e.g. the rationale for subsidizing microcredit

Promoting equity

Best option: give the poor the

cash. But:

Administration costs are too high

Possible political constraints

So we subsidize
But we need to consider what we
mean by equity

An equity/efficiency
tradeoff? Often, but not
always
Reasons there might not be an

equity/efficiency tradeoff:

When correcting market failure is not

possible or too costly, some redistribution
can improve efficiency

e.g. think about subsidizing education,

Psacharopoulos (1994) estimates returns to
primary education of 24 percent in Africa and 20
percent in Asiawe could try to create a credit
market to pay for primary education but this is
really not feasible.

Not always a tradeoff -2

Getting rid of some kind of subsidies

can improve both equity and efficiency

e.g. In Japan, the average farm hh income

is 110% of average hh income, yet over
2000-2 producers received $47.5 bn in
subsidies
Between 1996-2000, the US government
mailed farm subsidy checks to 31 addresses
in Beverly Hills and 803 in Washington D.C.

For better or worse, equity

and efficiency run into
politics and real budget
constraints

3 questions to assess the

political constraints
Who are the winners/losers and who
will they vote for (if they vote)?
Who are the interest groups around
this issue and how much power do
they have?
What is the time horizon of policy
makers?
Outcome need not be fair nor
efficient

Politics in action: food

subsidies in Sri Lanka

Food subsidy, almost universal from

independence

Maintained by govts of different

ideology in the name of political stability
and equity
Broad based political support,
particularly from organized labor
Subsidies to producers as well to keep
them happy

And making things better

could make them worse

1978-9 large devaluation, new govt

Implemented means test the pop.

Change from rations to food stamps and froze new
issues and nominal budget allocation
Removed price subsidies
Protected wage earners who were no longer getting
subsidies through inc. wages (interest groups)

But then, benefits erode with inflation

political constituency? (time horizon of policy
makers, beneficiaries did not have enough
voting power)

Three ways to pay the bill

1. Tax and redistribute

e.g. Health in Finland

taxes from the state (progressive income

and indirect) and municipalities
Patients pay only 24%, the remainder is
financed by local (43%) and national govt
(18%) and national health insurance (15%)
Over 80% of Finns are satisfied with their
health care, against EU average of 41%

Paying the Bill (2 )

2. Cross-subsidize

Can be within or across sector

Gabon: urban electricity subsidizes water and
electricity in rural areas and small towns.
Ecuador: surcharge on telecom subsidizes water

3. Grants

e.g. Tajikistan Pamir Power Project

Poor people, low capacity, irregular supply

Concession put in place, but move to market prices for
power immediately not feasible (500% increase
required)
Mix of IDA, Swiss and IFC funding for 10 year gradual
phase out of subsidized prices

Some things you need to

know to pay the bill:
1. Tax and
redistribute

Tax incidence, tax costs

Incidence of benefits, now
and post change

2. Cross
subsidize

3. Grants

Elasticity of demand
both for suppliers of funds
and beneficiaries
Size of financing gap
Funding source
Exit strategy, since not
sustainable

Do we know who we
subsidize?

Primary education is progressive, but higher education

is not

Country

Early
Childhood
,
Preschool

Primary

Secondar
y

Tertiary

Overall

Bolivia
(2002)

Progressiv
e

Regressive

Regressive

Cambodia
(1997)

Neutral

Regressive

Regressive

Cambodia
(2002)

Progressiv
e

Regressive

Regressive

Neutral

Ecuador
(1999)

Progressiv
e

Bell Curve

Regressive

Jamaica
(2000)

Progressive

Progressiv
e

Bell Curve

Regressive

Neutral

Madagasc
ar (2001)

Regressiv
e

Regressive

Mexico
(2002)

Progressive

Progressiv
e

Regressive

Regressive

Neutral

El
Salvador
(2002)

Progressive

Progressiv
e

Regressive

Regressive

Progressiv
e

Vietnam
(1998)

Progressiv
e

Regressive

Vietnam

Progressiv

Regressive

Health varies
Country

Type

Distribution

Bolivia (1999)

Social Insurance

Regressive

Public Expenditure

Progressive

Ecuador (1999)

Health Care IESS

Regressive

Health Care MSP

Relatively Neutral

Health Care SSC

Progressive

Mexico (2002)

All Public Health Expenditure

Regressive*

El Salvador
(2002)

Hospital Care

Relatively Neutral

Primary Health Care

Progressive

Jamaica (19912002)

Average Ratio of Poorest to

Richest Quintile for Public
Hospital Use (Q1/Q5)

1.83

Jamaica (19912002)

Average Ratio of Poorest to

Richest Quintile for Primary Care
Use (Q1/Q5)

0.82

Jamaica (19912002)

Average Ratio of Poorest to

Richest Quintile for Outpatient
Care (Q1/Q5)

1.76

Infrastructure subsidies are clearly

regressive
progressive
regressiv
e

So who do we subsidize?

First step is to look at incidence

data what share of the benefits
go to an income group?
But both the benefits and the
costs (taxes) to the individual
matter

At the national level, adding them up is key

To estimate the net effect of public subsidies

- tax

How do we implement
subsidies?

The rationale for the

subsidy tells us where to
start
If subsidies are
If we are doing

subsidies for
equity reasons we
need to target
both:

Access
Affordability

justified for
efficiency
concerns, we need
to target:

Overcoming/reduci
ng a market
distortion
Changing behavior

And what we need to know

Know your poor in order to

achieve access and affordability
Know your markets (including
public goods) when trying to
remove distortions
Know your elasticity when trying to
change behavior

We have some
(potentially) powerful tools

Know your poor (access and affordability)

Know your markets (remove distortions)

Market assessments, CEM, PSIA, WTP

studies

Know your elasticities (change behavior)

poverty assessments, poverty maps

Market assessments, ESW, WTP studies

Data is key household, investment

climate, market SURVEYS

But what about the

constraints? (1)

Political economy

Know your polity

PSIA

Keep in mind the political economy can be

an opportunity, not only a constraint
Use politics to put subsidies on the table
and in perspective:

e.g. Andhra Pradesh: introduced metering so that

subsidy was visible, transparent
e.g. Punjab: free power, but part of a fixed
agricultural budget

What about the

constraints (2)

Fiscal

Know your budget, know your

incidence (dont forget the taxes)

CEM, PER

For equity: think about real tradeoffs,

balance inclusion/exclusion

What can make subsidies

go wrong (or right)?

We need to avoid bad

design

Badly designed Information was

inadequate/wrong

Within the relevant market:

Lack of attention to other markets

e.g. Cote dIvoire water

e.g electricity/irrigation in India

Question of provider

Keep in mind subsidies are about govt

finance, not provision

And the environment

matters too

Constraints change (good design

initially)

Budget
Political economy
e.g. Sri Lanka food

Budget constraints tighten

Possible opportunity to narrow targeting

Or political economy binds and benefits erode

In the end good design

can have a powerful
impact
The Bangladesh secondary school stipend

Tuition and stipend subsidy for girls for

educational costs, supplies, uniforms and
transport.
Good design: priced well (~1/2 of costs),
tied to attendance. The subsidy was put
very close to the good it was aimed at.
Covered 1.9 million girls in 2004, for around
$25 million
Resulted in enrollment increases of 8-12
percentage points.

To take stock:

Not all subsidies are bad Bad subsidies

are bad.
To separate the good and the bad, think
systematically

Understand why we have this subsidy

Who is the subsidy for, who is getting it?
How is this subsidy improving access,
affordability, reducing distortions, or changing
behavior. Is this the best feasible way?

Benchmark on the counterfactual of no

intervention make an informed decision

Now how do we decide

what to do?

Why?

Equity

Efficiency

Equity
Will a lump sum transfer
work?
yes
no
No subsidy

Subsidy for
whom?
Access

Affordabili
Identify targetingty
mechanism
Identify political constraints
and opportunities
Identify fiscal constraints &
tradeoffs

Identify
target
poor

Efficiency
Behavior
know
elasticities
identify
closest and
least
distortionary
policy
handle

Reduce market
distortions
Externalities
& other MF

Public
Goods

know
markets

govt
funds these

identify
closest and
least
distortionary
policy handle
identify funding mechanism, fiscal
constraints and tradeoffs

assess
optimal
level of
provision

This is a PREM task

Subsidies are everywhere

PREM economists have a central role
in thinking about them
systematically

Understanding within sector

Adding up across sectors and taxes
Helping identify tradeoffs for the govt
We have an existing set of tools that
allow us to tackle these issues