Subsidy Cut

So, effective yesterday, petrol prices at the pump have been raised to RM2.30 and diesel to RM2.20.

Ballsy move, and to me, completely unexpected. With the 20sen cut in the petrol and diesel subsidy, Malaysia is within striking distance of abolishing fossil fuel subsidies entirely – at least, at the retail level. We still have the gas subsidy to deal with, but that’s less important for a couple of reasons: gas is a cleaner fuel (no negative externalities) and there’s also less implications for the government budget.

Resistance, compared to the similar 20sen cut last year, seems to me to be a lot more muted this time around. Nevertheless, resistance there is.

Some of it reflects the understandable concern over the impact on the lower income group. But that’s what the cash transfer under BR1M is for; it’s even allocated under fuel subsidies in the government budget.

If support for the disadvantaged is the goal, subsidies for petrol and diesel are an incredibly inefficient and wasteful way to go about it. Most of the benefits of energy subsidies goes to higher income households, not the lower income group. An IMF study found, on average, the top 20% gain six times more from energy subsidies than the bottom 20%, and that petrol subsidies are the most regressive (i.e. the benefit climbs higher the higher your income level). Cash transfers are a far more efficient and effective way of supporting the poor.

Some have complained about the timing of the cut (here for instance), just as global oil prices have begun falling. But that completely misses the point –  the best time to cut subsidies is when prices are falling, especially with the fixed price mechanism we use here in Malaysia. The reason is that it makes the final adjustment to market pricing – and ultimately, that’s the goal – that much easier to achieve. If prices are high, you’re going to have many more and deeper cuts, with correspondingly higher pain.

I’m flummoxed by the mention of India and the UK cutting prices. That’s neither here nor there. In India for instance, the petrol subsidy is fixed and prices adjust in line with the global market. With global crude prices declining, so will the retail price of petrol in India. The flip side is also true; when global prices rise, so will the pump price. The UK has full market pricing, and in fact taxes the use of petrol quite heavily along with taxes on car emissions. 60% of the price of a litre of petrol in the UK goes straight to the government, and UK drivers pay the second highest level of petrol taxation (and highest for diesel) in Europe. I can’t believe people are bringing up these examples.

If, as I suspect, the price of oil continues to decline, there may not be any need to make any further cut in the subsidy and it’ll disappear naturally. We’re not that far off, as another 10%-15% decline should do the trick. That would mean we can shift to a zero-subsidy regime without any further pain, something which would not be possible without the present cut.

Lastly, there’s the idea that a more gradual adjustment would be better. I have some sympathy for this view, though more for political economy reasons than economic ones. A gradualist approach, say a 5 sen cut every quarter, would be easier to sell politically and more palatable to the public.

However, it doesn’t make a whole lot of financial sense, which shows you how irrational people actually are. Say that after the September cut last year, the government switched to cutting 5 sen at three month intervals instead of the one-time 20 sen cut that we actually saw yesterday. While that would have made the whole thing an easier sell, if you take the net present value of the cuts (alternatively, call it the opportunity cost) the one-time cut would work out more in favour of households, because it came at the end of the period.

So what’s on the table next? Long term I’d still like to see fossil fuel use to be taxed, because just getting rid of the subsidy doesn’t account for negative externalities. There’s also still the issue of the targeted and tiered subsidy scheme that’s been rumoured about for months now. Personally, I think that should be taken off the table. With prices so low and still on the decline, the relative subsidy between income groups would be so small that it would be pointless to put such a system into place. In any case, cash transfers are a much cheaper and efficient way to achieve precisely the same thing.

Beyond that, I think there’s finally light at the end of the tunnel of this sage – we’re close to finally being rid of petrol and diesel subsidies, for good and all.