Why subsidies need to be cut

By Stephanie Jacob

Prime Minister Najib Abdul Razak once referred to subsidies as opium, saying that once given it is addictive and difficult to stop. Last week, the government said that it would resume its subsidy rationalisation programme to curb spending and cut the fiscal deficit. There is evidence that subsidies in general are an ineffective policy in helping the poor. But is the government willing to make the politically difficult cuts?

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The government managed to do something quite rare last week; it succeeded in bringing almost all Malaysians across various divides together. Unfortunately, the uniting factor was the people’s ire at its decision to reduce fuel subsidies, making petrol and diesel more expensive for the consumer.

That is a good illustration of what the government is up against if it wants to cut blanket subsidies and help the poor via welfare measures. Given that subsidies amount to RM30 billion a year or more according to some estimates (it could be even more depending on what is considered a subsidy), it’s likely to be a long and painful process.

The decision to resume with the subsidy rationalisation was made by the fiscal policy committee (FPC), which is chaired by the Prime Minister, and includes the Deputy Prime Minister, Finance Minister II, Minister in the PM’s department in charge of the Economic Planning Unit (EPU), Governor of Bank Negara, Chief Secretary to the Government, Secretary-General of the Treasury and Director General of the EPU as permanent members.

The FPC announced that the resumption of the subsidy rationalisation policy would start with a 20 sen hike in the retail price of RON95 petrol and diesel bringing their cost per litre to RM2.10 and RM2 respectively. The change would mean that the government’s total bill for fuel subsidies would now stand at RM24.8 billion or 11.9% of government revenue and 2.5% of gross domestic product (GDP), resulting in savings of RM1.1 billion for this year, and RM3.3 billion for 2014.

Domino effect

One of the biggest causes for concern was that this seemingly small jump in petrol prices would have a domino effect on everything from the price of produce to a daily bus ticket despite assurances that inflation as a result of the price hike would only be minimal.

To ease fears of the impact of the increase on the lower income group, the Prime Minister said that the cash handout programme Bantuan Rakyat 1Malaysia (BR1M) , which currently stands at RM500  ringgit per eligible person would be increased in the upcoming 2014 Budget.

Nonetheless, condemnation was loud and it quickly showed why reducing subsidies, especially those that have been in effect for so long, is a political minefield that most on both sides of the government would prefer to sidestep.

Subsidies especially in fuel, have almost become a given in this country driven partially by the belief that as a fuel-producing nation, it is only natural that Malaysians pay low prices at the pump. Even with this latest round of subsidy cuts, Malaysians still pay less for fuel than four of its Asean counterparts, including Indonesia which is also an oil producing nation.

Furthermore, subsidies policies at large have always been used by the government to show that it is in
touch with the needs of the common man on the street by ensuring that key goods such as petrol, and other basic necessities are priced at a more accessible rate.

In a nutshell, the government has subsidised both energy and non-energy products for over two decades now. Subsidised energy products include liquefied petroleum gas, petrol and diesel, while non-energy goods includes sugar, rice, flour and cooking oil. The government also subsidises education and other welfare-related services. Energy related subsidies currently accounts for the largest portion of the subsidy bill.

Are subsidies useful?

Of course it is worth noting that it has been long questioned if subsidies are in fact as useful as many would tend to suggest in reducing the burden of those in the lower income bracket. After all, the people are still bearing the cost, as the money for subsidies simply comes from some other source.

In its Citizen’s Guide to Energy Subsidy in Malaysia report, the International Institute for Sustainable Development (IISD) says that it is important to note that “subsidies do not reduce the cost of energy, they just change the proportion paid by consumers or producers, and move the rest of the costs on to other parts of the population. Someone still pays, but through taxes, foregone expenditure, foregone revenue or lack of investment in energy infrastructure. Indeed, the inefficiency of subsidies can actually increase the overall cost burden on society.”

There is also a significant case to be made that the biggest beneficiaries of the subsidies, especially in the Malaysian scenario tend to be those in the higher income bracket and businesses that also benefit from energy related subsidies.

If there were any exceptions among those unhappy with the hikes, they were generally to be found among the economists and financial analysts who have long said that Malaysia’s subsidy programme is too bloated, misdirected and unsustainable from an economic point of view.

“The move by the government to rationalise the subsidies is a step in the right direction, given the current economic conditions. We have long been expecting these strategic policy reforms, which would raise competitiveness and improve its credit rating,” Alliance Research economist Manokaran Mottain opined.

CIMB’s chief economist Lim Heng Guie called the announcement made by the FPC bold and said the measures were in line to get “Malaysia’s fiscal deficit and government debt back into a sustainable trajectory.”

In fact the international rating agencies such as Moody’s and Fitch described the government’s recent decision as a good start, but far from enough. With Moody’s saying “as the reduction is relatively minor, further progress on subsidy rationalisation and other fiscal reforms will be necessary to meet the government’s fiscal targets”; while Fitch said that this alone would not be enough to change its negative outlook on the Malaysian economy.

Opposition opposes cuts

Politically, the opposition was quick to condemn the government’s decision to reduce subsidies, calling it a cosmetic fix, rather than sound economic decision.

PKR member of parliament for Kelana Jaya, Wong Chen said that subsidy rationalisation was not the most pressing issue, “the primary purpose is to reduce the fiscal deficit…that being the case, the first and priority step, is to clean up the government through eliminating corruption and implementing good transparent governance. Only when that is achieved, can the government have any basis to rationalise subsidies.” Subsidy rationalisation was therefore really only step two in the process, he concluded.

His tone on the rationale behind subsidy cuts and reductions however was slightly more accepting, as he said that should the government still need to address the fiscal deficit after it had done the above, then rationalisation could be considered, but called for it to be part of a comprehensive reform process.

Instead of offering subsidies across the board, targeted programmes should be put in place to ensure that only those in need benefit. “Blanket subsidies will need to be reformed to be replaced by some targeted subsidies, for example short term financial aid…(and) in order to balance out the social pain of subsidy rationalisation, (there also) should be improvements in productivity and minimum wages,” said Wong.

According to the MP, the problem lies not with subsidies themselves, rather he says that the uneven and unequal distribution of the subsidies has resulted in overspending and unsustainability.

It is a matter that the IISD also highlights in its report, “studies show that in general, the poor are not the principal beneficiaries of energy subsidies, (this is) a situation that holds true in Malaysia. This is because subsidies are rarely targeted specifically at the low income groups…but are often ‘blanket subsidies’ available to all consumers regardless of their wealth.”

“Energy subsidies leave poor worse off”

The report goes on to say that this basically means that the subsidies benefit energy companies, suppliers and the wealthy in urban areas more than they do they poor. According to the report “blanket energy subsidies can often leave the poor worse off, as they bear the same cost of the subsidy, while accruing fewer of the benefits than the rest of the population.”

The IISD report points out that a wealthy person can afford to purchase much more subsidised petrol than a poor person, which often translates into the wealthy consuming more of the subsidy than the poor. It adds that because the marginal dollar is more valuable to the poor, the cost of settling their share of the subsidy bill is a bigger pinch.

Therefore, it is fair to say that there is a good case for subsidy rationalisation, what needs to be addressed however, is the manner in which it is done.

In general, the consensus is that no subsidy should be a ‘blanket’ one, rather it must be precisely targeted to the appropriate groups. In Malaysia, all users of electricity, including consumers, enjoy huge energy subsidies.

Independent power producers (IPPs) produce electricity which is then sold to Tenaga Nasional (TNB). The large amount of subsidies and the fact that many of the IPPs are well connected politically have made them a target for criticism, with many questioning why subsidy rationalisation did not begin with them.

The IISD report highlights that the IPPs receive gas subsidies of more than RM10 billion and also benefit from questionable power purchase agreements (PPAs), which critics say allow them to sell the power they produce to power distribution companies like TNB at substantial profits (Table 5).

But it is important to remember that IPPs are NOT the beneficiaries of the subsidies. If they pay more for fuel, they simply pass the costs on to Tenaga Nasional Bhd which will have to charge higher tariffs or lose money. The subsidies go towards keeping tariffs low, benefiting all electricity users including households, industries and others.

These subsidies come largely from Petronas, which is required by the government, its sole shareholder, to subsidise the gas being sold to these IPP’s. According to the IISD report, the national oil company also subsidises gas imported from Indonesia, Thailand and Vietnam. As a result, Petronas loses billions in revenue, which otherwise would go towards higher dividends (which will translate into revenue for the government) and corporate tax.

For Wong Chen and many of his fellow opposition lawmakers the pressing question that must be raised is why the consumer was the first to be hit and suggests that the first subsidies to go should have been those that “benefit the corporates and the tycoons”.

The question is an interesting one, and the government should address it if it wants to show that it is in fact serious about rationalising subsidies in a holistic manner, rather than pursuing so called cosmetic solutions.

After all despite the overall proof available that suggests that subsidies do not work,  the policy in itself will be hard to rationalise, if the most effective actions that can be taken are ignored and the average Malaysian is expected to shoulder much of the burden, so as to maintain the substantial profits of a few big players.

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Tomorrow: How the government can raise revenue.