Iran: Subsidy Reform amid Regional Turmoil

On a chilly day in February, while thousands of Iranians swarmed Tehran’s Eghelab Avenue in support of Iran’s Green Movement, a small but noisy crowd gathered just a few blocks north with a different motive. This crowd was protesting their missing application for a program that has captured the imagination of millions of ordinary Iranians for the last two months, cash deposits in their bank accounts.

On December 19, 2010, the government ended the decades-long subsidy program for bread and energy products like gasoline, and replaced it with direct payments of about $45 per month per individual. As protestors challenged autocratic regimes across the Middle East, the cash subsidy program seemed to present most Iranians with a serious distraction from national politics.

The recent subsidy reform is the single most important market reform program undertaken since the unification of the exchange rates under President Rafsanjani in the 1990s. Then, as is happening now, the exchange rate reform started in fits and starts, with charges of IMF and World Bank influence and warnings of economic ruin, but over time its errors were corrected and kinks ironed out. The exchange rate unification effort nearly collapsed because of errors in implementation (inexplicably a large devaluation was preannounced causing a run on the Central Bank’s foreign exchange reserves and huge short-term borrowing from abroad, forcing a painful austerity program on the population). But with government persistence the reform eventually succeeded and multiple exchange rates were replaced by a single rate, which today most Iranians take for granted and have come to view as a rational way to run a modern economy.

President Khatami originally thought to reform Iran’s massive subsidies—estimated today at about $70 billion, nearly 20 percent of GDP, and mostly geared toward energy products—but failed in his attempt due to parliamentary opposition. President Ahmadinejad decided to launch his version of the subsidy reform program—grandly named the Economic Transformation Program—in an unlikely time, in the wake of popular uprisings following his controversial election in June 2009 and economic recession. He had the support of the Supreme Leader Ali Khamenei and the parliament, but his program was attacked as reckless and a grave danger to the anemic economy. His reformist opposition dismissed it as a populist stunt to win the approval of the poor and appease the middle class.

Two features of the program have political salience, prices of bread and all energy products were increased to market levels in one shot, and at the same time money was transferred back to people’s bank accounts. One reason for the failure of previous attempts was gradualism, which allowed opponents of subsidy reform several opportunities to stop it. President Ahmadinejad braved political waters by going for shock therapy, albeit a managed one, price discriminating in favor of the poor using an innovative gasoline card, which registered how much gas each car used per month, and the meters for utilities at homes and offices. The rich are charged a higher price than the poor for the same product. The cash-back program was also initially designed to heavily favor the poor, but this plan collapsed last summer when the government found out that its method for identifying the poor based on income deciles calculated from self-reported survey data was highly flawed. In a rare display of pragmatism, President Ahmadinejad appeared on national television to ask the “good people of Iran to forget the plan [based on income deciles].” Contradicting the critics who believed his main objective in the subsidy scheme was to pay off cronies and recruit an army of poor followers, he dropped the graduated payment scheme in favor of uniform payment to all citizens. All the work to fill and analyze 15 million forms that families had filled revealing (or not) their income and wealth had gone to naught.

In order to forestall angry reactions to the sudden hike in prices and to overcome deep cynicism of the Iranian public about ever seeing their government give anything back to them—especially with large sections of the population in open revolt—the government chose an innovative plan. Bank accounts were set up in the name of household heads, usually a male, into which the government deposited the first tranche of the cash subsidy, about $90 per person covering two months. The money deposited in these accounts could be seen but not withdrawn until further notice. What to do with the cash subsidy (yaraneh) once it was to be released soon became the talk of the town. Then, in a dramatic gesture, at 10 pm on December 18, President Ahmadinejad appeared on television to announce that prices would increase as of midnight and the bank accounts would release the funds the same day.

Many had predicted that skeptical Iranians would be rushing to their banks the next morning to collect their money before it disappeared, but bank offices remained calm. Perhaps it was the numbing effect of skyrocketing fuel prices, or a rare display of trust in the government, we will never know. But, surprisingly, the day on which the price of key necessities increased multiple times went by without an incident. Bread, the national staple, at 20 cents per loaf had doubled in price; gasoline, powering 12 million cars on Iran’s roads increased four times; natural gas, which flows directly to the homes of 75 percent of Iranians, increased by a as much as eight times; and diesel fuel that powers the nation’s commercial transportation increased nine-fold.

For the poor, who spend much less than the rich on driving and heating their homes, the excitement of getting a chunk of cash per month most likely outweighed the pain of disappearing subsidies. A rural family of five, with one or two persons earning $10 per day each, suddenly had about $450 at the bank. For Iran’s severely poor (below the so-called $2 per day poverty line), about 10 percent of the population in 2010, [1] the cash payment of $1.50 per person per day is not negligible, nor even for the person with the median income of $4.50 per day. Many of the roughly 4 million families that had not taken the offer seriously to bother filling the necessary forms to set up bank accounts for the cash subsidy now crowd government offices to get them into the system.

Because in the past the rich benefitted more from the subsidies, the cash back offers Ahmadinejad the opportunity to make good on his promise of redistribution. The initial impact of the redistribution, before figuring in the increase in prices, was to reduce the Gini coefficient of income inequality by 8 points, from 0.42 to 0.34. In light of the hastily announced cash benefits in various Middle Eastern countries, from Morocco to Saudi Arabia, Iran’s program stands out as much more than an instrument to pacify the restive masses: it kills two birds with one stone, reducing waste while reducing poverty and improving equity. However, as a model for other countries it falls well short of superior examples from outside the region, such as the Progresa-Oportunidades program in Mexico, which also used subsidy money to persuade families to keep their children in school. Iran’s subsidy reform law is formally known as the Law of Targeting Subsidies, but as it turned out, the only targeting was a consequence of the uneven distribution of the original subsidies.

Iran’s subsidy reform program has cleared a big initial hurdle in that it made it possible for the government to adjust prices to market levels without causing mass protests. However, it is too soon to call it a success. Two serious problems loom on the horizon. First, people only began to feel the full impact of the removal of subsidies in February as their first utility bills with adjusted prices arrived. The shock to the poor is not huge because utility prices increase steeply with use. Therefore, they should continue to come out ahead in the balance of the cash they receive and the higher prices they pay for utilities. It is a different story for the average middle class family, who will see its initial gain disappear. Their dissatisfaction could spill over into the ongoing political protests and setback the program’s progress and even cause its cancellation.

Second, production and employment will suffer as consumers cut back on their non-essential expenditures and spend their subsidy money on imported goods on which prices do not rise. In that case, more of the demand stimulus from the cash program would benefit the Chinese rather than Iranian producers. The government is trying to help firms, or sectors, that are facing serious challenges, such as the trucking sector, by delaying the full impact of the price increase or encouraging banks to lend to them. But so far, its only consistent policy has been to stop them from raising their prices. Anecdotal evidence suggests that many businesses that were already in financial trouble since the current recession began, and are unable to get help from the government, are closing down and laying off workers. Unemployment, which was last reported to be close to 15 percent, is likely to increase. The poor are unlikely to come ahead in this round of adjustments to the price hikes. They are disproportionately represented in unskilled occupations and marginal jobs that are more susceptible to being cut when businesses retrench. Another susceptible group is the youth, who already account for 75 percent of the unemployed and are already in the forefront of the opposition to the government.

Iran’s subsidy reform has enjoyed impressive initial success, but it has not cleared troubled waters yet. With the rest of the region in turmoil, dissatisfaction with the implementation of the price increases or the cash-back program can easily spill over into the streets, setting energy subsidy reform back for at least another decade.

Footnote:

[1] Using 2009 expenditure survey data and 18000 rials as the poverty line in 2010 (about $3 at the PPP exchange rate of 6000 rials per dollar).