Current Issues: Subsidy is it GOOD or BAD?

Before we start, lets define what is subsidy. I got this from wikipedia.

subsidy - In economics, a subsidy (also known as a subvention) is a form of financial assistance paid to a business or economic sector. A subsidy can be used to support businesses that might otherwise fail, or to encourage activities that would otherwise not take place.

Subsidies can be regarded as a form of protectionism or trade barrier by making domestic goods and services artificially competitive against imports. Subsidies may distort markets, and can impose large economic costs.[1]

Financial assistance in the form of a subsidy may come from one's government, but the term subsidy may also refer to assistance granted by others, such as individuals or non-governmental institutions, although these would be more commonly described as charity.

Is subsidy good or bad? That is a subjective question.
BUT if we view good in economic terms as increasing productive benefit for the nation, increasing wealth and availability of goods and services now and in the future, then there are some form of subsidies that fall under this GOOD category.
I have cut and pasted this article below. Then we would notice that the forms of subsidies before 1980's are the ones that falls under GOOD category. But thing started going downhill from there.
Coming back to the petrol price hike issue, I am of the view that subsidizing petrol and diesel is BAD for the nation. A fast way of depleting our nation's resources.

this article from www.malaysia-today

A Critical Review of Price Control & Subsidies in Malaysia

Written by Dr. R.Thillainathan

(A Note prepared for delivery at LSE Alumni’s Forum on Rise & Fall of Subsidies on 26.5.08)

The Forum is on the subject of the Rise & Fall of Subsidies. Under DrM the extent and size of subsidies widened and expanded. The framework he created for the control of prices of petroleum products was a time bomb. I am sorry it did not explode in his face. Instead it exploded in the face of his chosen successor PM DB. In the process it led to subsidizing consumption on a colossal scale and on an indiscriminate and inequitable basis. More areas of investment were also subsidized. Such investment subsidies is being further expanded under DB.

Production & consumption subsidies – nature, extent & implications

Historically, the economic and financial management of Malaysia has been generally prudent. Reliance on subsidies and price control was limited and very selective. But DrM was more radical with his price control experiment. An experiment that has turned out to be a nightmare for Malaysia and his successor. It distorts resource allocation, makes for inequity and threatens to undermine the country’s sacred legacy of fiscal prudence.

Before DrM subsidies were aimed at production and investment and not at consumption. A more serious problem with subsidies then – it was implicit and opaque and not explicit or transparent. Therefore it was less amenable to public scrutiny. And it made it more difficult to question the government on its subsidy program.

Investment activities that were subsidized heavily but implicitly were as follows:

- double cropping of padi (with irrigation provided free of charge);

- land development and resettlement (with the administration cost of the scheme not recovered from the settlers);

- provision of education (where fees charged were small relative to cost and more so for higher education) and

- key areas of manufacturing and tourism (where profits earned were exempted from tax).

As the padi farmers and settlers were amongst the poorest in the country, the subsidies extended to them were not wholly inequitable. University graduates and businessmen (in non-traditional areas) singled out for subsidies were less deserving no doubt. But in the first few decades of independence it may have been justifiable to subsidize graduates and businessmen given the high rate of unemployment and the critical importance of knowledge workers for development.

DrM greatly widened fiscal incentives (to cover agriculture and IT services) and expanded the size of implicit subsidies (by exempting profits earned over a longer period).

Dato Seri DB has also aggravated inequities. Firstly by widening the class of exempt investors. It now covers even those engaged in real estate development. And secondly by withdrawing the tax-exempt status of equity investments of workers with the EPF and of retail investors with PNB and the likes (by replacing the imputed system of taxation of dividends with a single tier system of taxation).

Let us now look at explicit subsidies. Its coverage and size was always limited until DrM’s time bomb exploded in DB’s face. The handouts under the school food & nutrition program are the only items of consumption that were subsidized and strictly in a limited way. Production inputs subsidized were fertilizers as well as (to an extent) credit in padi farming and textbooks for schooling. The payment of a guaranteed price to local padi farmers has been, until recently, more in the nature of a production and not a consumption subsidy. (See footnote 1 in the attached Annex Schedule). Now with a run-up in the world price of rice and a near unchanged guaranteed price, the padi farmers are likely to be the real losers and the licensed traders/importers the big winners.

DrM’s consumption subsidy time bomb took the form of the approved price mechanism (APM). He erected this back in 1982 for petroleum products. The mechanism maintained the price payable by the consumer to the government’s fixed (or controlled) price. To ensure that the producer received the market price, it adjusted the tax payable by the oil companies or the subsidy payable to them.

DrM was the lucky PM. During his long over-stay as PM, to maintain the fuel price (paid by consumers), only the tax rate had to be adjusted and little or no subsidy was payable.

DB was not so lucky. Since he became PM oil price has escalated, (partly thanks to the easy money policy of the US).

In 2008, assuming an oil price of USD100-120 pb, the fuel subsidy is estimated at RM18 billion and the tax forgone at RM7b. Therefore the total consumption subsidy to motor vehicle owners, the well-off in Malaysia, is a colossal RM25b.

In 2006, when oil price averaged USD70 pb, the total subsidy paid was RM10 billion. Of this RM7.6b was captured by motor vehicle owners and operators. This excludes the tax revenue forgone of RM7.3b.

In 2002, during DrM’s last full year in office, when oil price averaged USD25.50 pb, the total subsidy paid was only RM3.7b (of which fuel subsidy was probably RM2b).

DrM’s rotten legacy (with respect to price control and the resulting consumption subsidy) was not confined only to controlling the price payable by the consumers (to an arbitrary price it had fixed).

It also extended to a second type of price control – one aimed at regulating profit of utilities with monopoly power. A utility was permitted to increase its price provided the return on its capital was below the prescribed threshold return. However, under the Mahathir Administration, the maintenance of price of a utility (at an unchanged level), was accepted as an end in itself.

This applied not only to the utilities such as water, electricity and telecommunications but also to gas.

Petronas, which is the producer and distributor of gas in Malaysia, is required to sell it at a controlled price to the electricity generators at a price well below its international price. The Mahathir Administration had decided to control the price of gas because it was also controlling the price of electricity. This has led to cross-subsidization of not only electricity generators but also electricity users. It interferes with the smooth operation of the market mechanism and distorts resource allocation. To the extent that the subsidy is an off-budget financing arrangement it is more opaque and makes meaningful analysis of such arrangements more difficult

For an oil price of USD100-120 pb, the implicit subsidy from the control of gas price is estimated at RM20b.

It is staggering to note that now the consumption subsidy, and just for fuel, will far outstrip the development expenditure of the public sector. The fuel subsidy in 2008 is estimated at RM45b versus the projected total development expenditure of RM40b. Interestingly the RM200b 9MP development expenditure target was itself a record. The size had worried many economists on its likely inflationary or crowding out effects.


Fuel price control & subsidy – an inspired insight or a monumental folly

I am surprised that some had viewed DrM’s design of the APM as an inspired insight. It was in fact a monumental folly. Stabilizing the fuel price through an adjustment in duty (which offered in any case only a limited cushion) or through a subsidy payable, leads to the squandering of a scarce resource. And as this is a depleting resource the government failed to take into account the real risk of a continued rise or a sudden jump in price (as has certainly been the case from 2004). And once the public gets used to a fixed price, the government will find it very costly (except in a crisis) to raise the price, and hence remove the subsidy especially in a democracy, (again as is amply evident in Malaysia).

The massive subsidy for fuel (almost the only consumer good subsidized in the country) is enjoyed by motor vehicle owners and operators, the better off segment of society. There is no case for the granting of this subsidy. No such subsidy is being granted to non-vehicle owners and operators, the worse off segment of society. Only some users of public transport may deserve the subsidy but there are less indiscriminate and inequitable ways of addressing their needs.

The removal of the fuel subsidy will no doubt greatly increase the cost of owning and operating motor vehicles and force the less well off amongst them to use public transport. As the coverage and frequency of public transport services is not satisfactory this will greatly inconvenience this group. Therefore the removal of the subsidy has to be accompanied by a corresponding improvement in public transport, (both bus as well as mass transit rail transport including an effective system of feeder buses to support mass rail transport). And given the very bad state of traffic congestion encountered by road users in getting to their work place and back, priority should also be given to the introduction of urban congestion charge on road users. There is a strong case for the revenue collected from this charge to be spent on cross-subsidizing public transport. Of course the imposition of the congestion charge will immediately reduce the number of motor vehicles getting into the city. Public bus transport can be stepped up concurrently (which is not very difficult) to cope with the increased demand (with mini buses re-introduced to service commuters in the suburbs)

The removal of the subsidy will also impose a painful readjustment on energy-intensive industries or force them to become more fuel efficient. But this is something to be welcomed in the interest of building a more competitive and resilient economy.


An aside on DrM’s zero inflation target & price control

In passing it is also instructive to refer to a third type of price control - reliance on which was greatly increased by DrM as a means to achieve his so-called zero inflation target[1]. This form of price control was aimed at price maintenance as an end in itself, and applied to industries dealing in so-called essential goods such as sugar, cement, steel, motor vehicles and even chicken. To make price control more palatable to the businessmen, the authorities protected their profits by strictly regulating competitive imports or entry into these industries, and by allowing the businessmen to seek a price review based on changes in their cost of operations. This type of price control activity with import or entry restriction can expose the regulator to capture by the regulated.[2] It can enable the businessmen to charge a higher price or short-change on quality thereby undermining the welfare of consumers or the competitive position of other businessmen who are end users of the controlled products.[3] Where the authorities have been slow in allowing price adjustments in the face of major shifts in supply or demand conditions, such price control activities have led to shortages and black marketeering. This has been found to be the case from time to time in the cement and steel industries.

Where the Government control activity has taken the form of a severe restriction on imports regulated through the issue of import permits with a nominal regulation of prices, as is the case with the import of motor vehicles, this has led to abnormal profits in such distributive trades and intense competition amongst rent-seekers to capture such profits.[4] Rent-seekers are always on the lookout for opportunities to create contrived scarcities to earn monopoly rents. To eliminate such incentives and opportunities, the Government has to make a firm commitment to competition in all its economic pursuits.


Badawi Administration’s limited attempt at curbing growth in consumption subsidies

The Badawi Administration, after the general elections of March 2004, started raising the prices of petroleum products. But it halted this process from 2007, partly on account of some public disquiet and more in order not to prejudice its prospects in the subsequent general elections which it called in March 2008. Now that the elections are over it has no choice but to raise the fuel price and eliminate the unprecedented and massive subsidisation of consumption if the country’s legacy of fiscal prudence is to be restored.

In 2004, the total Government revenue was around RM100b. But only RM8.8b was generated from taxes on motor vehicles. However, petroleum products were enjoying a subsidy that year of RM4.2b. Less the subsidy net taxes on motor vehicles was only RM4.2b. In 2008 motor vehicle owners are likely to end up enjoying a subsidy on a net basis of around RM10b.

There is no case for motor vehicle owners, certainly a very well-off group, to enjoy such subsidies. There is also a strong case for the Government to subject the consumption of petroleum products to sales tax. The level of the sales tax on petroleum products in Malaysia is a lot lower than most countries, including those in the Region. At the current level of oil prices, the duty has to be waived. In fact the Government has to provide a substantial subsidy, in addition, to keep prices at the current level. Even if Malaysian consumers pay prices which reflect market prices and which includes the full Malaysian duty, the prices paid by Malaysian consumers will still be lower than overseas prices. Therefore, in the interest of fiscal prudence as well as equity the Government should let prices rise to the desired level, at least on a phased basis.

Collecting taxes on motor vehicles through a duty on petroleum products is also more efficient as the duty payable will be related to usage. Therefore, it will create the right incentive for users to be less wasteful and to economise on their use when prices are higher.

Road tax as well as import and excise duties on motor vehicles are a less efficient form of tax.[5] They cannot be justified as a wealth or luxury tax as other forms of wealth or luxury consumption are not subject to such taxes. If the purpose is to regulate the car population, it is best to require a certificate of entitlement (COE) to own a car (as in Singapore) or to operate the car (as can be done for use of a car in Kuala Lumpur’s Central Business District or CBD.) The certificates can then be auctioned off amongst the higher bidders. The Government is now better placed to make this policy shift with the sizeable investment it has made on mass transit rail transport. The additional investment required to improve this form of public transport will be a lot less than that required on flyovers and elevated highways. The massive investments for an improved road network in any case can alleviate traffic congestion only on a temporary basis.

The Government continues to build more flyovers and elevated highways in the Klang Valley instead of improving the inter-face between the different mass rail systems, extending their coverage, reintroducing a mini bus feeder system within each suburb and by ensuring a more effective enforcement of traffic rules. One wonders if the DB administration’s continued reliance on the system of negotiated tenders – another rotten legacy of the DrM administration – (and in spite of the DB Administration’s declared intention to rely on it only on an exceptional basis when it came to power in October 2003), has distorted incentives of the decision makers.

Where improvements in public transport (including better bus services) are combined with a Road Pricing System for entry into KL’s CBD, the use of revenue generated from COEs and the Road Pricing System to cross-subsidise public transport can be easily justified as users of public transport do not impose any external costs on other road users.

The improvements will greatly reduce the multi-billion RM losses the economy is presently suffering from the time lost in commuting within the Klang valley and from the enormous stress traffic congestion imposes on commuters.


Conclusions

Price control and price subsidy has been on the rise in Malaysia from DrM’s early years as PM. There is no sign of its fall under the DB administration.

Price control is inefficient for attaining economic or welfare goals for several reasons. Firstly, it distorts resource allocation. Secondly, it dispenses with the services of the price mechanism which provides a costless way of coordinating economic activities which are by their very nature extremely complex and involved. Thirdly, beneficiaries cannot be targeted and thus ends up benefiting those who do not deserve any assistance. Often those who deserve the assistance are only a small minority and there are other more efficient and less inequitable ways (such as income transfers) of reaching out to them. Fourthly, price control encourages illegal and immoral activities including bribery, corruption, smuggling as well as illicit manufacture.

The size of consumption subsidy, (and almost entirely due to the control of fuel price), has gone almost completely out of control. Ineptitude, opportunism or lack of grit is now threatening the integrity of the government’s finances as well as the very fabric of the economy.

The production subsidies accorded to businessmen through a system of fiscal incentives (or tax breaks) have been increasing from the early years of the Mahathir administration. Many corporations including MNCs have thus not paid taxes for many, many years running. More importantly, under the current full employment environment, investments generated by fiscal incentives create no additional jobs and in fact reduces tax revenue. Why is this so? With full employment, the new investment displaces an existing investment which is currently paying taxes. And hence the country ends up collecting less tax revenue.

The alternative to a system of fiscal incentives is to rely on a lower tax regime to promote investment. A lower tax regime can make for more investment, higher profits and hence more taxes. This happened in Malaysia in spite of the big reduction in tax rates during the mid and late 80s. If there are no tax breaks, there will be more corporate taxpayers. The resulting gains on tax revenue from the removal of fiscal incentives will far outweigh any likely losses in tax revenue from the reduction in the tax rate. These reforms will also make for less distortion in resource allocation.


R. Thillainathan

25.5.08



Appendix: Relationship between total subsidies1 paid and oil price, 1999-2007

Year




Subsidies




(RM billion) Oil price (USD pb)



1999 1.14 18.56


2000 4.82 29.89


2001 4.55 24.92


2002 3.68 25.48


2003 2.68 30.35


2004 5.80 41.20


2005 13.39 58.47


2006 10.11 69.60


2007 12.15 74.00


Source: MOF Treasury Economic Reports for relevant years.


Notes:

1.As per 2002/03 TER goods accorded subsidies were as follows: diesel & LPG, rice, fertilisers, textbooks as well as items given under the food & nutrition program for school children. With respect to rice, the government controlled the price payable to padi farmers. Those licensed to buy the poorer quality rice from the local farmers are also licensed to import the higher quality rice from abroad such as Thailand. The higher the guaranteed price for local rice, the more likely is the buyer/importer to make a loss from engaging in the rice trade business. So where the government fixes a high guaranteed price it has to subsidise the rice trader to cover his losses and make a normal return for engaging in the business.

2.As is clear form the data DrM’s administration did raise the fixed price in response to the increase in oil price from 2001. Fortunately for him the extent of the rise in price was small relative to the rise in oil price in the mid-2000s. There is no doubt that he would also not have raised the fixed price from 2007 on account of electoral considerations. This is readily evident in his decision not to introduce the VAT/GST in spite of its widespread adoption the world over. In designing the APM he should have realized that once set up it becomes an excellent tool in the hands of any populist politician to maintain himself in power and he is probably no exception.

3.In 2006 as per the TER fuel subsidy accounted for 76% of the total subsidy paid.

4.These are best estimates and not actual.


[1] DrM’s infamous experiment with price control (through the restructuring in 1994 of the Department of Domestic Trade into the Ministry of Consumer Affairs) was aimed at achieving his target of zero inflation. In this context he had opined that the pursuit of inflation targeting by economists via the control of money supply and interest rate was simplistic and easy.

[2] This type of price control was dealt with at length in R. Thillainathan, Malaysia’s Experiment with Zero Inflation and Price Control – An Assessment, Malaysian Institute of Economic Research, 1995 (See MIER Monograph Series No. 4).

[3] In the steel industry, end users who wish to import steel products on account of their more stringent quality requirements, have to convince a panel made up of domestic steel manufacturers and regulators as to why they should be given a permit to import the products. The domestic car makers have also faced this requirement but as they are in a promoted industry, one promoted by the previous Administration, their challenge was a less onerous one.

[4] From January 2004 until 2007, the Ministry of Domestic Trade & Consumer Affairs started the practice of licensing jobbers to supply diesel and Mogas to independent distributors in the rural areas who are not a franchisee of an oil company. As the price of diesel was controlled well below its market price for many classes of consumers, this opened up possibilities for smuggling diesel to foreign countries or reselling it to consumers who are not eligible for such a subsidy. This licensing requirement therefore opened up a new rent-seeking opportunity in classic text book terms.

[5] High road tax has led to evasion. And bribery of enforcement officers by the evaders is not uncommon.



Dr. R. Thillainathan is past president of the Malaysian Economic Association. He obtained his 1st degree from the University of Malaya and Masters and PhD at the London School of Economics.