Economic Research Forum (ERF)

From energy subsidies to universal basic income: lessons from Iran

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In December 2010, Iran introduced an ambitious energy subsidy reform that combined large price increases for fuel with generous cash transfers. This column explains the key lesson: that despite severe flaws in the programme’s implementation, it is possible to reduce the distortions caused by cheap energy and offer citizens a minimum basic income that is not excessively harmful to work incentives.

In a nutshell

Energy subsidy reforms that do not include some form of income maintenance as compensation for the poor often spark social unrest.

Because of mismanagement in the implementation, Iran’s energy price reform has lost credibility – but this is a mistake.

By providing a universal basic income, Iran’s reform shows the potential for tackling the economic and environmental damage caused by cheap energy without causing a rise in poverty and inequality.

One of the most vexing policy challenges facing MENA governments is reform of energy subsidies. According to the International Monetary Fund, about half of all energy subsidies in the world are in MENA, and of the top ten countries that most heavily subsidise fossil fuels, five are in the MENA region. Besides the damage they do to the environment and the distortions they create in the economy, energy subsidies are very costly.

In the last few years, momentum for energy price reform has picked up across the developing world, including in the Arab world. Several oil-rich countries – the Gulf Cooperation Council (GCC) members in particular – that do not use tax revenues to pay for the subsidies and are therefore less motivated to cut them, have also joined the club as government revenues from energy exports have declined sharply following the oil price collapse of 2014.

Although their motives for energy price reform are different from governments that finance subsidies with limited tax revenues, the main dilemma they face is the same: how to prevent the reform from hurting the poor. The poor spend a larger proportion of their incomes on energy, so they will bear the brunt of any price increase. Reforms that do not include some form of income maintenance as compensation for the poor often spark social unrest, as they did in Mexico in January 2017.

In dealing with this dilemma, the experience of Iran’s massive 2010 energy subsidy reform offers valuable lessons. The reform programme, designed and implemented by President Mahmoud Ahmadinejad, had two parts: large price increases, ranging from four-fold for gasoline to nine-fold for diesel; and generous cash transfers.

On 19 December 2010, as energy prices leaped, the government released the cash transfers that it had placed in individual accounts of about 60 million Iranians. Within a few months, nearly all Iranians (then over 70 million) would be on the roster.

There are two important lessons to be drawn from Iran’s experience. The first is to get the mathematics right. Ahmadinejad’s team did not, and the cash transfers they offered exceeded new revenues from higher energy prices.

Energy price increases will necessarily cause some inflation; there is no need to add to it by printing money. Iran’s programme had a deficit of about 25%, which was financed by printing money. This pushed inflation very high (to 35% in 2013) and contributed to the collapse of Iran’s currency in 2012.

The ensuing economic chaos eroded the reform’s initial popularity, undoing its initial gains. Energy consumption, which had declined in the first year of the programme, started climbing again. In the first five months of the current Iranian year (21 March to 21 July 2017), gasoline consumption was up by 8.7% compared with the same period a year ago.

Despite the failure to sustain the price reforms, the other component of the programme, namely cash transfers, had several benefits. Because it used banks to reach individuals, it encouraged many who had never used a bank to open an account and to learn how to use an ATM.

The banking infrastructure also had to expand quickly, with ATMs placed in most villages. More importantly, the cash transfer programme offered the country a valuable experience with ‘universal basic income’ (UBI) – a method of guaranteeing minimum welfare to everyone that has been gathering support in recent years.

Iran’s subsidy reform did not start out as a UBI scheme. Initially, transfers were designed to go to lower income families, but failing to identify them, the government decided to make it universal.

Whether by design or by error, Iran’s transfers were significant enough to qualify as UBI. In the Iranian fiscal year 2011 (21 March 2011 to 20 March 2012), transfers were about $90 PPP per person per month – which was equal to 28% of median per capita expenditures and exceeded the monthly expenditures of 2.8 million Iranians.

In terms of their impact on poverty and inequality, the transfers were also quite significant. Not only did poverty and inequality not increase following the energy price increases, as they were expected to do, but both declined after the reform (Salehi-Isfahani, 2017; Atamanov et al, 2016).

Besides its simple administration and reliable reach, UBI has an important advantage over means-tested welfare schemes in that it avoids the so-called cliff effect. This is a sharp increase in the implicit tax on earned income, which can be as high as 100% if every dollar earned above the threshold is subtracted from the cash transfer.

Opponents of UBI point to distortions created by the additional taxes that will pay for cash transfers. In the case of Iran – and other oil-exporting countries with energy subsidies – this is not true since revenues come from elimination of the subsidies, thereby reducing distortions.

UBI has also been criticised because it may discourage work. Economic theory suggests that unearned income in general can reduce labour supply, though empirical support for this prediction is absent. Evidence from large lottery winners suggests a negative labour supply effect, but none of the studies address small increases in unearned income such as what UBI would entail.

In a recent ERF study, we examine the effect of Iran’s cash transfers on labour supply (Salehi-Isfahani and Mostafavi-Dehzooei, 2017). Contrary to claims made by opponents of Iran’s cash transfer scheme, which are only backed by anecdotal evidence, our systematic examination does not find any effect.

We use panel data to make comparisons of the labour supply of transfer recipients, using variation in the significance of transfers in household incomes. Interestingly, we find a significant positive effect of the transfers on the labour of the self-employed.

We conjecture that the cash transfers may have relaxed a credit constraint, thus enabling some self-employed workers to expand their business. The stream of cash expected over time was a good source of income against which to borrow.

Because of mismanagement in the implementation, Iran’s energy price reform has lost credibility. Many would use it as an example of what not to do. But this is a mistake.

Consider this simple fact: Iran consumes twice as much oil and gas domestically as it exports. Whereas the government earns more than half of its revenues from oil that it sells abroad, it earns little from the energy it sells domestically. What better way to sell the latter at market prices and use the profits to offer UBI?

So the lesson from Iran’s experience for oil-rich countries – such as the GCC, Iraq and Libya – is that it is possible to reduce the distortions caused by cheap energy and offer their citizens a minimum basic income, which is, at the same time, least harmful to incentives to work.

Further reading

Atamanov, Aziz, Mohammad-Hadi Mostafavi, Djavad Salehi-Isfahani and Tara Vishwanath (2016) ‘Constructing Robust Poverty Trends in the Islamic Republic of Iran 2008-14’, World Bank Policy Research Working Paper No. 7836.

Salehi-Isfahani, Djavad (2017) ‘Poverty and Income Inequality in the Islamic Republic of Iran’, Revue Internationale des Etudes du Développement 2017(1): 113-36.

Salehi-Isfahani, Djavad, and Mohammad Mostafavi-Dehzooei (2017) ‘Cash Transfers and Labor Supply: A Large-Scale Program in Iran’, ERF Working Paper No. 1090.

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