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We construct a dynamic model of a small open economy to analyze the effects of large energy subsidies. The model includes domestic energy production and consumption, trade in energy at world market prices, as well as private and public sector production. The model is calibrated to Egypt and used to study reforms such as reductions in energy subsidies with corresponding reductions in various tax instruments or increases in infrastructure investment. We calculate the new steady states, transition paths to the new steady state, and the size of the associated welfare losses or gains. Our main results for a 15% cut in energy subsidies are: (1) Steady state gross domestic product drops in most of our experiments as less energy is used in production. (2) Steady state consumption rises in most of our experiments. (3) Welfare can rise by as much as 0.6% in consumption equivalent terms. (4) The largest gains in terms of output and of welfare can be obtained when savings from energy subsidy cuts are used to fund additional infrastructure investment. (JEL E21, E63, H55, J26, J45) To understand the effects of subsidies and taxes on an energy sector and on consumption in a given country requires establishing a complete picture of the market in which it operates and of the various policies--past and present--that have applied to it. (IEA 2010c, 11) 1. INTRODUCTION A report by the International Energy Agency (IEA 2010a) in 2010 identified 37 countries that together account for 95% of global subsidized fossil-fuel consumption and found that total fuel consumption subsidies were about $557 billion in 2008, a stark increase from $342 billion in 2007. Countries with the highest subsidies for energy turn out to be smaller, oil-producing countries like Iran ($65 billion in subsidies in 2009, 20% of gross domestic product [GDP]), Saudi Arabia, Venezuela, and Egypt (IEA 2010b) The underpricing of energy can lead to excess consumption of energy that together with the need to finance these subsidies can have adverse economic effects, both intra- and intertemporally. Energy subsidies may therefore have large adverse effects on capital accumulation, economic growth, and hence welfare, especially for future generations. The IEA estimates that many countries forgo faster growth of up to 2.6% by subsidizing energy (IEA 2010c). Since 2008 many major oil-subsidizing countries have started to bring their prices in line with world market prices, among them China, Russia, India, and Indonesia. Many of the concerns about the inefficiency of energy subsidies have focused on environmental aspects and green house gas (GHG) emissions in particular. The IEA (2010c) estimates that a world-wide reduction of fuel subsidies could decrease GHG emissions in the long run by around 10%. There are relatively few studies of the short-term and long-term macroeconomic effects of reductions in energy subsidies. These effects are complex and require an explicit dynamic modeling approach. There are many interrelated effects: (1) Phasing out energy subsidies alters the price of energy relative to other consumption goods and hence not only the quantity demanded for energy but also the demand for other goods. (2) The degree of complementarity/substitutability between these consumption goods together with the expectations of the time path for the phase out influences savings behavior and thus capital accumulation of households. (3) Changing energy subsidies influences use of energy in production. Whether energy is a complement or a substitute to other factors of production influences total output and marginal products of all factors of production. (4) Changes in factor payments influence household income and thus consumption and savings behavior. (5) Phasing out energy subsidies allows for other changes in the government budget such as changes in tax rates or other government expenditures, which in turn will influence firm and household behavior. … |
