Gasoline subsidies are inefficient because they lead people to drive too much and own low-MPG vehicles.
Recently I have been spending a lot of time thinking about global fuel subsidies. The most extreme example is Venezuela, where gasoline costs only 6 cents per gallon. That’s not a typo. The price in Venezuela is less than 1/50th of what I pay in California. It is no coincidence that gasoline consumption in Venezuela is 40% higher than any other country in Latin America, and three times the regional average.
Gasoline subsidies are inefficient because they lead people to drive too much and to own large, low-MPG vehicles. In a new EI@Haas Working Paper titled, “The Economic Cost of Global Fuel Subsidies”, I examine Venezuela and other countries that subsidize gasoline and diesel. Using the latest available data from the World Bank, I find that subsidies for gasoline and diesel totaled $110 billion in 2012. The top ten countries (below) represent 90% of global fuel subsidies.
Many of these countries are major oil producers. Gasoline and diesel subsidies have long been viewed in many oil-producing countries as a way to share the resource wealth with a nation’s citizens. This is not the view in all major oil-producing countries, however. Prices are at or above market in Iraq ($2.95 per gallon for gasoline), Mexico ($3.26), Russia ($3.74), and Canada ($5.00).
These subsidies impose enormous economic costs. Subsidies create “deadweight loss” by enabling transactions for which the buyer’s willingness-to-pay is below the foregone revenue from selling oil. In other words, it costs the government more to provide the subsidy than the value the subsidy creates for gasoline consumers. In Venezuela right now there is someone driving around who values gasoline at only $.50 cents per gallon. Gasoline can be sold in international markets for about $3.00, so each time this person uses a gallon of gasoline the world becomes worse off by $2.50.
The total amount of this deadweight loss depends on the elasticities of demand and supply. For a given size subsidy, the more elastic are demand and supply, the larger the deadweight loss. Estimates in the literature for the long-run elasticity of demand for transportation fuels range from -0.6 to -0.8 (Brons et al., 2008). In the main analysis in the paper I use -0.6 while noting that deadweight loss is 18% higher when -0.8 is used instead. And I assume that supply is perfectly elastic. Incorporating less than perfectly elastic supply would decrease the estimated deadweight loss, but only modestly because fuel consumption in most countries is small relative to the world oil market.
Under these assumptions, the total global deadweight loss in 2012 is $44 billion. The top ten countries (below) are similar but not identical to the previous figure.
Saudi Arabia takes the top spot with $12 billion in deadweight loss in 2012. Venezuela is number two with $10 billion in deadweight loss. In 2012, Venezuela had the cheapest fuels on the planet so even though the total dollar value of subsidies is higher in Iran and Indonesia, the subsidies in Venezuela impose more economic cost because the subsidy per gallon is so high.
Incorporating external costs increases the economic costs substantially. Parry, et al. (2007) find that the external costs of driving are about $1.00 per gallon. Under my baseline assumptions this would imply that global fuel subsidies impose external costs worth $32 billion annually. Combined with the estimated deadweight loss ($44 billion), the total economic cost of fuel subsidies is $76 billion annually.
While these calculations could undoubtedly be refined substantially, the analysis makes clear that fuel subsidies are not just benign transfers from sellers to buyers. It would be useful in future analyses to explore alternative assumptions about demand and supply, but these subsidies are extreme enough that under any reasonable assumptions the estimated economic costs are going to be very large.
Subsidy reform is difficult but not impossible. Just last summer, Indonesia took a major step forward by increasing gasoline and diesel prices by $0.75 per gallon (more here). Prices remain well below market and Indonesia has nonetheless become a net importer of gasoline (here), but the increase should still be considered a substantial victory for economic efficiency. Moreover, the Indonesian government combined subsidy reform with increased funding for cash transfer programs, thereby mitigating any distributional impacts.
In future work it will be important to expand the analysis to include other energy markets. Coal, natural gas, and electricity, for example, are also widely subsidized. Recent analyses of the broader energy sector find that the total dollar value of global energy subsidies is almost $500 billion annually (IEA 2012; IMF 2013) and much more can be done to understand and quantify the economic costs of these policies.
For more see “The Economic Cost of Global Fuel Subsidies” (by Lucas Davis), American Economic Review: Papers and Proceedings, 2014, 104(5), 581-585
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.