Subsidy Liberalisation: Harsh but Necessary

Subsidy Liberalisation: Harsh But Necessary
I. Introduction
Hot off the heels of the Budget 2014 announcement, the general public is widely concerned about the impact certain policies will have upon their cost of living. With the proposed implementation of the Goods and Services Tax (GST) on April 2015 and the abolishment of sugar subsidies, Malaysians are looking at an upcoming period of inflationary prices. Prior to Budget 2014, Treasury Secretary-General Tan Sri Dr Mohd Irwan had already suggested the complete elimination of existing subsidies, describing it as `a gradual liberalisation towards the market’1. As we approach this period with caution, will this further implicate the rakyat’s lives?

Malaysia’s subsidy predicament

With subsidy rationalisation being widely advocated by the government, it would not be surprising to see a drastic reduction in subsidies over the next few years as the government attempts to balance the budget through fiscal consolidation. Moreover the total number of registered cars and motorcycles has both exceeded the 10 million mark in 2012 as shown in Table 1, and this upward trend will only serve to raise the fuel subsidy bill if the government does not phase it out. With global oil prices rising, the exponential increase in cars will further compound the existing subsidy bill. This paper seeks to explore the feasibility of subsidy liberalisation while examining the possible impact it has on the society, and provides suggestions to approach this issue.

Table 1: Total registered vehicles in Malaysia, 2005-2011

As commonly practised globally, subsidies are provided by the government during the infant stages of an economy, especially in the energy sector. The concept relies on the basis of making cheap energy available to the industry and consumers to boost the economy, because the subsidy has a strong multiplier effect on the growth of GDP. By maintaining a low cost for transportation and electricity, it stimulates demand for consumer and governmental spending while industrial firms can operate at competitive costs on both the domestic and international fronts, thus boosting exports. Through these channels, an energy subsidy can stimulate the economy as in the case of fuel for Malaysia in 1983, but only up to a certain threshold. The strength of this multiplier inevitably hits a plateau once the country’s industrial sector is up and running, succumbing to the law of diminishing marginal returns. Thus subsidy liberalisation should have been gradual over a long span of years, to soften inflation and ease our economy through the transition to market-priced fuel. Evidently, the government pursued the populist policy over the years and still maintains artificially low-priced fuel up till today. By the end of 2013, Malaysia would have clocked 30 years of fuel subsidies and taxpayers’ money continue to fund this bill.

Malaysia’s rating outlook was downgraded to negative by Fitch Ratings due to soaring debts and lack of budgetary reforms which could have adverse implications on foreign capital inflows because of a drop in investors’ confidence. Post-Budget 2014, Moody’s did raise our rating outlook from stable to positive due to perceived budgetary reforms but there is still a lot of work to be done. We have always been struggling to reduce fuel subsidies, which in 2012 was RM 25.2 billion, comprising more than half the total subsidy bill of RM 42.4 billion. The Ministry of Finance reported that the government aims to reduce the subsidy bill to an estimated RM 37.6 billion in 20133. Removing the elephant in the room will receive tough resistance but for the sake of balancing our budget and developing the people’s mind-set, the government must employ aptly timed reforms to phase out fuel subsidies consistently with considerations for all groups of Malaysians.

For a brief outlook on Malaysia’s subsidy status, the International Monetary Fund’s (IMF)

2013 report on worldwide energy subsidy reforms presented Malaysia with the dubious honour of being one of the most generous countries in Developing Asia. Energy subsidies from the first-placed Malaysian government made up almost one quarter of government revenue at 23.39 percent. Furthermore, these subsidies were 5.12 percent of GDP in 2011 which earned second spot in Developing Asia4. On a positive note, Malaysia fully records fuel subsidies in our budget and does not attempt to disguise it through the expenses account of state-owned enterprises. Through this transparency, methods to reform fuel subsidies can be developed and results analysed after implementation.

III. Subsidy’s Three-pronged impact, largely unnoticed
Impact 1: Drains government revenue
In 2009, the Senior Director of the Ministry of Domestic Trade and Consumer Affairs Ismail Ahmad revealed how fuel subsidies are calculated. In 1983, Malaysia employed what it claims to be an “automatic pricing mechanism” (APM) to determine prices for petrol, diesel and liquefied petroleum gas (LPG)5. The term “automatic” assumes that the pricing mechanism passes on global market price fluctuations to the consumers using a pre-set formula. However, in Malaysia the price of RON956 petrol and diesel has not undergone significant changes since 2009 which indicate that the market fluctuations have not been passed on to consumers. Instead, the APM has become a formula which computes the subsidy value required to cover the difference between the market price and the fixed retail price set by the Malaysian government.

RON95 petrol and diesel are kept at a low retail price through 2 contributions borne by the government to make up the said difference, the exemption from sales tax and subsidies. According to the Sales Tax Act (1972), the government can actually collect a sales tax on petroleum products if the market price is lower than the fixed retail price. Only when the market price rises above the retail price will the government top-up the difference with a subsidy7. The government consequently factors in the deductions of sales tax and subsidies given to calculate the retail price of fuel that is charged to consumers at the pump. Hence the Malaysian government initially exempted the sales tax from 1983 up until the market price inevitably caught up with the retail price, and that was when subsidies had to be given for diesel in October 1999 and for RON95 petrol in June 20058. Evidently, it has gone largely unnoticed that the government is foregoing revenue twice on this scheme by spending on subsidies in addition to excusing sales taxes.

Impact 2: Fostered a deeply-rooted subsidy dependence syndrome
Subsidies are the source of vast inefficiencies in the market. It nurtures habits in the human mind-set such as complacency and over-dependence on the government, an on-going trend in Malaysia. Worse still, prolonged periods of subsidies eventually lead to wastefulness and non-conservation of resources. When consumers do not pay the full price of products, they tend to underestimate the true value of it as in the case of petrol and diesel. Fuel subsidies are meant to benefit the very poor group in the economy, but ironically the opposite has been proven true with the burden of expenditure subjected more on the poor.

The basis of this problem is that fuel subsidies have created a mentality that subsidies are a necessity for Malaysian people. A large majority of the population has adapted to subsidies and do not comprehend the reasoning of paying market prices for fuel. Instead, they feel the pinch of the increasing costs of living as they attempt to adjust their consumption based on the intermittent removal of subsidies. Factoring in the inflationary effect this has on the economy, the government is faced with a tough balancing act in completely phasing out subsidies.

Impact 3: Unintended beneficiaries receive the largest slice of the economic pie

Malaysia currently employs blanket subsidies for petroleum products. The downfall of this method is the issue of controllability, who really benefits from this scheme? Even though it is a convenient way to ensure the subsidy reaches all consumers, blanket subsidies are subject to abuse by unscrupulous people because everyone is given free access to an unlimited supply of subsidised petrol in Malaysia. Thus, this opens the door to opportunists who take advantage of price arbitrage and smuggle the petrol to a foreign country for sale at a higher price.

Owing to such porous borders with Thailand and Indonesia, subsidised fuel is being siphoned out by the thousands of gallons. In September 2013, Kedah’s Anti-Smuggling Unit foiled an attempt to smuggle 27,300 litres of subsidised diesel to Thailand, estimated to be worth RM
54,600. Security measures are difficult to tighten, hence this is all the more reason to liberalise fuel subsidies because there are alternatives to provide assistance to the rakyat. Leaving this issue unattended only causes crippling losses to the country and in effect, basically sponsors illegal activities. Foreigners are enjoying Malaysia’s subsidies while we struggle to reduce our budget deficit.

It is well-known that blanket fuel subsidies benefit the rich and high-income households because they are the comparatively larger consumers of energy. Thus, its regressive nature is highly inequitable and widens the disparity between the rich and the poor. Statistics show that 20 percent of the richest households capture 43 percent of fuel subsidies whereas the poorest 20 percent of households only receive 7 percent of the benefits11. As graphically shown in Chart 1, the high-income group benefits immensely from subsidies in transportation as they spend more than 20 percent of their income on travelling expenses. The lowest income group on the other hand, spend no more than 5 percent of their income on transportation costs. The fact is apparent since luxury cars are built with a full tank of 80 litres but a motorcycle tank only fills a maximum of 6 to 10 litres. Ultimately it defeats the main purpose of subsidies, to provide the basic necessity of travelling.

Chart 1: Household expenditure as a percentage of income according to income classes, Malaysia. 2009/2010

The subsidy scheme seems to have lost its objective, which is to extract public benefits and provide fuel as an essential for the people. The blanket subsidy does not adhere to its functionality because only a tiny portion of the funds are actually channelled for its real purpose. The bulk of it goes towards funding the luxurious travelling of fuel-guzzling vehicles and worse still, to foreigners in neighbouring countries due to rampant smuggling. To amplify existing problems, the subsidy disease has cultivated habits of wastage amongst the citizens. This is excluding the fact that the government is struggling with public finance, hence a subsidy solution must be found now.

IV. Suggested approaches to phase-out subsidies
Subsidy liberalisation is prominent on the government’s agenda, but concrete implementation would face tough resistance with the economy in an inflationary state. The government needs to tackle the subsidies problem immediately, so identifying key methods which appease the general public is decisive, considering the political will required to carry it out. As aforementioned, the nature of subsidies makes it incredibly challenging to remove once it has been implemented because they are highly sensitive and often rejected by local communities who are accustomed to cheap fuel.

Suggestion 1: Prices – Fuel goes up, vehicles come down
First, examining Malaysian’s consumption pattern will shed light on the relation between subsidies and the people’s spending. Economic principles suggest that consumers spending associate strongly between two complementary goods if they are bought to be used together, which in this case would be fuel with motor vehicles. The strongest acceptance effect can be evoked by reducing the price of the good which is strongly associated with the consumption of fuel. Hence, pairing the removal of fuel subsidies with the abolishment of road tax or reduction of vehicles excise duties and taxes will be a form of assistance for the people, giving them the impression that their income is not shrinking but are reallocated instead. Subsidy liberalisation would certainly get better reception if the prices of vehicles drop at the same time.

Due to excessive governmental intervention, our fuel prices are too low and car prices too high. Buying a car is a one-time payment of a huge sum but purchasing petrol weekly on a much smaller scale can grow to be of significant value within a lengthy period of time. Weekly expenditure can be perceived as more expensive than a one-off payment even though the total sum might be similar in value, and this can be attributed to the fact that humans view current income as more valuable than future income. Thus it will have a significant impact on motorist’s behaviour if they are paying market price for fuel at RM 2.73 per litre even though they bought their car at market price. This is ascribed to the way we see prices in large or small numbers. Therefore, the people should be allowed to purchase vehicles at market rate and with consumable fuel becoming more expensive, the usage of petrol can be expected to decrease significantly as people feel the squeeze more in their weekly income. As a result, overconsumption of fuel can be curbed with this policy.

Malaysians should be convinced that their consumption spending has been shifted from vehicles to petrol. Employing the policies of cutting subsidies and excise taxes together will be timely to entice public reception while also dampening the economic impact on private consumption and inflation. Developing the offset effect in people’s perception helps rationalise that cheaper vehicles will soften the price hike of fuel. For fiscal consolidation purposes, the reduction of tax should be lower than the reduction of subsidies to obtain a net gain from this policy. Furthermore with the revised National Automotive Policy (NAP) to be announced in January 2014, it provides the government a suitable opportunity to reduce vehicle prices to coincide with subsidy reforms. This will deliver twofold benefits to the economy as the deadweight loss of taxes and subsidies are reduced because Malaysia allocates resources more efficiently.

Suggestion 2. Limit subsidies, prior to eventual removal
The best effort to limit subsidies in Malaysia is practised in the industrial sector for the purchase of diesel, which is set at market price for businesses and factories. The government launched a system of fleet cards for public transportation firms in 2006, to encourage the use of diesel instead of petrol. Operators who registered with the Ministry of Domestic Trade, Co- operatives and Consumerism received a fleet card which entitled them to a 15 sen per litre discount. Moreover, a monthly quota was set for each category of vehicle such as 570 litres for school buses and 720 litres for taxis13. Transposing this system to the consumer sector would be a large task and prove costly, but it is certainly feasible by associating the issuance of fleet cards with vehicle sales. Furthermore, limiting subsidies in the form of quotas can put an immediate halt to smuggling and wastage while directing benefits to the targeted group of poor people. The cost of fleet cards implementation is possible and would be worth the savings accumulated over several years from the plugging of leakages, in addition to wider public acceptance with the view of full subsidy removal in the future.

By installing quotas on subsidies, the government saves in every segment of the community by establishing a more efficient system. The low-income people are covered through the quota. Although the lower middle-income population might feel the bite, they are more elastic to price changes and can adapt their lifestyle. The upper-middle and high-income community will not receive much subsidies because they have sufficient monetary resources and setting the market price on fuel will curb their over-usage and wastage.

Suggestion 3. Substitute subsidies for vouchers as an alternative
A constant agenda advocated by the government is to support the low and middle income groups, evident through the cash hand-outs of BR1M14, BR1M 2.0 and BR1M 3.0 in recent budgets. These channels are well-targeted but the problem of cash incentives is the inefficient utilisation to spend it on the intended purposes. Thus, it would be inadvisable for the government to cut subsidies and channel it solely into BR1M hand-outs, as proposed by Treasury Secretary-General Tan Sri Dr Mohd Irwan. Although BR1M is the populist policy, the additional revenue from subsidy cuts can be given back to the people in the form of redeemable vouchers for specific goods that they intend to provide for the poor. Fuel vouchers are similar to quotas which can be issued during the filing of income tax, to control the amount of fuel each household or person can receive. This will ensure the targeted income groups are covered by the quota, for example 50 litres per month. We can explore the possibility of giving subsidies through deduction from income tax as well, if the government wants to protect the lower middle income group. This will be practical, cheaper and easier to facilitate. Fuel prices would be set to market rate once subsidies are liberalised and the consumers can receive tax breaks based on the amount of petrol they used during the month.

Suggestion 4. Pick the right timing during a period of inflation
In this year’s post-budget dialogue annually organised by the Malaysian Economic Association, Treasury Secretary-General Tan Sri Dr Mohd Irwan shared studies from foreign countries who have implemented GST that inflation spikes were a one-off event which eventually tapered off15. For Malaysia, the inflationary pressure would take roughly one year to moderate. During the period immediately after GST implementation in April 2015, there will be an expected spike in inflation of about 1 to 2 percent, with the Treasury estimating that the Consumer Price Index (CPI) will increase to 3.5 to 3.8 percent. It might be of comfort that in the year that GST was implemented in our neighbouring ASEAN countries, total household private expenditure still increased as well as the following few years according to Index Mundi16. Having abolished sugar subsidies in Budget 2014 and with the announcement that energy subsidies reduction will raise the cost of electricity by 15 percent in early 2014, timing of policies is crucial to prevent inflation from spiralling out of control.

It will be tough for the government to reform subsidies during an inflationary period that Malaysia will soon experience. Selecting the right periods to shave fuel subsidies can possibly complement or clash with the GST-induced inflation and either dampen or swell the inflationary shock on the economy. In another scenario, subsidy cuts would have to be enforced before and after the inflationary period stimulated by the GST. The Ministry of Finance will have to carry out comprehensive studies to identify appropriate timing windows which will help keep inflation under control. It will be a gradual and painful process but the necessary price to pay for years of subsidised fuel.

Suggestion 5. Bridging the gap of asymmetric information with the rakyat
It goes without saying that the government urgently needs to gain public support to implement subsidy reforms and must recognise the expected reaction of the people to solve this problem. Addressing the people’s needs is crucial in attaining a good reception from society. Targeting certain policies has very differing effects depending on how the people perceive their own welfare. By outlining a comprehensive policy plan, the government can gain good public sentiment as observed in the case of the Philippines and Turkey, by spelling out the ultimate goals of reforming for the future of Malaysia17. Transparency and extensive communication with the public is a key aspect in garnering public support18. A good example would be the ideal scenario where our fuel prices are linked to market prices, and the fluctuations can be fully transparent because global market prices are published internationally and are self-explanatory. There is no hidden information and it would be hard to reject price variations.

Engaging with the society by committing to an elaborate 5 to 8 year liberalisation policy time frame would be a step forward in disseminating information effectively. There should be specific plans for gradual year by year reduction of fuel subsidies, such as 10 sen per litre per year. Clearly this method only functions if the government does not renege on their commitments, and it is time to build public trust after the latest debacle of broken promises regarding toll price hikes. Moreover, the government has significant control over the media to pursue aggressive public education on energy efficiency and reforms to explain the current situation faced by the entire country. Also, neutral academic institutions such as universities, research firms and think-tanks possess the onus to organise conferences and dialogues to further discuss these topics on public policy, so that the public’s input and output can be exchanged. With their established credibility and influence, this would be an effective method to facilitate inclusive participation of the people as we are all stakeholders in this matter.

Suggestion 6. Strong political will and transparent reallocation
Principally, the government needs to take a stance of strong political will to carry out the fuel subsidy reforms. It is simply unsustainable to continue subsidizing fuel in the long run. The faster the subsidies are reformed and eventually liberalised, the better it is for the long-term future of Malaysia. Having just been re-elected as the federal government, the opportunity is fresh to push through reforms in a bid to cut Malaysia’s budget deficit. As explained by the
Prospect Theory, humans are myopic and short-term changes in income and lifestyle will lead to instantaneous reactions, especially so if the cost of living is inflated. However this will be temporary and the people will adjust their spending accordingly over a period of time, such as reducing wastage and travel planning. Public dissatisfaction and unrest is one of the main factors which suppress government political will but knowing that people will eventually smoothen their consumption, the government has to keep the long-term future in mind.

The money saved must be a combined effort with reallocation of resources to the right areas such as education, health and social protection. These are the industries which deserve subsidies and public benefit stands to gain the most from these areas. An educated, healthy and secure society cultivates good habits and rewards the public with positive externalities.

Suggestion 7. Slashing unrestrained government expenditure
For decades now, the government has carried out a wide range of economically market- distorting policies from the assortment of hefty subsidies to Proton’s monopolistic protectionism. It should be acknowledged that these policies are beneficial and serve their purposes in the short run during the infant stages, but once the policies exceed a certain time frame, it starts to negatively affect the economy through prolonged distortions. Malaysia is now paying the price for decades of market failures and it would not be fair if the rakyat were forced to pay the full brunt of cost to shift the economy back to market equilibrium. The government as the elected leader, must rightly take a haircut in every sector and spend prudently in conjunction with the removal of subsidies. Taking away subsidies from the people is not the only solution to the budget deficit, as the government has been proven through the Auditor-General’s report to be spending lavishly on unnecessary items. It would be far easier to identify wastage and reduce expenses within the government coffers than to squeeze the rakyat dry to raise more revenue.

This is the only acceptable step to conclude with, and the most crucial key to reconcile the whole country’s interest in line with public policy and public acceptance. Thus discipline and altruism is required from both the government and the people, working as a cohesive Malaysian unit.

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*Jarren Tam is the Research & Programme Executive at the Centre for Public Policy Studies (CPPS), Malaysia. He can be reached at [email protected] / [email protected]