Household Energy Demand and the Equity and Efficiency Aspects of. Subsidy Reform in Indonesia

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1 Household Energy Demand and the Equty and Effcency Aspects of Subsdy Reform n Indonesa Susan Olva Department of Agrcultural and Resource Economcs Unversty of Calforna, Davs olva@prmal.ucdavs.edu John bson Department of Economcs Unversty of Wakato, New Zealand jkgbson@wakato.ac.nz Contrbuted paper prepared for presentaton at the Internatonal Assocaton of Agrcultural Economsts Conference, old Coast, Australa, August 2-8, 2006 Copyrght 2006 by Susan Olva and John bson. All rghts reserved. Readers may make verbatm copes of ths document for non-commercal purposes by any means, provded that ths copyrght notce appears on all such copes. * Fnancal support from the Wakato Management School s gratefully acknowledged.

2 Household Energy Demand and the Equty and Effcency Aspects of Subsdy Reform n Indonesa Abstract The proper desgn of prce nterventons requres consderaton of equty and effcency effects. In ths paper, budget survey data from 29,000 Indonesan households are used to estmate a demand system for fve energy sources, whch s dentfed by the spatal varaton n unt values (expendtures dvded by quanttes). We correct for the varous qualty and measurement error bases that result when unt values are used as proxes for market prces. The prce elastctes are combned wth tax and subsdy rates to calculate the margnal socal cost of prce changes for each tem. The results suggest that even at hgh levels of nequalty averson there s a strong case for reducng the large subsdes on gasolne and kerosene, supportng the reforms that have been carred out recently. JEL: D2, Q3 Key words: Demand elastctes, Energy, Fuels, Subsdes, Unt Values

3 I. Introducton Managng the demand for energy s emergng as a crtcal polcy ssue as world fuel prces contnue to rse sharply. Whle popular attenton has focused on the plght of consumers n developed countres, the need for adjustment s lkely to be far hgher n some developng countres as energy markets n some developng countres are hghly dstorted, especally from consumer subsdes (IEA, 999). For example, the overnment of Indonesa spent over US$ 6 bllon on consumer fuel subsdes n These subsdes have a major effect on the overall energy balance n Indonesa because households account for about 45 percent of total energy consumpton. The subsdes also have large fscal effects rsng world ol prces had caused spendng on fuel subsdes for 2005 to rse as hgh as US$ 3 bllon, whch s about one-quarter of the government budget (Sen and Steer, 2005) Dramatc reforms have been attempted n response to ths escalatng cost of fuel subsdes. In October 2005, the subsdsed prce of kerosene was rased 86 percent, from Rp 700 per ltre to Rp 2000 per ltre (Table ). The prces for desel and gasolne were rased by approxmately 90 percent, followng on from ncreases of 30 percent n March As a result of the prce ncreases, domestc fuel prces n Indonesa are now closer to nternatonal prces kerosene, gasolne and desel are now 3 percent, 68 percent and 68 percent of nternatonal prces respectvely (World Bank, 2005). Moreover, a tmetable has been set for completely phasng out fuel subsdes, wth those on gasolne and desel to go by the end of 2006 and those on kerosene by the end of These energy subsdes are to be replaced wth a set of targeted subsdes, whose benefts are meant to be restrcted to low-ncome groups (Kompas, 2005 and Jakarta Post, 2005). It s unclear whether these ambtous plans for reform wll be realsed because many prevous attempts at reformng energy prce polcy n Indonesa have caused poltcal dffcultes. Attempted reforms n 2003 were reversed after wdespread protests whle the prce As of Aprl 2006, US$ Rp. 8,900. 2

4 rses n 998 are beleved to have precptated the downfall of the Suharto regme (Economst, 2005). Moreover, these subsdes have been long-term features of the Indonesan economy, datng back to the md 970s (Dck, 980). The subsdzaton of especally kerosene has been seen as one feasble way of meetng equty objectves, because the poor use kerosene as ther man cookng fuel. Ths relance on energy subsdes reflect the lmted capacty for ncome transfers, whch s a feature of many developng countres. Even though there was early evdence that a dsproportonate share of the subsdy was beng captured by rcher urban households, the subsdy polcy contnued to be strengthened such that at the end of 980, the prce of kerosene was only 8 percent of world prces (Ptt, 985) The objectve of ths paper s to provde emprcal evdence to help assess whether the proposed reforms of energy prce polcy n Indonesa are lkely to be welfare-enhancng. Specfcally, we analyse the equty and effcency of prce reform n the household energy sector n Indonesa. To acheve ths objectve we estmate the margnal socal costs of ndrect taxes and subsdes on fve fuels and energy sources; kerosene, gasolne, lubrcant ol, LP, and electrcty. These margnal socal costs depend on the rate at whch household welfare falls as prces ncrease, and on the rate at whch publc revenue rses (Ahmad and Stern, 984). If a reform s optmally desgned, the costs n terms of socal welfare of the last dollar saved by cuttng subsdes on each good should be equal. To obtan the two requred parameters the welfare dervatve and the revenue dervatve nformaton s needed on tax rates, consumpton patterns, and aggregate demand responses. The analyss follows the recommendaton of Newbery (2005) to use the basc prncples of publc fnance to ntroduce order nto dscussons of how energy taxes and subsdes mght ratonally be set. Energy subsdes n Indonesa have prevously been dscussed by Ptt (985) who concluded that the prce of kerosene should be ncreased on both equty and effcency grounds. In part ths concluson rested on an estmate of the elastcty of kerosene 3

5 consumpton wth respect to ts own prce of -.04, suggestng that prce dstortons would create large substtuton effects. One concern s that ths elastcty s calculated from household survey data, wth prces proxed by unt values (expendtures dvded by quanttes). Deaton (990) shows that treatng unt values as prces s lkely to lead to elastctes beng too large n absolute terms. Ths potental bas n consstent wth tme seres estmates of the own-prce elastcty of kerosene demand n Indonesa beng between -0.3 and -0.5 (Summers, 979). To measure the requred prce responses more accurately, we use methods developed by Deaton (990) to correct bases that result from usng these data rather than actual market prces. It wll, thus, be one of the few studes that uses ths novel source of nformaton to fll n the gaps whch have prevously prevented emprcal analyss of tax and subsdy reform n many developng countres. II. The Margnal Tax Reform Approach Unlke the tradtonal optmal tax lterature, whch attempts to derve those tax rates that mnmze welfare loss for the collecton of a gven revenue, margnal tax reform takes the exstng tax system as gven. The am of the analyss s to dentfy the drectons of reforms at the margn, takng the exstng tax system as gven, whch may be more relevant for polcy makers (Ahmad and Stern, 984). Specfcally, a decrease n the subsdy rate, τ on good, (or equvalently, a tax ncrease) wll cause welfare to change at rate V / τ and revenue to change at rate R τ /. The rato of these two dervatves gves the margnal socal cost, λ of savng one unt of revenue by decreasng the subsdy rate on good : V / τ λ =. () R / τ oods wth low λ ratos are those that are canddates for ether a tax ncrease or a subsdy reducton. When all the ratos are the same there s no scope for benefcal reform. 4

6 Ths approach can be mplemented by notng that the numerator of () s just the rato of two average budget shares: w w ~ ε (Deaton, 997). The frst average budget share, w s ε weghted to reflect equty consderatons: w ε = M m= ( x m n ) x ε m m w m M m= x m (2) where w m s the budget share for good n household m, x m and n m are the total expendture and sze of household m, and ε s the coeffcent of nequalty averson. 2 A range of values between zero (no nequalty averson) and two (a hgh degree of nequalty averson) are commonly used to see whether tax reform recommendatons are robust to partcular ethcal judgements (Ahmad and Stern, 984). In terms of the calculaton of equaton (2), the larger s ε the closer the average budget share wll be to budget shares of the poorest households n the sample. The second average budget share s the so-called plutocratc budget share whch s based on ratos of total expendtures and gves the bggest weghts to the rchest households: w ~ = M m= x m w m M m= x m. (3) The denomnator of the λ-rato represents the effcency aspect of tax- and subsdy-nduced prce changes. A gven change n the tax rate wll produce a larger revenue effect, the greater s the total consumpton of the good and the less the substtuton away from taxed goods: ε w ~ w λ = τ θ + ~ + + τ w τ k k + τ k θ k w ~. (4) The total consumpton of the good s shown byw%, whle the substtuton effects are shown by θ, the dervatve of the budget share for good k wth respect to the (log) prce of good. The tax k 2 Consder judgements about the effect of takng Rp000 from someone to gve some of t to a person wth half the ncome and destroyng the rest (e.g., due to effcency losses). When ε=0 the judge would approve of ths transfer only f the poorer person receved all Rp000. But when ε takes the values of (or 2) the amount the poorer person receves has to be only Rp500 (or Rp250 f ε=2) n order for the resultng dstrbuton to be judged as gvng the same level of socal welfare as before the transfer (Creedy, 996). 5

7 factor gves the share of tax n the fnal prce. For example, lubrcant ol faces a VAT rate of 0 percent n Indonesa, so the tax factor s 0.0 ( + 0.0) = 0.09, whle kerosene prces are only 3 percent of the prces n other countres, so the tax factor s 0.69 ( 0.69) = The frst term of the denomnator n equaton (4) measures the own-prce dstortonary effect of the tax or subsdy. If t s large and postve, as would be the case for a heavly subsdsed and prce elastc good, the term wll contrbute to a smallλ and would ndcate the low cost of savng fscal expendtures from decreases n the subsdy on ths good. The last term s the sum of the tax factors multpled by the cross prce elastctes, and captures the effects on other goods (and the resultng revenue changes) from the change n the tax on good. III. Data and Estmaton Methods Data from the consumpton module of the 999 SUSENAS survey are used for 28,964 households located on Java. 3 Respondents n ths survey are asked to recall ther expendtures over the past month for approxmately 300 dfferent products. For food, fuels and electrcty they are also asked about the quantty purchased so that unt values can be derved. These unt values are needed because the survey does not collect market prces. The survey s samplng procedure nvolves selectng clusters of up to sxteen households wthn dstrcts and regons. Ths spatal clusterng encourages the assumpton that households wthn each cluster face the same prces and ths feature s exploted by the estmaton method used below. The fve energy products consdered electrcty, LP, kerosene, gasolne and lubrcant ol contrbute almost 4.4 percent of the average budget, rangng from LP at 0.4 percent to electrcty at.82 (Table 2). The frst three columns of Table 2 descrbe some of the characterstcs of the unt values. Items lke electrcty and kerosene have unt values avalable for almost every 3 Java contans approxmately 60 percent of the Indonesan populaton and, economc actvty s also concentrated there, so the results should stll be relevant to natonwde prce reform. 6

8 household whle nformaton for tems lke LP and gasolne s much less readly avalable. Means of unt values are also shown n the table. These are computed from those households who make market purchases of the commodty under consderaton. The coeffcent of varaton ndcates the degree of heterogenety wthn each group, whch s least for commodtes lke kerosene and gasolne where there s lttle qualty varaton. The procedure used to get the prce responses needed for the margnal reform calculatons starts wth a two-equaton system of budget shares (w c ) and unt values (v c ) that are both functons of the unobserved prces, (p Hc ): w c N = α = β ln x c + γ z c + θ H ln p +( f +u c ) H= H c c (5) ln v c = α = β ln x c + γ z c + N H = ψ H ln p H c + u c (6) the ndcates goods, ndcates households and the c ndexes clusters. Amongst the explanatory varables, x s total expendture of household, p H are the unobserved prces, z s a vector of other household characterstcs, f c s a cluster fxed-effect n the budget share for good and u 0 c and u c are dosyncratc errors. In the frst stage, the procedure removes the household-specfc effects of ncome and other demographc characterstcs from the budget shares and unt values. To do so, equatons (5) and (6) are estmated usng OLS wth dummy varables for each cluster n place of the unobserved prce (a wthn estmator). In addton to x and z, ths specfcaton also controls for all cluster fxed effects, ncludng those of unobserved prces, so the β 0 0, γ, β, and γ parameters can be estmated consstently, even n the absence of market prce data. These four parameters are used to create adjusted budget shares and unt values that have the qualty effects due to ncome and other factors removed. The frst stage regressons also produce resduals needed n the second stage for estmatng the covarances that are used to correct for 7

9 the effect of any measurement error n unt values and budget shares. The error terms, e e 0 c and c, from equatons (5) and (6) contan all the varablty n w c and v c that are not explaned by x, z, or the cluster fxed effects. Assumng a sngle prce per cluster, the unexplaned varaton around the cluster mean can ndcate measurement error. In the second stage of the Deaton procedure, a between-clusters errors-n-varables regresson s appled to the (adjusted) average budget shares and unt values, whch have been purged of household characterstcs at the frst stage. If t were not for the effect of prces on cluster-wde qualty varaton, the parameters estmated at the second stage would be suffcent for calculatng the prce responses. Instead, a separablty theory of qualty (Deaton 988) has to be used to dentfy the prce effects at the thrd and fnal stage. IV. Econometrc Results The frst stage (wthn-cluster) estmaton of the budget share equatons explans from 47 percent (kerosene) to 27 percent (lubrcant ol) of the varaton n budget shares (see Table 3). 4 The budget share equatons also ndcate three luxury goods gasolne, LP and lubrcant ol, each wth expendture elastctes between 2.69 and Kerosene has an expendture elastcty of 0.43 and for electrcty t s.0. The only unt value to show any response to household expendtures s lubrcant ol, where the qualty elastcty, s Table 4 contans the estmated own- and cross-prce elastctes. The symmetry restrctons from demand theory have been mposed on these estmates. In addton to the fve energy sources, there s an extra row and column for other consumpton, the estmates for whch are obtaned from the homogenety and addng-up restrctons. The elastctes are condtonal not only on household sze and the dummy varables for household characterstcs 4 In addton to total expendtures, the other varables used at the frst stage nclude (log) household sze, a set of demographc varables (the number of household members n each of thrteen age and sex categores as a 8

10 mentoned above, but also on a set of provnce and urban dummy varables. These dummy varables are used at the second stage (between-clusters) to control for any longer-term nterregonal prce dfferences. 5 Such controls are needed because Deaton (997) argues that the response to prce changes n the short-run s most relevant for evaluatng tax and subsdy reform. In addton to the prce elastctes, the table also nclude bootstrapped estmates of standard errors. To calculate these standard errors, 000 random draws are taken from the second stage data (.e., the cluster average budget shares and unt values, after the effect of household total expendtures and other characterstcs have been controlled for). For each of these random draws, all of the elastctes are recalculated, n effect creatng 000 versons of Table 4. The length of the nterval around the mean of each bootstrapped elastcty that contans 63.8 percent of the bootstrap replcatons s calculated and one-half of ths nterval s used as the estmate of the standard error. The ratonale s that f the dstrbuton of the elastcty estmates was normal, s the fracton of a normal random varable wthn two standard devatons of the mean (Deaton, 997). The estmated own-prce elastcty of demand for kerosene s (wth a standard error of 0.). Ths s close to the estmate obtaned by Ptt (985) who also used household survey data, but wthout the correctons for the possble bases caused by unt values that Deaton (990) ntroduced. The smlarty of elastcty estmates, and the contrasts from the tme seres estmates, suggests that Ptt s concluson that t would be both equtable and effcent to reduce the subsdy on kerosene may n fact have been correct. The own-prce elastctes are also large (n absolute terms) for electrcty and LP, although only the one for rato of household sze), and nne educatonal dummes. These varables are based on those used by Deaton (990). 5 It s not possble to add them at the frst (wthn-cluster) stage because the cluster fxed effects would oblterate them. 9

11 electrcty s precsely estmated. Ths suggests that subsdes wll have caused a consderable amount of substtuton nto these products. V. Margnal Socal Cost Calculatons Table 5 shows the effcency effects of cuttng subsdes (or rasng taxes) on each of the goods, dstngushng between the terms n the denomnator of equaton (4). The frst column shows the tax factors, whle the second column shows the own prce elastctes of qualty and quantty together. The product of the frst and second columns, whch s shown as the thrd column, gves the own-good contrbutons to the tax dstorton that would be caused by a margnal ncrease n prce. The largest effects are for kerosene and then electrcty, for whom rasng prces would save the largest amount from the government s subsdy budget (gnorng any cross-prce effects). However, the cross-effects are largest for gasolne and LP and once these are taken account of, the most attractve canddate for prce rses are kerosene followed by gasolne. In Table 6, the results of brngng n the equty effects are reported for a range of values of the dstrbutonal parameter ε. The frst two columns are for ε = 0 where there are no dstrbutonal concerns; the cost-beneft ratos are smply the recprocals of the last column n Table 5 and gve the same rankng of the relatve tax costs. The margnal cost of rasng kerosene prces s lowest, and for rasng lubrcant ol prces (whch are already taxed) s hghest amongst the fuels. However, all of the λ for the energy sources are much lower than for other consumpton ndcatng the general desrablty of removng energy subsdes. Movng across to the rght-hand sde of Table 6, equty effects become ncreasngly stronger, and kerosene loses ts place as the most attractve canddate for a prce rse. Instead, wth an nequalty averson parameter of ε=2 the lowest cost of addtonal revenue would come from 0

12 rasng LP prces, followed by gasolne prces. The best canddate for a subsdy at these hgher nequalty averson levels s electrcty. VI. Conclusons In ths paper we have used household budget survey data from Java to estmate the margnal socal cost of ndrect taxes and subsdes on fve energy sources. Regardless of assumptons about nequalty averson, all of these energy sources are attractve canddates for prce ncreases, when compared wth the socal cost of revenue rased from taxes on other goods and servces. From a polcy perspectve, the results suggest that there s a strong case for reducng the large subsdes on gasolne and kerosene n Indonesa, supportng the reforms that have been carred out recently. In terms of methodology, the man feature of the study s that we correct for the bases that are lkely to affect prce elastctes estmated from unt values. To the extent that most other countres have household budget surveys lke the one used here, ths method could be used more wdely to provde some emprcal underpnnngs to recommendatons about prce reforms.

13 References Ahmad, E. and Stern, N. (984) The theory of reform and Indan ndrect taxes Journal of Publc Economcs 25 (3): Creedy, J. (996) Measurng ncome nequalty Australan Economc Revew 29(2): Deaton, A. (988) Qualty, quantty, and spatal varaton of prce Amercan Economc Revew 78(3): Deaton, A. (990) Prce elastctes from survey data: Extensons and Indonesan results Journal of Econometrcs 44(3): Deaton, A. (997) The Analyss of Household Surveys: A Mcroeconometrc Approach to Development Polcy. Baltmore: The John Hopkns Unversty Press. Economst (2005) Indonesa s ropey Rupah September st. [On-lne] Avalable Internatonal Energy Agency (999) World Energy Outlook: Lookng at Energy Subsdes, ettng the Prces Rght. Internatonal Energy Agency: Pars. Jakarta Post (2005) Indonesa may cut fuel subsdes by as much as 60 percent by November [On-lne] Avalable 2

14 Kompas (2005) Dana kompensas BBM: 40 juta orang dapat subsd secara langsung [Onlne] Avalable Newbery, D. (2005) Why tax energy? Towards a more ratonal polcy The Energy Journal 26(3): -40. Ptt, M.M. (985) Equty, externaltes and energy subsdes: The case of kerosene n Indonesa Journal of Development Economcs 7 (3): Sen, K. and Steer, L. (2005) Survey of recent developments Bulletn of Indonesan Economc Studes 4(3): Summers, L. (979) The demand for kerosene n Indonesa Manuscrpt prepared for the Publc Sector Polcy n Indonesa Project (Harvard Insttute for Internatonal Development, Cambrdge, MA) Cted n Ptt (985) World Bank (2005) Indonesa: Economc and Socal Update, October. World Bank, Jakarta. 3

15 Table. Developments of Regulated Fuel Products Prces (Rupah per ltre) Jan 2003-Feb 2005 Mar-Sep 2005 October 2005 Fxed Prce Prce % change from Feb 05 Prce % change from Mar 05 % change from Feb 05 asolne,80 2,400 33% 4,500 88% 49% Kerosene % 2,000 86% 86% (household) Automotve Desel,650 2,00 27% 4,300 05% 6% Source: World Bank (2005) Table 2. Commodtes, Sample Szes and Budget Shares for Java, 999 Commodtes Number of households wth unt values (a) Mean unt value (b) Coeffcent of varaton of unt value (c) Number of clusters wth unt values (d) Number of households n clusters n (d) (e) Percentage shares of total expendture (f) Electrcty 26, ,87 26, LP 2,32, , Kerosene 23, ,846 23, asolne 5,735, ,430 5, Lubrcant Ol 3,698, ,430 5, Note: (a) s the number of households wth a well-defned unt value, whch equals the number of purchasng households mnus those who report n rregular unts. (b) n Rupah. Table 3. Frst Stage Estmates: Effect of Total Expendtures on Quantty and Qualty for Java Budget Share Equaton Unt Value Equaton Commodtes o o β t( β ) R 2 β t ( β ) R 2 ε Electrcty LP Kerosene asolne Lubrcant Ol Note: o β s the dervatve of the budget share wth respect to log total expendtures, β s the dervatve of the (log) unt value wth respect to log total expendtures (a.k.a. the qualty elastcty ), R 2 s for the budget share and unt value regressons, and ε s the expendture elastcty of quantty. 4

16 Table 4. Symmetry Constraned Estmates of Own and Cross Prce Elastctes for Java, 999 Electrcty LP Kerosene asolne Lubrcant Ol Other Cons Electrcty -.043* * * (0.02) (0.02) (0.03) (0.05) (0.02) (0.06) LP (0.2) (0.89) (0.97) (4.42) (0.30) (3.5) Kerosene * * * (0.03) (0.08) (0.) (0.26) (0.04) (0.22) asolne (0.3) (0.85) (0.65) (.28) (0.5) (0.87) Lubrcant Ol * * (0.5) (0.2) (0.32) (0.54) (0.4) (0.67) Other Cons (0.00) (0.00) (0.00) (0.00) (0.00) (0.37) Note: Standard error n ( ); * statstcally sgnfcant at 5% level. Results for Other Cons derved from homogenety and addng up restrcton. Table 5. Effcency Aspects of Prce Reform n Java wth Symmetry Restrcton Commodtes τ + τ θ Own effect Cross effects Total ~ w Electrcty LP Kerosene asolne Lubrcant Ol Other consumpton Table 6. Equty Effects and Cost-Beneft Ratos for Prce Reform n Java wth Symmetry Restrctons ε = 0 ε = 0. 5 ε = ε = 2 Commodtes w w λ w w λ w w λ w w λ Electrcty LP Kerosene asolne Lubrcant Ol Other consumpton