November 6, 2013 9:27AM

Egypt’s Subsidy Nightmare

If you think that Western welfare states are in a pickle, imagine what they would look like if, instead of transferring money, governments tried to help people by giving all of them free or cheap stuff. One does not need to be an economist to see the inefficiency of in-kind transfers, but many countries use redistribution of stuff – typically in the form of commodity subsidies – as the main tool of redistribution and social assistance.

In Egypt, the government subsidizes the prices of fuels and certain food products at artificially low levels. Obviously, the wealthy – who can afford to consume more of the subsidized commodities – are the largest beneficiaries of the subsidy system. In urban areas of Egypt, for example, the top quintile of the income distribution receives eight times as much in energy subsidies as the bottom quintile.

As I argue in a new Cato Policy Analysis published today, commodity subsidies are behind Egypt’s fiscal meltdown – the country is currently running a deficit of 15 percent of GDP, while being kept afloat only by the inflow of funds from the Gulf countries. To avert a looming fiscal catastrophe, Egyptian policymakers need to act now. The paper, which I also summarize here, provides a list of recommendations about how the reform should be approached:

Firstly, [the reform] will have to be quick and complete – unlike the partial adjustments that were made to subsidy programmes in the past. Every failed reform attempt causes Egyptian rulers to lose some of their credibility. If yet another partial reform is tried, people will simply refuse to take it seriously and instead demand, perhaps in a violent way, the preservation of the status quo.

Secondly, a successful reform will have to come as a part of a broader package of structural reforms. Egypt’s energy markets are marked by heavy government involvement and lack of competition. Simultaneously, the patterns of Egyptian food prices display strong downward rigidities, with domestic prices not falling even when international prices do. That is a sign of uncompetitive, inflexible markets.

Thirdly, it is unreasonable to expect Egyptians to buy into the subsidy reform if the government does not commit to sharing its benefits with the population. Such commitment can take the form of cash transfers that would replace the existing commodity subsidies. After all, the enormous size of subsidy spending creates large opportunities for fiscal savings and for fairly generous payments to those in need. The government could essentially save half of its subsidy spending and still be able to pay every Egyptian household a sum of $373 annually. Or, with a basic system of means-testing in place, it could pay the poorest 40 per cent of households $933 every year while still spending only one half of what it currently spends on subsidies. That may sound modest, but Egypt’s GDP per capita is only slightly above $3,000, and one quarter of the country’s population is living on less than $37 a month.

 You can download my new policy analysis here.