The Roadmap, Part VII: Clarity on Gas Prices

Where Juan Cristobal dares to imagine a future where we tax the consumption of gasoline, instead of mindlessly subsidizing it.

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A few years ago, a group of experts identified the types of policies that most countries with high growth experiences had implemented, as well as the ones they avoid. Their results, published in “The Growth Report,” are as close to an approachable recipe book on growth as you’re going to find.

This is the seventh part in a series on what Venezuela can learn from that exercise. In Part II, I tackled the importance of inserting Venezuela into the global economy. In Part III, Quico discussed getting the macroeconomic fundamentals right. In Part IV, we looked at why you need a financial system that fosters savings and investment. In Part V, I discussed the importance of letting the market tell you what you’re good at. In Part VI, I made the plea for political parties to find some sort of consensus as a pre-condition for any strategy to work. Here’s part VII, where I start discussing (to quote Mel Brooks) the things we “oughtn’t to do but we do anyway”.

Turns out the first thing on this list is the policy choice Venezuela is most famous for:

It happens once every few months: a new ranking comes out listing countries by their internal price of gas, from highest to lowest.

If you’re like me, your eyes automatically veer to the bottom of the list – not to see if Venezuela is listed as the cheapest gas in the world (duh), but to see how wide the gap has gotten.

But there is an interesting tale to be told at the top of the list. Right there, among the countries with the most expensive gas, is Norway. Norway! A major oil and gas producer, like us; unlike us, a modern, civilized society.

 
By subsidizing energy, the message our economy gets is “invest in energy-intensive industries, because that’s where the money is.” It’s a signal that disconnects our economy from its real advantages.

Norway has really expensive gas because instead of subsidizing energy, they tax the hell out of it. And while taxing energy in a country with lots of it might be counter-intuitive, it makes so much sense it was included in the list of “things to do” by the Commission on Growth and Development, publishers of The Growth Report. Subsidizing energy is at the top of their list of things to avoid.

They don’t beat around the bush: “In many parts of the developing world, energy is subsidized. This is also a mistake. According to research by IMF economists, Indonesia and Yemen spent more on fuel subsidies in 2005 than on health and education combined. Although removing the subsidies is politically difficult, the costs of not doing so are high …”

In other words, removing energy subsidies and replacing them with energy taxes appears to be something countries with high levels of growth do. In spite of this, you would be tempted to be a contrarian on this one, because … why should that be the case? A subsidy on energy, after all, is a subsidy for industry and for consumers. Countries subsidize all sorts of things, and the report certainly does not suggest doing away with all subsidies.

What makes energy subsidies so damn toxic?

First, the strain it causes in our public finances.

Energy is very difficult to substitute away from – your ability to not use as much energy following a price increase is very limited, something we economists like to call having an “inelastic demand.” And when you face a good with inelastic demand, taxes on these goods will bring in lots of money precisely because consumers will not decrease their consumption when they are imposed. It’s the same thing with cigarettes and booze, so not surprisingly many people say modern man is “addicted to oil.”

These taxes can be enormous. In the UK, for example, total fuel taxes amount to 38 billion pounds per year, roughly 7% of total taxation and 2.5% of GDP. Translate that to Venezuela, and we would be talking about $7.5 billion in lost taxes, a massive amount of money. If we add the money we use to subsidize energy, the amounts involved are much, much larger. Failing to be rational on energy simply leaves too much money on the table.

Subsidies on energy also damage our economy because they send the wrong signal on what we should be producing and what we should be consuming.

One of the main uses of the price system is that, when left to operate relatively freely, it tells a society what it should be focusing on. For example, when walnuts are much more expensive than olives, this suggests that resources would be better spent growing walnuts than olives. Company earnings go up, wages go up, collected taxes go up.

When you subsidize energy, this creates a massive, artificial advantage for industries that use energy very intensively – thinks like steel mills, oil refining, and industries that use a lot of air conditioning.

 
Countries that have shown high growth rates do not subsidize their domestic energy. The evidence on this is fairly overwhelming.

The general point is that industries that rely heavily on energy tend to provide few jobs, unlike other industries that we call “labor intensive” such as textiles.

By subsidizing energy, the message our economy gets is “invest in energy-intensive industries, because that’s where the money is.” It’s a signal that disconnects our economy from its real advantages.

A few years ago, some cattle-raising friends in Santa Barbara told me the story of a rancher who had imported Holstein cows from the Netherlands. The cows were so traumatized by the unbearable heat, the rancher had to install air conditioning units in their stables so that the cows could be more at peace. Do you think such inefficiencies would occur if the rancher had to pay international prices for electricity?

Or take buses. Have you ever wondered why Venezuelan long distance buses are air conditioned down to like 12 below zero? Here’s the little secret: cold air masks odors. Since fuel costs nothing, the extra cost of cranking up the AC and keeping the bus extra cold is lower than the cost of actually cleaning the bus properly. Talk about a perverse incentive: gas subsidies actually make bus owners use diesel as cleaning fluid!

These ridiculous tales of air-conditioned cows and sub-zero buses underscore another point: energy subsidies tell people to consume lots of energy, and this creates huge social costs.

Not only is it inefficient from an environmental point of view – fomenting traffic, pollution, and the like – but it also creates enormous inefficiencies such as the ones highlighted above.

Subsidizing energy means you subsidize demand and disincentivize the supply of the stuff – is it any wonder we are facing massive blackouts and lines at the pump? And think about the havoc these blackouts create on the rest of our economy.

Subsidizing energy also creates huge opportunity costs, symbolized by the things we cannot afford precisely because we are giving people free gas. It’s become a running joke to compare money spent on subsidizing energy as money spent on not subsidizing education and health, but it’s true nonetheless.

Moreover, it’s a terrible way to engage in social policy. People typically claim that gas should be cheap in Venezuela because “there must be some benefit to living in an oil-producing country.” But this is nonsense – the money spent subsidizing energy goes to big industrialists, truck drivers, and your wealthy aunt in El Cafetal that drives an SUV paying practically nothing for gas, while she bangs her pots against the government.

Countries that have shown high growth rates do not subsidize their domestic energy. The evidence on this is fairly overwhelming. It is about time we face the facts and realize that while having cheap gas and low electricity bills is great for your personal finances, it is the road to ruin.

17 COMMENTS

  1. “Taxing the hell outta energy” may be a logical thing to do when the rest of your trading partners are doing the same, e.g. Norway and the rest of Europe. Were Norway to do this unilaterally, they would suffer enormous production cost disadvantages with the rest of the world. Germany gets away with high energy costs because of other competitive advantages, quality products and a highly educated work force to name a few. But, yeah, OK, …maybe, moderately high taxation does have its’ advantages. . Heavy taxation in general, however, leads to BIG governments with enormous bureaucracies. The EU has become a monster bureaucracy with a pompous we-know-better attitude. Big governments, through high taxation rates, breed bad politicians. Just imagine a semi-literate Hugo Chavez-like figure coming to power in Oslo, pockets stuffed with real cash and pontificating to the world his (it could only be a male;)) loopy opinions on most everything. The horror, …the horror.

    • “Big governments, through high taxation rates, breed bad politicians.”

      Seriously, you think it is taxation that breeds bad politicians! I would gladly have a Norwegian politician run a country. And what about all the corrupt low tax politicians taking backhanders from businesses to keep their overheads low.

      Unqualified statements merely demonstrate prejudices, not facts relevant to the discussion.

      • I don’t like high taxes any more than the next guy. However, in this case, high taxes are warranted due to the negative externalities associated with gasoline and excessive energy consumption. And also because, well, subsidizing energy is simply not something succesful countries do.

  2. If not tax the hell out of it, at least let it float to meet the price in the region. Otherwise you create an incentive to smuggle fuel to neighboring countries and sell it for a profit.

    Both VZ and Egypt suffer from this black market. Fisherman find it far more profitable to load up on cheap domestic fuel, then sell it to other fishermen or islands offshore than it is to actually try to catch fish.

  3. If gas prices were determined exclusively on a non subsidized basis then they might be calculated using four criteria:
    1.- a below cost basis ( current Venezuelan system) which entails a deep economic sacrifice for the State.and the total distortion in the use of gasoline within the country
    2. a ‘cost basis’ excluding profits , (many state services world wide are retributed but on a non commercial basis.)
    3. a ‘cost plus such a profit as would represent a sufficient incentive for the production refining and selling of gasoline products in a normal competitive market’, and
    4. the’ cost of opportunity’ basis ( at the price which an exported bl of gasoline would bring.
    …… Meaning there are many different ways of defining a subsidy …..

    My own ideal preference would be criteria #3, but then the impact on transportation costs for the general population might be susbstantial , specially considering that most Venezuelans are poor (even much of its middle class is poor by international standards) and that there is no decent public transport system available to soften the impact of full commercial pricing.

    Taxes on gasoline in Europe are high because owning a motor car and using it on a daily basis was something of a luxury when they first appeared on the streets of its main cities, also there were a lot of wars being fought or war debts that needed paying . Additionally in Europe public transport has ususally been good and accessible to most people not the case in latin America.

    So although the most rational and optimal use and allocation of gasoline would result from the application of criteria # 3 , the hardship it would impose on the general population would be such (relative to other much richer countries) that perhaps establishing it would require some planning and meet some preconditions before it could be fully implemented.

    By the way US Cow farmers magazines years ago told of veterinary studies which showed that milk cows whose heads received cooler wafts of air (no necessarily through an AC sytem) were much more productive than milk cows that had to stand high ambient temperatures . The cooling effect could be obtained by the use of well placed fans along the milking bays ………!! Never thought that the idea would be adopted by a Zuliano milk rancher …..!!

    The Venezuelan subsidies on gasoline are totally irrational and should be replaced by something more reasonable and effective ….

    Also to be noted is that Venezuelan use of gasoline is TAXED only not as much as in other places …!!, the tax is included in the price.

    Juan really hit it with this piece, it touches on a treasure trove of topics which need study and reflection and discussion on a deeper level than is customary …….

      • Aren’t there cold enough places in Venezuela for those cows to be raised? Aren’t there cow breeds more fit to bear zuliano or llanero climate? I think planning makes a better solution to this riddle.
        As for the article, my respects! That thing of “there must be some benefit to living in an oil-producing country” makes my ears bleed every time I hear it.
        Tradúzcase y reprodúzcase.

        • Aren’t there cow breeds more fit to bear zuliano or llanero climate?

          I’m sure that Fidel would be glad to send Venezuela some of the heirs of Ubre Blanca, the Wonder Cow. Seriously, a look at Cuban milk production from the early 1960s to present, compared with the rest of Latin America, will quickly dissuade one from seeing Cuba as as model for milk production. While milk production for Latin America is at present about 3.5 times greater than it was in the early ’60s, Cuban milk production has increased by only a factor of 1.7 or so.[70% versus 250%]

          Brahma hybrids – based from cattle imported from India-are used in hot climates in the US and other places, but they are most used for meat production.

          • Its easy to criticize Venezuelan gas subsidies , more difficult is to think generally when are subsidies (involving sacrifice to public income ) justified and how they should be determined with optimal over all result for the countries economic growth and long term sustainable increases in the populations standard of living . Usually susidies should be phocused to produced a particularly targeted result which raises a countrys long term economic health productivity…..not just to benefit people short term …..!!

            Is subsidizing green methods of electrical generation always economically rational should also be part of the question , for example is subsidizing the production of methanol from maize something wise and rational if it makes the price of maize as a food much higher??

    • You bring up a very good point Bill Bass that Juan Cristobal didn’t really take into consideration. It’s that in Norway the public system WORKS and is efficient and not as many people use cars as means of transportation. In the meantime in Venezuela those who can afford any kind of car will have one. So taxes on gasoline are going to have a much bigger (and varied) impact in Venezuela than in Norway and this is something to think about.

      I agree with BB that this is a topic that should be studied more, especially when it comes to its potential impacts. Regardless though, what a superb article.

  4. Once visited Finland and most cars in the streets were imported from Germany , the economies of scale didn’t justify Finland setting up motor car factories or assembly plants (even if producing car was a ‘classy’ activity) , instead they spent their resources in producing things they could produce cheaper than Germany ( forest products for example) , selling them those products and importing their cars from Germany . That meant a lot of sense . Of course the question might arise what if it was cheaper to import ALL our milk from Colombia , should we them shut down all our dairies whatever effect that has on the livelihood of thousands of dairy farmers, thats one problem OECD countries have with their own agricultural sectors ……. What if that leads to Colombia overcharging us for their milk supplies once we become totally dependent on them ?? Don’t know the answer to that ….!!

  5. Great post Juan! An additional reason for taxing gas to the hilt is that subsidized gas prices promote urban growth. You actually want to promote exactly the opposite.

  6. […] This is the eighth part in a series on what Venezuela can learn from that exercise. In Part II, I tackled the importance of inserting Venezuela into the global economy. In Part III, Quico discussed getting the macroeconomic fundamentals right. In Part IV, we looked at why you need a financial system that fosters savings and investment. In Part V, I discussed the importance of letting the market tell you what you’re good at. In Part VI, I made the plea for political parties to find some sort of consensus as a pre-condition for any strategy to work. In part VII, we started discussing the things we need to stop doing, beginning with subsidies for energy. […]

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