Abu Dhabi, UAESaturday 7 December 2019

Consumer attachment makes GCC subsidy cuts even more painful

Subsidies for many essential goods were set up to alleviate poverty in low-income households and raise living standards, but they have become expensive, ineffective and highly wasteful. Yet, people do not want to let them go.
Freshly baked flat bread from the Ghazi bakery in central Abu Dhabi, made with subsidised flour. Silvia Razgova / The National
Freshly baked flat bread from the Ghazi bakery in central Abu Dhabi, made with subsidised flour. Silvia Razgova / The National

“The less there is to justify a traditional custom, the harder it is to get rid of it,” said Mark Twain.

Subsidies in the GCC are a tradition that is particularly difficult to justify, and Twain’s maxim has probably underlain some of the challenges faced by the Arabian Gulf governments as they have tried to scale back subsidies. Biases in the way that humans think present more obstacles to reform.

Economists have been advising the GCC countries to dispense with subsidies long before the 2014 oil price crash, and the associated budgetary pressure. Subsidies were originally introduced as a way of raising the living standards of lower-income households, by lowering the price of some of the key commodities that they purchase.

But subsidies have come to resemble acquiring a Ferrari to travel from your living room to your kitchen – extremely expensive and highly ineffective.

To see why, note that an effective poverty-alleviating subsidy should lower the prices of commodities that are consumed by low-income households, while leaving those that are consumed by high-income households unchanged. A good example is public transport – used heavily by the poor and rarely by the rich.

GCC subsidies satisfy the first condition but they spectacularly fail to satisfy the second: electricity, water, fuel and flour are consumed by low-income households, but high-income households consume them in much larger quantities.

Thus, compared with a system of direct income support for low-income households, or to an updated selection of commodities to subsidise, the prevailing GCC subsidy system redistributes income from the poor to the rich, rendering it fundamentally counterproductive.

In fairness, the GCC subsidy systems were a good choice at the time of conception: most households lived modestly and the tools required to efficiently administer means-tested income support, such as electronic databases and detailed censuses, were absent. The 21st century GCC economy, however, is an unrecognisable descendant of its 20th century progenitor.

Subsidies are also highly expensive because they engender wasteful consumption; the GCC countries are some of the highest per-capita energy consumers in the world, and this is mostly the result of artificially low energy prices. A negative corollary has been needless environmental damage.

Even if the GCC governments craft compensatory support schemes for low-income households, they will still struggle to overcome a behavioural bias known as “loss aversion”.

As a precursor to a famous experiment, when people are given the chance to select between a free mug and a free chocolate bar, they pick the mug 50 per cent of the time, and the chocolate bar 50 per cent of the time, confirming that the two have a similar value. Nothing strange so far. Behaviour becomes anomalous when, instead of giving people a choice between the mug and chocolate bar, the researcher allocates each individual one of the two goods based on a coin toss. After receiving the mug or chocolate bar, and holding it for a couple of minutes, the researcher offers the opportunity to trade the good they were assigned for the other one at no cost. What happens?

They should be willing to trade 50 per cent of the time, because the coin ensures that people end up with the good that they prefer half of the time. In fact, people end up trading less than 30 per cent of the time, whichever good they receive.

This anomaly, the endowment effect, is the result of people developing an irrational attachment to objects in their possession. That explains why most people refuse to sell their old pen for $1, even though they can buy a new one for 10 cents. It also explains why humans vociferously oppose threats to eliminate existing public parks, yet exhibit scant support for proposals to create new ones.

Loss aversion poses a problem for policymakers who want to replace an existing, inefficient benefit with a new, efficient one because for most people, the pain of losing something that they already have is stronger than the joy of receiving something that they did not previously have, even if the two benefits are objectively equal.

In the GCC, governments are now convinced of the ineffectiveness of subsidies and are considering alternatives to compensate citizens for their removal, such as direct, means-tested transfers or subsidy cards. Despite the moral and economic wisdom of such actions, low-income households have reacted negatively, including hand-wringing on social media and calls for boycotts of previously subsidised commodities.

The opposition is not merely an artefact of loss-aversion, as the subsidy reforms coincide with a broader decline in the economic capabilities of the governments, caused by declining oil prices. Thus, for example, while GCC citizens were previously almost guaranteed public-sector jobs with generous salaries, all six governments have described such luxuries as no longer tenable. Yet, humans’ irrational attachment to what is already in their possession undoubtedly has a role to play in the subsidy-reform backlash.

What can GCC governments do to circumvent loss-aversion? Research has yielded practical advice on how to diminish the incidence of loss-aversion, most notably giving people a lot of experience in owning and surrendering the good in question, but such strategies are of no use to policymakers considering infrequent reforms to policies that have been in place for decades.

Whatever the impediments to subsidy reform, the need for their implementation constitutes a rare congruence of views among economists, environmentalists and ethicists and so the GCC governments must persevere. “I am a slow walker,” said Abraham Lincoln, “but I never walk back.”

Omar Al Ubaydli is the programme director for International and Geo-Political Studies at the Bahrain Centre for Strategic, International and Energy Studies, an affiliated associate professor of economics at George Mason University in the US.

business@thenational.ae

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Updated: June 11, 2016 04:00 AM

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