Do higher income customers benefit more from subsidies than do poorer customers?

You're in the section: Frequently Asked Questions -> Social Pricing and Rural Issues -> Do higher income customers benefit more from subsidies than do poorer customers?

[Response by Sophie Trémolet and Diane Binder, June 2009]

Many governments in developing countries have encouraged subsidies as a social welfare tool to give poor people access to basic public services. Subsidies are generally defined as the difference between the incremental cost of service and the capacity to pay of users1: in many cases, poor people cannot afford the services purchased by the comparatively richer customers, as the overall costs of providing the service are high relative to what customers can afford. In these situations, it might be necessary to provide subsidies to ensure affordable prices to the poor. However necessary, subsidies can at the same time lead to inefficient resource use and the creation of financially weak service providers. Besides, direct subsidies have often been ill-targeted and have benefited middle-class users rather than the poor, while service coverage and quality remain insufficient2.

Whilst subsidies can play a role in the extension of service to poor consumers, there is a growing consensus that subsidy schemes should be more carefully designed. Research has shown that poor consumers rarely benefit from broadly-based subsidy schemes, as they are plagued with several problems:

  • “Errors of exclusion”3 are the most frequent. Poor consumers are most of the time not connected to formal utilities and receive water services from other sources, i.e. from small independent service providers (SSIPs). As a result, those consumers are not eligible to benefit from subsidies when such subsidies are passed through tariffs. Errors of exclusion also happen in the case of IBT (Increasing Block Tariffs) when poor consumers actually consume above the first block, and therefore are not eligible to receive the related subsidies. In addition, regulators may require that consumers have secure land tenure titles in order to receive subsidies, which precludes the very poor living in informal settlements.
  • “Errors of inclusion”4 also happen. This happens, for example, in the case of IBT when all customers benefit from a low first block, set at a level below average costs of service provision. Surveys show that the case for subsidy should be assessed rather than assumed. In many cases, the willingness to pay of end-users is no lower than the proposed prices. Consumers who may have been willing to pay the standard price, whether they belong to the middle class or they are considered to be poor, may still receive subsidies.
  • Subsidy schemes may continue beyond their usefulness, because policy makers neglect to re-evaluate the schemes, the needs of the poor change, or lobbying groups advocate for further subsidies5.

Possible strategies to address the poor effectiveness of subsidy targeting include the following:

  • Thoroughly assess the amount of subsidies needed: a subsidy that covers the full cost of service would for instance eliminate incentives for efficient use of water.
  • Subsidize access rather than consumption: quantity-targeted subsidies, such as in increasing block tariffs or volume-differentiated tariffs, perform poorly compared to other transfer mechanisms such as connection subsidy mechanisms. Econometrics analysis even shows that they provide smaller subsidies for the poor6. While consumption subsidies are affected by metering conditions and rate of coverage, and are based on the tenuous assumption that low-volume consumers are poor consumers, connection subsidies mitigate most exclusion risks, encourage poor people to obtain access and encourage efficient usage, as prices reflect marginal costs. This is the case only if all subsidies are transferred through connection charges, not if tariffs are left at current levels, which is often the case. However, connection subsidies are not a panacea, since they raise an issue of fairness for consumers who had previously contracted unsubsidized connections.
  • Make sure that subsidy delivery mechanisms are triggered by household indication of demand.
  • Use an administrative selection method (instead of quantity consumed) through proxies such as geographical area, income distribution, household size, etc
  • Use the service-level-targeted subsidy, where subsidies are granted for lower levels of service, presumably unattractive to the wealthier consumers, which enables a self-selection process for accessing the subsidy;
  • Estimate errors of inclusion or exclusion of existing and proposed subsidy schemes to assess options correctly.

 

Resources

Impact of Market Structure on Service Options for the Poor
Presented at Infrastructure for Development: Private Solutions and the Poor, 31 May – 2 June 2000, London, UK.
Ehrhardt, David

Designing Direct Subsidies for the Poor – A Water and Sanitation Case Study
Note no. 211 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, June 2000.
Vivien Foster, Andres Gómez-Lobo, and Jonathan Halpern

New Designs for Water and Sanitation Transactions Making Private Sector Participation Work for the Poor
Washington, D.C.: The World Bank, undated.
World Bank

Water, Electricity, and the Poor : Who Benefits from Utility Subsidies?
Washington, D.C.: The World Bank, 2005.
Komives, Kristin, Vivien Foster, Jonathan Halpren, and Quentin Wodon

Taking into account the poor in Water Sector Regulation
Water Supply and Sanitation Working Notes, Note n°11, Water Supply and Sanitation Sector Board of the Infrastructure Network, World Bank Group, August 2006.
S. Trémolet & K. Hunt

Pro-Poor Subsidies for Water Connections in West Africa
Water Supply and Sanitation Working Notes, Note No. 4. World Bank, Washington, DC., 2005.
Debomy, Sylvie, Donald T. Lauria, and Omar S. Hopkins

Access by the Poor in Latin America’s Utility Reform Subsidies and Service Obligations
Discussion Paper No. 2001/75, World Institute for Development Economics Research, United Nations University, Helsinki, September 2001.
Chisari, Omar O., Antonio Estache, and Catherine Waddams Price

Scorecard for Subsidies: How Utility Subsidies Perform in Transition Economies
Note no. 218 in Public Policy for the Private Sector. Washington, D.C., October 2000.
Lovei, Laszlo, Eugene Gurenko, Michael Haney, Philip O’Keefe, and Maria Shkaratan

Measuring the Impact of Energy Reform – Practical Options
Note no. 210 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, May 2000.
Foster, Vivien

The role of energy subsidies
in Energy Services for the World’s Poor, Washington, D.C.: The World Bank, 2000, pp. 60-66.
Barnes, Douglas F. and Jonathan Halpern

Footnotes

  1. See Social Aspects.
  2. See Pricing for the Poor.
  3. When members of the target group are not captured by the eligibility criteria (Halpern, Foster,& al.)
  4. When relatively well-off people find themselves benefiting from subsidies (Halpern, Foster,& al.)
  5. See Pricing for the Poor.
  6. Halpern, Foster and al.