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I N C LU S I V E G R E E N G R O W T H: T H E PAT H WAY TO S U S TA I N A B L E D E V E LO PM E N T

BOX 2.3

The political economy of subsidy reform

What lessons have been learned about subsidy reform? An analysis of the political economy of subsidy reform—which looks at the few attempts that have been successful—suggests the need for careful analysis of the likely social impact of the reform and implementation of a program of appropriate support for those affected (Nikoloski 2012). Other elements of success include political will and institutional capacity, as well as an effective communications and outreach strategy that explains the justification for the reform and the benefi ts to be derived from it. As for the timing and pace of the reform, there is no clear lesson as to whether “big bang” or gradual approaches are more successful.

Another study, which focuses on petroleum product subsidies, confi rms the importance of addressing the political logic that led to subsidy creation and either compensating the political interest that would otherwise oppose reform or fi nding a way to insulate the reform from its opposition—advice that applies to any subsidy reform (Victor 2009). In addition, it is critical to ensure the transparency of the costs and purpose of the subsidy. Reforming a subsidy may be easier if all members of society are fully aware of the costs they are paying and the extent to which they or others are benefiting.

Moreover, the political economy of reform will likely require compensatory transfers to the middle class. In the Islamic Republic of Iran, for example, where the law that reformed fuel and food subsidies stipulated that 50 percent of the revenues raised had to be redistributed to households, the initial thought was to target the bottom 30–50 percent of the income scale. In the end, 80 percent of households received significant transfers (Guillaume and others 2011)—no doubt contributing to the success of the reform. In the end, the redistributive impacts of a carbon price scheme depend on how revenues from the scheme are used. Compensatory measures can offset unwanted distributional effects. However, such schemes require the institutional capacity to manage the classical challenges of redistributive policies: political acceptability, imperfect information and targeting, and behavioral issues.

To be effective, incentives must reflect behaviors Designing effective environmental policies requires a good understanding of how behaviors are determined and how they can be influenced. 2 The hypothesis of rational behavior—under which price-based

instruments are optimal—is only a rough approximation of how people actually make decisions. In practice, individuals make decisions in a variety of ways: “by the head” (based on calculation), “by the heart” (based on emotion), and “by the book” (based on rules) (Weber and Lindemann 2007). Alternative or complementary policies and measures are therefore needed to address behavioral biases or changes in values and preferences. Four types of behavioral biases are particularly important. First, “cognitive myopia” prevents people from accurately balancing future benefits and immediate costs and from assessing the desirability of reductions in immediate benefi ts in exchange for future gains (Ainslie 1975; Benartzi and Thaler 2004). Second, individuals are inconsistent in their treatment of time (Ainslie 1975): they apply high discount rates to costs and benefits that will occur at some point in the future, discounting much less when both time points are in the future and one occurs later than the other, in a kind of “hyperbolic discounting.” These biases explain why it is difficult to implement policies that entail immediate costs but future benefits even if the result is a net (discounted) gain. A classic example is the failure of consumers to buy more energy-efficient appliances even when

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