Reducing fuel subsidies and the implication on fiscal balance and poverty in Indonesia: A simulation analysis

There is an urgent need for phasing out fuel subsidies in Indonesia due to a severe budget deficit and a worsening of income distribution. Fuel subsidies, of which almost 72% are enjoyed by the 30% of the richest income groups, have consumed on average 63.8% of the total subsidies between 1998 and 2013. This paper aims at evaluating the relationship between existing fuel subsidies and fiscal balance and at analysing the poverty impact of phasing out fuel subsidies. Applying a CGE-microsimulation, this study found that removing 25% of fuel subsidies increases the incidence of poverty by 0.259 percentage points. If this money were fully allocated to government spending, the poverty incidence would decrease by 0.27 percentage points. Moreover, the 100% removal of fuel subsidies and the reallocation of 50% of them to government spending, transfers and other subsidies could decrease the incidence of poverty by 0.277 percentage points. However, these reallocation policies might not be effective in compensating for the adverse impacts of the 100% removal of fuel subsidies if economic agents try to seek profit through mark-up pricing over the increase of production costs.

► Massive fuel subsidies reduce fiscal spaces used to alleviate poverty in Indonesia.
► Indonesia can avoid a budget deficit by 78% cutting of fuel subsidies.
► A CGE-microsimulation is applied to analyse the impacts of fuel subsidy reallocation.
► The 50% of reallocation fuel subsidies decreases the poverty by 0.277 percentage points.
► Mark-up pricing done by economic agents reduces the effectiveness of reallocation.