Fuel Subsidies and Unemployment: A CGE Model Applied to Iran

Abstract

This study analyzes the effects of eliminating fuel subsidies on the labour market, focusing on oil producing countries with significantly underpriced fuel commodities. The Islamic Republic of Iran is used as a case study. Two alternative options are analyzed, with the extra revenue from subsidy elimination redistributed back to household as extra income versus directing the revenue into increased investment. A purpose-builit static and dynamic CGE model is deployed in conjunction with a unique Social Accounting Matrix (SAM) of Iran. It is shown that the current structure of the economy is heavily biased towards industries that are crude oil and fuel intensive in production. Redistributing the extra revenue back to households would not be enough to overcome these distortions. The labour market suffers under such a scenario, even though Real GDP and household welfare rise. Industries contract due to the Dutch Disease effect and the more expensive inputs, causing overall production and employment to decline. Channelling the extra income into investment, however, improves the labour market’s fortune dramatically in the long run. Firstly, there is increased capital accumulation due to the rise in investment. Secondly, the structure of the Iranian economy shifts. Capital is directed towards non-fuel or crude oil intensive industries, allowing the economy to adjust away from its current reliance on industries dependent on these inputs. Consequently, employment of all types of labour in the economy experience a marked rise.