Wednesday, January 11, 2012


By Debo Alonge

Pricing Trend in Nigeria
Rather than taxing petroleum products, Nigeria currently has a subsidization policy on petroleum products evidenced by the fact that the current prices of petroleum products are far lower than the international prices (Hossain, 2003).
There are basically two types of fuel subsidies:
(i) Direct subsidies – here the retail price of fuel is cheaper compared to normal industrial commodities
(ii) Indirect subsidies – this includes exemption from sales tax / VAT or via lower-cost domestic fuel production, make the retail price of the fuel cheaper than in countries which depend on the world market.
Subsidizing fuels has high costs. Moreover universal price subsidies almost always benefit high-income households more than the poor, because richer households consume more energy. It also hinders efficient reforms of the downstream petroleum sector. There is an indirect cost arising from higher interest rate as government borrows to finance some of the fiscal gap created by large subsidy.
A high level of evolutionary trend has been witnessed in the pricing of petroleum products in Nigeria, especially in the last decade. Every administration, faced with mounting development challenges and limited fiscal space has had to review upwards petroleum products prices in order to reduce the explicit and implicit subsidies on petroleum products consumption in Nigeria. Table 1 shows the trends in pump prices of gasoline and diesel between 1991 and 2008 in US cents per litre. The major driving forces in the price movements have been the rise in international products prices as well as naira/dollar exchange rate. Another interesting feature from the table and Figure 1 is that until 2004, gasoline prices were higher than diesel prices in line with international trend, however, since 2004, with the deregulation of the diesel market, its price has outpaced that of gasoline which is still subsidized substantially.

Why Remove Subsidy
In recent years, the decision to phase out energy subsidies has gained widespread acceptance globally. This is principally because they often fail to achieve their objectives. IEA in the World Energy Outlook (2010) presents a comprehensive argument in favour of subsidy removal. The following are some of the arguments presented against energy subsidy: (1) it encourages wasteful consumption, (2) threatens energy security, (3) discourages investment in energy infrastructure, (4) places burden on state budget, and (5) disproportionately benefits the rich.

Theoretical Expectations for Appropriate Tax System
Tax theory suggests the following properties for a good tax policy:
(i) If the objective of tax policy is government revenue, then higher tax should be levied on goods with low price elasticity of demand. In other words, goods for which demand is least sensitive to price increases should bear the highest tax rates - The Ramsey Rule.
(ii) Second, goods that are close substitutes should be taxed at similar rates to prevent demand substitution
(iii) On equity ground, goods accounting for a larger share of budget of the rich should taxed more heavily
(iv) Furthermore, goods that generate high emissions or negative externalities should also be taxed at a high rate to discourage their consumption.

However, in practical applications of these principles, there are usually some other considerations. For instance, in spite of the relatively higher emissions generated by diesel, it often attracts lower tax than gasoline.

Excess Burden of a Tax
We start by our definition of excess burden of a tax using the Harberger triangle and its further development by Nan (1994)
Fig. 2:  Excess Burden of a Tax using Harberger’s Triangle

Initial equilibrium is established at point d with quantity q and price p. The imposition of tax t will lead to a fall in demand assuming the tax is imposed on the demand side; hence there a leftward shift from D1 to D2 and new equilibrium is established at point c. Without tax, the entire welfare gain associated with this market is realized. However, tax introduces a deadweight loss measured by the area of triangle ‘adc’ into the system. 
Where: p is the price before tax imposition, q is quantity before tax is imposed,
 is the compensated demand elasticity and t is the tax rate.

Assuming also that

From the foregoing, it follows that the excess burden and who ultimately bears it depends on the demand and supply elasticities. If we consider the two extreme cases of (i) perfectly elastic supply curve, the excess burden will return to the traditional formulation of Harberger

Government Tax Revenue 
Imposition of a tax engenders a consumption difference represented by (q – Q) in Fig. 1 and

Optimal Tax Rate
This analysis views optimality in tax rate as one that minimises excess burden constrained by a given level of government revenue. Using the Lagrangian Multiplier method to solve the constrained optimization problem, an optimal tax rate is defined as follows:

The above equation can be rearranged to obtain:

Empirical Application
We derived information on demand elasticities from a 2008 study by Iwayemi, This is presented in the table below with each fuel and their respective elasticities.
Table 2: Long Run Elasticities for the Energy Products in Nigeria
Price Elasticity Of Demand
Aggregate Energy (ED)
Gasoline (PMS)
Diesel (AGO)
Dual Purpose Kerosene (DPK)
Source: Iwayemi, Adenikinju and Babatunde (2008)
For the supply elasticity, we will follow the 0.3 used by Nan (1994) in similar study for the United States, with the assumption that supply elasticities are relatively uniform globally. For quantity, we used the level of consumption reported for each fuel by the International Energy Agency (IEA) where gasoline has the highest level of consumption with 163.26 kbbl/d (19158196.2 litres), followed by diesel with 32.43 kbbl/d (3805588 litres)  and kerosene 16.83 kbbl/d (1974962.9 litres).Although fuel prices fluctuate, the last published data on fuel prices in Nigeria at the time of this study is the GTZ International fuel prices (2009) which puts gasoline at 59 Cents/litre, diesel at 113 Cents/litre and kerosene 45 Cents per litre. Lastly for government revenue, since the tax system is not yet in place, we went for five per cent of the expected tax revenue for the US ($447024533). The choice of five per cent ($22351226.5) is informed by: (1) Nigerian economy is only a fraction of the US economy and (2) tax revenue is expected to be lower in Nigeria because it is a net exporter of oil while the US is a net importer.

Table 3:          Proposed tax rates
Proposed tax rates (%)
Our analysis shows that the optimal tax rate for gasoline, diesel and kerosene are 9.97, 2.17 and 5.17% respectively. The rate derived for gasoline appears to be on the high side due to the low demand elasticity of -0.055.
Returning to equation (1), we derive the total excess burden associated with the optimal tax rates as follows: gasoline, $262079; diesel, $79080 and kerosene, $998; Giving a total excess burden of $342157 for the three products.
In an attempt to compare the results of this study with earlier studies, we found that the optimal tax rate obtained by Nan (1995) recommended about 2.7% on the average for both commercial and residential consumers in the US. On the other hand, the recommendation by the Clinton Administration presents a higher tax rate of 9.54% for commercial and 4.99% for residential consumers. Our result, especially for gasoline, closely approximates the Clinton Administration’s. However, if we consider the average tax rate for the three products used in this analysis, the outcome comes in between Nan and Clinton Administration’s findings. Although such a high tax rate may be outrageous in Nigeria given the level of development and abundance of oil, the study presents a path breaker for further analysis as we move into the future.

Limitations of the Study
The key limitations of this study are:
Literature: the literature in the area of energy taxation is scanty
Data: the author made assumptions relying on data from another country as no published data on supply elasticity is available at the time of this study. Moreover, the data used for expected revenue was also assumed because at the moment petroleum products are still subsidized in Nigeria hence there is no policy in place yet to set the expected tax revenue.

The Home Run
This analysis has attempted to define optimal tax rates for petroleum products in Nigeria following the minimization of excess burden subject to a given level of government revenue as the definition of tax optimality. Although, petroleum products are still highly subsidized in Nigeria, efforts have been made in the last few years to deregulate and the level of subsidy has been on the decline. If this gradual subsidy phase-out is successful, we look forward to a situation where oil products will be taxed at economically efficient rates. The rates suggested in this study are fraught by certain limitations which can be improved on in the future.

It is recommended that the present day government in Nigeria continues with the subsidy phase-out even though faced with various political challenges (Okogu, 1993). This is because I am of the opinion that a high level of investment is required especially to improve the refining capacity of the country which cannot be achieved if the subsidization system persists.
Other benefits will also accrue in the form of more efficient consumption, better environmental quality, income redistribution and government will be able to pursue more developmental programs.

Still on the prominent subsidy debate in Nigeria, here is a continuation of Debo Alonge's article on defining an optimal tax regime for petroleum products in Nigeria (written in 2010). He has highlighted the issues in the petroleum product pricing in Nigeria and gives reasons to support the subsidy removal in Nigeria being a preferred option in the petroleum industry, and why a tax regime should be introduced in the extractive industry. The debate continues… Feel free to put up comments, arguments, and suggestions on this issue. For more information about this article and to view Debo's professional profile, click here -->

1 comment:

  1. There is need for Government to commence a program to fully deregulate the downstream sector by ensuring that the 4 Refineries in Nigeria are retrofitted not just the usual TAM, it has to be done by experts for example my friend who was on the team of CHIYODA Corporation that built the instrumentation of Kaduna Refinery is still in Texas and he has the economic and technical reports of Kaduna Refinery. He can provide technical assistance to ensure that the Refinery is retrofitted and come back to life and NNPC with just E&P companies that have shown track records can get into the operations of the Refineries under JV working arrangement of which NNPC should be made to be commercial oriented. Also, foreign investors should have attractive fiscal incentives for which to enter into either BOT or JV arrangement with local partners to establish modular Refineries in Nigeria. When these are put in place then they can stem the importation of petroleum products but Nigeria will begin to cover both domestic and export markets.
    We can provide advisory and consultancy services to both Federal Government of Nigeria, State Government, indigenous companies and foreign companies that wants to participate in the downstream and upstream of Oil & Gas. Dr. Victor E.G. Ayika, Principal/CEO, Vega American