Energy Subsidies and Public Social Spending : Theory and Evidence

This paper shows that high energy subsidies and low public social spending can emerge as anequilibrium outcome of a political game between the elite and the middle-class when the provisionof public goods is subject to bottlenecks, reflecting weak domestic institutions. We test this andother predictions of our model using a large cross-section of emerging markets and low-incomecountries. The main empirical challenge is that subsidies and social spending could be jointlydetermined (e.g., at the time of the budget), leading to a simultaneity bias in OLS estimates. Toaddress this concern, we adopt an identification strategy whereby subsidies in a given country areinstrumented by the level of subsidies in neighboring countries. Our Instrumental Variable (IV)estimations suggest that public expenditures in education and health were on average lower by0.6 percentage point of GDP in countries where energy subsidies were 1 percentage point of GDPhigher. Moreover, we find that the crowding-out was stronger in the presence of weak domesticinstitutions, narrow fiscal space, and among the net oil importers.