A Macroeconomic Analysis of Energy Subsidies in a Small Open Economy

We construct a dynamic general equilibrium model to analyze the effects of large energy subsidies in a small open economy. The model includes domestic energy production and consumption, trade in energy at world market prices, as well as private and public sector production. The model is calibrated to Egypt and used to study reforms such as reductions in energy subsidies with corresponding reductions in various tax instruments, or increases in infrastructure investment. We calculate the new steady states, transition paths to the new steady state and the size of the associated welfare losses or gains. In response to a 15 percent cut in energy subsidies, GDP may fall as less energy is used in production. Excess energy is exported and capital imports fall. Welfare in consumption equivalent terms can rise by up to 0.6 percent of GDP. Gains in output can be realized only if the government re-invests into infrastructure.