# **3. Modeling the Impacts of Petroleum Subsidy Reform**

Assessing economic and poverty impacts of petroleum subsidy reform requires an economy-wide model that captures the major linkages between subsidy reduction, production, consumption, and households. In addition, given that many of the effects arise from changes in relative prices, social accounting matrix (SAM)–based CGE models are more suitable than SAM-based multiplier models that have previously been used in comparable studies.

The CGE model is used in this paper and is constructed consistently with the neoclassical general equilibrium theory. The theoretical background and the analytical framework of CGE models have been well documented in Dervis, de Melo, and Robinson (1982); the detailed mathematical presentation of a static CGE model is described in Lofgren, Harris, and Robinson (2002). The recursive dynamic version of the CGE model is based on this standard CGE model with the incorporation of a series of dynamic factors. The early version of this dynamic CGE (DCGE) model can be found in Thurlow (2004), and its recent applications include Diao et al. (2007) and Breisinger, Diao, and Thurlow (2009), and Breisinger et al. 2010. A summary of the main equations can be found in Tables A.2 in the Appendix.

To develop the DCGE model for Yemen, we first update a 2007 SAM to represent Yemen’s economy in 2009 as the main database for the model. For the updating process we used national accounts data for 2009 provided by the Ministry of Planning and International Cooperation (MOPIC). Major data sources for the 2007 SAM construction include the latest supply-use table from the Central Statistics Organization (CSO), balance of payments from the Bank of Yemen (BoY), government budget data from the Ministry of Finance, the 2008 Agricultural Yearbook from the Ministry of Agriculture and Irrigation, and the latest Household Budget Survey (HBS 2005/2006). These data sources have been complemented with information from the International Monetary Fund and the World Bank. The model is very detailed at the production, commodity, factor, and household levels and includes 65 production activities, 65 commodities, 15 factors of production, and 12 household types.<sup>10</sup> Factors of production include labor according to the skill level (unskilled, semiskilled, skilled) and employment by the public and private sectors.

In addition to the SAM as the main data source to calibrate to a set of parameters in both production and demand functions, a DCGE model also requires several elasticities. The main elasticities include the substitution elasticity between primary inputs in the value-added production function, which determine the ease with which, for example, users of fuel can substitute fuel for other inputs; the elasticity between domestically produced and consumed goods and exported or imported goods; and the income elasticity in the demand functions. The income elasticity with regard to fuel, for example, decides how consumers react to higher prices. We estimated the income elasticity for Yemen from a semi-log inverse function suggested by King and Byerlee (1978) and based on the data of HBS 2005/2006 for rural and urban households separately. These elasticities range from, for example, 0.31 for cereals to 2.2 for transport and 1.95 for fuel, where most elasticities are lower for urban households than for rural.<sup>11</sup> For

> 10 For a detailed list of production activities, commodities, factors of production, household types, and other accounts of the 2007 SAM, see Table A.3 in the Appendix.

> 11 Table A.4 in the Appendix presents the complete list of imputed income elasticities.

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