subsidized fuel consumption to the market price: high-income consumers have more incentive to switch from higher octane, non-subsidized fuel to lower octane, subsidized fuel; and the smuggling of subsidized fuel to other economies and its mixing with other fuel types. Smuggling is likely to swell where neighboring economies allow their fuel prices to move with international prices and the difference between Indonesian prices and international prices expands, creating an increasing incentive to smuggle Indonesian fuel products to other neighboring economies. Some anecdotal evidence suggests that when the gap between Indonesian and neighboring economies’ fuel prices is wide, smuggling is very significant, but estimates of the volume of smuggling vary widely and limited data restrict our ability to disentangle smuggling from other determents of fuel demand. More detailed data would enable better estimates, for example monthly data on fuel consumption in the provinces near neighboring economies and for otherwise similar provinces where fuel is more likely to only be consumed locally.

Short of a significant drop in international crude oil prices, Indonesia’s policy-makers have two means of addressing expanding fuel subsidy costs: increase the retail price of the subsidized products, or reduce the quantity of subsidized products consumed. As measures to restrict consumers purchasing of subsidized products are likely to be technically demanding,<sup>9</sup> we explore the re-pricing option here. Increasing the price of one of these fuel products will lead households to reduce their consumption of that product, and to switch to other products. Increasing prices by another US 10 cent per liter (Rp 1,000 or 17%) from the current price of Rp 6,000 is estimated to reduce gasoline consumption by 3 percent but increase transport diesel consumption by almost 11⁄2 percent. A 20 percent increase in the price of kerosene — relatively modest given its very large subsidy — would lead to about 31⁄2 percent less kerosene being consumed. These elasticity estimates, and the error correction models used to estimate them, are tabled in Annex 4. Accounting for these estimates of demand responses, the lower panel in Table 7 reports our estimates of the likely spending on fuel and energy subsidies overall with various increases in domestic fuel prices given various world crude oil prices **.**

**<u>Table 7.  Estimated central government expenditure on energy subsidies</u>**

|_InternationalCrudeOil Pr_|_ices(US$):_|$60|$70|$80|$90|$100|$110|$120|$130|$140|$150|$160|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Oil & as revenues|US$ bil.|13.0|16.1|19.2|22.3|25.4|28.5|31.7|34.8|37.9|41.0|44.1|
|g|% GDP|2.6|3.3|3.9|4.6|5.2|5.8|6.5|7.1|7.7|8.4|9.0|
|_Oil & gas-related outlays:_|||||||||||||
|No change in subsdized|US$ bil.|9.2|12.3|16.3|20.3|24.3|28.3|32.3|36.3|40.3|44.3|48.3|
|product prices|% GDP|1.9|2.5|3.3|4.1|5.0|5.8|6.6|7.4|8.2|9.0|9.8|
|_Increasing regulated keros_|_ene, gasoline_|_, diesel an_|_d LPG p_|_rices by:_|||||||||
|15%|US$ bil.|7.2|10.3|14.3|18.3|22.3|26.3|30.3|34.3|38.3|42.3|46.3|
||% GDP|1.5|2.1|2.9|3.7|4.6|5.4|6.2|7.0|7.8|8.6|9.4|
|30%|US$ bil.|5.2|8.3|12.3|16.3|20.3|24.3|28.3|32.3|36.3|40.3|44.2|
||% GDP|1.1|1.7|2.5|3.3|4.1|5.0|5.8|6.6|7.4|8.2|9.0|
|50%|US$ bil.|2.5|5.7|9.7|13.7|17.7|21.7|25.7|29.6|33.6|37.6|41.6|
||% GDP|0.5|1.2|2.0|2.8|3.6|4.4|5.2|6.0|6.9|7.7|8.5|
|100%|US$ bil.|-4.2|-1.1|3.0|7.0|11.0|15.0|19.0|23.0|27.0|31.0|35.0|
||% GDP|-0.9|-0.2|0.6|1.4|2.2|3.1|3.9|4.7|5.5|6.3|7.1|

Note: Estimates are made from a June-2008 baseline, of WTI at US$110 and after the May-08 product price increases. _Source: World Bank staff estimates._

> 9 From late 2007 the Ministry of Energy proposed distributing a so-called ‘smart card’ to households, that would entitle the holder to purchase a limited quantify of fuel each month, requiring larger consumers (generally richer households) to pay the economic cost for any additional fuel. This proposal was dropped mid-2008 due to concerns about its technical feasibility.

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