A jump in fuel prices is never welcome by the general populace. Yet in Nigeria, where fuel prices are regulated, the government has recently allowed the price of refined petroleum products' to rise, and is prepared to continue doing so.

The Nigerian government routinely imports petroleum and sells these imports at below cost on the domestic market to keep price levels down. In 2003, this subsidy on imported petroleum products amounted to more than 1% of Nigeria's Gross Domestic Product. Allowing prices to increase to their market levels will ease the government's financial burden, while also encouraging both local and inward foreign investment - including the building of more refineries - into the domestic petroleum sector. Indeed, investors shy away from situations where they may face rising costs but are required by law to keep their prices low.

However, until recently efforts to assess the economic impacts of higher fuel prices paid little attention to poverty effects. This was a major oversight. In a country like Nigeria, where more than half of the population lives on less than 1 US dollar per day, it is important to evaluate policies that may raise poverty levels. Moreover, it is critical to evaluate such effects before implementing the policies so that complementary reforms, where necessary, can be put into place to address the burden on the poor.

Fuel shortages affect both the rich and the poor. Prices at the pump for premium motor spirit (PMS), diesel and kerosene all go up when there are shortages. While PMS is used by the rich to fuel their cars, it is also a basic fuel for the transportation sector used mainly by the poor. Diesel and kerosene are also used by the poor. The government's importation of these products in the past has thus benefited both groups.

A recent study by this author and others investigated the effect that increased fuel prices would have on poverty in Nigeria. This enabled explicit poverty assessments to be carried out by incorporating information on households from a national household survey. The study also explored the possible role of fiscal policy in managing the effects of the subsidy removal.

It was found that subsidy removal, without spending the associated savings, would increase the national poverty level. This is due to the consequent rise in the cost of inputs relative to the selling prices of products sold by most firms and farms. The key commodities which experience nominal output increases are refined petroleum products, production of which provide income for an extremely small number of households.

The posture of the government's fiscal policy stance following subsidy removal will be important in determining poverty effects. For example, the inflation resulting from subsidy removal can be considerably reduced with a conservative fiscal policy response. In this case, inflation comes from two sources: the initial increase in general prices due to the higher cost of fuel and more spending by the government as funds are freed up. Therefore, if their goal is to reduce the inflationary effect, the government will want to keep spending to a minimum, focusing on areas that can increase the country's productive capacity.

By contrast, a highly expansionary policy of spending all savings from subsidy removal would favour rural households while increasing urban poverty. This is because urban households earn most of their incomes from input-intensive sectors while rural households tend to produce inputs. An expansionary policy also fuels inflation, further decreasing urban income.

A non-inflationary expansionary policy that increases transfers to households would have the least negative effect on poverty. To achieve this goal, government spending of associated savings needs to increase purchasing power and raise production so as not to stimulate inflation. Wasteful projects which do not add much to the country's productive capacity should be avoided.

Two areas that would benefit from more expenditure are transportation and electricity. Investments in transportation infrastructure would dampen prices in the economy as transportation costs are reduced. An improvement in electricity generation will also have a large impact on production levels and costs in the country. Presently, many firms are seriously constrained by the lack of electric power for production. It should kept in mind, however, that such investments will take years to materialize.

In the short run, increasing transfers to households would reduce the negative effects of fuel subsidy reform considerably. With proper targeting, poor households could be supported for a limited period, for example, a year. After this period the positive effects from the careful investments suggested above should start yielding fruits. Moreover, as new refineries are built competition in the market will ensure that prices are as low as possible. This was observed in the telecommunications industry where SIM card costs were reduced by more than 90% due to increased competition.

The views expressed in this article belong to the author, and do not necessarily reflect those of the AIAE, nor the GSI. The research mentioned in this article are based on the study Does Subsidy Removal Hurt the Poor?, available on-line at http://www.aiae-nigeria.org/Publications/Researchpaper2.pdf. Manson Nwafor is an Associate Fellow of the African Institute for Applied Economics, Enugu, Nigeria. His main area of research is the poverty effects of economy wide policies. He can be contacted at mansonnwafor@yahoo.com