The paradox of fossil fuel subsidies

Fossil fuel subsidies represent a significant and widespread fiscal tool that governments can employ to maintain stability in domestic price levels. We develop and estimate a Bayesian dynamic stochastic general equilibrium (DSGE) model tailored for Malaysia, a net-exporting energy economy that captures this key channel of fiscal policy intervention. Fossil fuel price subsidies are often motivated as a means to stabilize vulnerable households, yet the government of Malaysia does not have a targeting policy. Accordingly, we use the model to address how consumption responds to an increase in inflation driven by a fossil fuel price shock. The results indicate that, while a fossil fuel price subsidy stabilizes consumption, we find that a subsidy can ”crowd out” non-energy consumption as fiscal intervention increases. Furthermore, we find that while aggregate welfare increases with fiscal stabilization, the highest level of welfare is achieved with targeted subsidies, a contradiction which questions the merit of the current Malaysian energy policy.