Iran - The Economy Role of the Government

Role of the government

The central economic role of government in post-World War II Iran has been the manipulation and allocation of oil revenues. Since the beginning of the production of petroleum in commercial quantities in the 1920s, government oil policies have reflected the varying priorities of the different regimes and have exacerbated economic and cultural cleavages within the society.

During the reign of Reza Shah (1925-41), oil revenues were modest, and most of the proceeds from oil went to Britain through the Anglo- Iranian Oil Company (AIOC). For its revenues, the regime relied upon indirect taxes (customs duties and excise taxes) on items such as tea and sugar. In contrast, after 1951, the government of Mohammad Reza Shah (1941-79) relied on oil income to finance the policies of centralization by which it was able to control most aspects of Iranian society until nearly the end of the shah's rule.

Reza Shah's regime financed its development programs through modest oil royalties, customs revenues, personal income taxes, and state monopolies. During his reign, oil production royalties, although still low, quadrupled in terms of the rial; this money was spent on defense and industrial development. Between 1926 and 1941, higher tariffs boosted annual customs revenues from approximately US$5.6 million to US$16.3 million. Institution of a small income tax replaced the local levies and enabled the government to extend its influence into the provinces; by 1941 the income tax provided annual revenues of US$10.8 million. Finally, the government relied upon state monopolies on consumer goods such as sugar, tobacco, tea, and fuel, which contributed approximately US$46.5 million annually by the early 1940s.

The Beginnings of Modernization: The Post-1925 Period

Reza Shah introduced the concept of centralized economic planning to Iran at the expense of older societal values and traditions. Reza Shah consolidated power by developing support in three areas: the army, the government bureaucracy, and the court circle. Once his power was consolidated, he pursued economic, social, and cultural reforms. Reza Shah believed that the secret of modernization lay in replacing many religious and social norms of traditional society with the values of a twentieth-century nation-state. Reza Shah's policies favored the urban over the rural, the wealthy over other classes, and industry in general over agriculture. Developing this "new order" gradually cost Reza Shah most of his base of support. Nevertheless, government centralization enabled him to achieve full control over the economy.

Economic development began with the expansion of the transportation system. The first project was the expansion of the Trans-Persian Railway. In the first five years of his reign, Reza Shah developed a network of railroads that connected ports to inland cities, thereby encouraging trade between rural and urban centers. By 1941 railroads crossed Iran from north to south and from east to west.

The existence of a modern transportation system by the 1930s encouraged industrial growth, which was further promoted by government financial incentives. Construction of modern manufacturing plants was a high priority, as was the development of whole industries rather than small, individual factories. Financial incentives included government- sanctioned monopolies, low-interest loans to prospective factory owners, and financial backing for plants and equipment by the Ministry of Industry. The number of industrial plants (excluding those processing petroleum) increased 1,700 percent during Reza Shah's reign.

In 1925 only about twenty modern plants existed, of which five were relatively large, employing about fifty workers each. By 1941 the number of modern plants had risen to 346, of which 146 were large installations. These large plants included thirty-seven textile mills, eight sugar refineries, eleven match factories, eight chemical companies, two glassworks, one tobacco-processing plant, and five tea-processing plants.

Between 1926 and 1941, the oil industry labor force increased from 20,000 to 31,000. By 1941 the oil industry employed 16,000 workers at the Abadan refinery and another 4,800 at drilling sites in Khuzestan. These wage earners, in conjunction with those employed in emerging modern industrial enterprises, formed a working class of about 170,000 and represented about 4 percent of the total labor force in 1941.

Rapid industrial growth created a modern, urban working class that nonetheless coexisted with people who had more traditional occupations, values, and ways of life. This new industrial work force developed in the five major urban centers, where 75 percent of the modern factories were located: the towns of Tehran, Tabriz, and Isfahan, and the provinces of Gilan and Mazandaran. Tehran's population alone increased from more than 196,000 in 1922 to about 700,000 by 1941. Modernization accelerated the pace of life through changes in culture, education, and traditional social norms, including those governing the role of women.

The cost of developing the military establishment, centralized ministries, large-scale industrial plants, and institutions of higher education increased the budget nearly 1,800 percent during Reza Shah's reign. The Iranian national budget grew from approximately US$15 million in 1925 to US$166.5 million in 1941 (based on the 1936 exchange rate). Because industrial development was predicated on oil revenues, the government's lack of control over the oil industry created periodic tensions with foreign oil companies. The emphasis on industrial development also demonstrated the need for development planning.

The concept of development planning by the government dates back to 1947, when it was initiated by Mohammad Reza Shah's government as a series of seven-year cycles. The Plan Organization consisted of leading government officials, who provided guidelines from which a development strategy was formed. Planning had a direct impact on the public sector because of its effect on allocations of capital expenditures. In Iran's mixed economy, however, the planners had no direct power over private sector investments and development; instead, they had to rely on indirect measures, such as fiscal and financial incentives.

The First Development Plan (1948-55) failed, except for strengthening the role of the Plan Organization, which, after 1973 was called the Planning and Budget Organization and in January 1985 was transformed by the parliament, or Majlis, into a ministry. The basic development strategy was the pragmatic approach of accelerating growth by incorporating the latest technology into large-scale, capital-intensive industry. Expansion of the infrastructure, however, preceded the development of industry. The planners often built ahead of demand, creating physical and economic incentives for the private sector. Diversification of industry was also a goal, although the planners recognized that the excessive dependence on oil revenues would have to continue at first to provide the capital to diversify. Diversification was intended to facilitate import substitution, and development of large-scale industry meant that many plants producing for export could achieve economies of scale.

The Second Development Plan (1955-62) focused on public sector expenditures, with an investment program to be funded by foreign loans and 80 percent of oil revenues. The government spent so much money, however, that the regime faced severe inflation and depleted foreign currency reserves by fiscal year (FY) 1959. Although Iran was experiencing economic problems, the plan provided for the construction of several reservoir dams, the most important of which were located on the Dez, Safid, and Karaj rivers. Simultaneously, private sector investment in light industry remained strong until the economic crisis that began in 1959.

During the middle and late 1950s, economic instability exacerbated chronic social problems, such as overcentralization of government, concentration of land in the hands of relatively few wealthy landlords, enormous bureaucracy, and regressive tax laws. As early as 1949, the shah voiced his intention to consider needed changes, especially in land reform. It was not until the 1960s, however, that he actually instituted agrarian reform. The intervening decade was a period of consolidation following the regime of Reza Shah; it also featured a period of government control by Mohammad Mossadeq.

Oil Revenues and the Acceleration of Modernization, 1960-79

During the reign of Mohammad Reza Shah, significant increases in oil revenues, coincident with the centralization of the economy, compounded societal stress and imbalance. The modernization that continued throughout the shah's rule affected the economic infrastructure but not the monarchical political structure. The gap between the two was accentuated by the Western industrial policies promulgated by the shah.

In the 1960s, economic planning focused on four main goals. The first was rapid development of large industries by capital-intensive methods and the use of the latest technology; the second was employment of foreign advisers and technicians to guide the modern industrial complex. The third was encouragement of large industrial profits, and the fourth was control of wages by reallocating savings from labor costs to capital investment. It was assumed that wealthy industrialists would reinvest their capital in the economy, thereby stimulating economic development. But such investment did not occur, and the gap in income between industrial owners and the commercial class, or bazaar (traditional middle class merchants), was never closed, which contributed to the revolutionary pressures that eventually brought down the regime.

The bazaar did not benefit from the 1974-78 oil boom; as a consequence, bazaar members helped lead and finance the Revolution. The series of national reforms and development programs that Mohammad Reza Shah had embarked on in the 1950s came to be known in 1963 as the "White Revolution". The White Revolution was simultaneously the shah's attempt at economic modernization and his attempt at political stabilization. He intended to accelerate nation-building and to enhance his regime's image as the promoter and guardian of the public welfare.

Land reform was a major element of the shah's economic development program. Land reform affected both the economic structure and the social mores of the agrarian component of society. The Third Development Plan (1962-68) and the Fourth Development Plan (1968-73) together infused US$1.2 billion into agriculture through land reclamation, subsidized irrigation projects, and land redistribution programs. These programs undermined traditional rural authority figures, encouraged commercial farming, and transformed the rural class structure. By the 1970s, the rural class was divided into three components: absentee farmers, independent farmers, and rural wage earners.

The third plan was transitional to a new time frame of five years for development plans. Oil revenues supported the US$1.9 billion national budget, which fostered an economic boom in the public and private sectors. The government concentrated its activities on heavy industries, dam building, and public utilities, as well as on expansion of oil and gas production. Private industry benefited from bank credits given as part of the third plan.

The fourth plan accelerated economic growth and integrated sectoral and regional concerns into a national development program. During the fourth plan, the annual rate of growth in gross domestic product (GDP) averaged 11.8 percent, which exceeded the growth target. The strongest growth occurred in industry, petroleum, transportation, and communications. Several large projects under construction during the fourth plan included a steel mill, an aluminum smelter, a petrochemical complex, a tractor plant, and a gas pipeline leading to the Soviet border. Farming and crop production were given low priority during this period of industrialization, which widened the large gap between the industrial and agricultural sectors.

The third and fourth development plans affected the urban population in particular because of the emphasis on the increased production of consumer goods and the expansion of industries such as gas and oil. Between 1963 and 1977, many industrial facilities were constructed, primarily in urban areas.

The Fifth Development Plan (1973-78) set investment at US$36.5 billion; this figure almost doubled to US$70 billion as a result of large increases in oil revenues during the period. Almost two-thirds of the capital allocated under the fifth plan was concentrated in housing, manufacturing and mining, oil and gas projects, and transportation and communications. Some additional oil revenues were spent on ad hoc defense and construction projects rather than on the fifth plan's priority areas.

In the period between the quadrupling of oil prices in 1973 and mid- 1977, Mohammad Reza Shah pushed both industrialization and the establishment of a modern, mechanized military much too rapidly. As a result, inflation increased, corruption became commonplace, and rural-to- urban migration intensified. In addition, because of a lack of technically trained Iranian personnel, the shah increasingly brought foreign consultants into Iran. This further exacerbated an already severe housing shortage in Tehran.

In mid-1977, the shah appointed Jamshid Amuzegar as prime minister, and the latter immediately launched a deflationary program. This sudden slowdown in the economy led to widespread unemployment, especially among unskilled and semiskilled workers, which further increased the gap between rich and poor. The economic slowdown was a major factor in radicalizing large segments of the population and turning them against the shah.

Some argue that rapid modernization created the disequilibrium that brought about the shah's fall. Others, however, stress the importance of the way in which the rapid modernization was implemented. After the economy's initial development, inequalities in income distribution were not addressed. Those at the lower end of the economic spectrum--for example, small merchants and businessmen, urban migrants, and artisans-- felt disadvantaged in relation to workers in large businesses, industries, and enterprises with foreign associations. Western-educated Iranians rapidly became a well-paid elite, as did factory workers. Bazaar merchants, students, and the ulama, however, did not benefit so directly from modernization.

The increased availability of health and educational resources in towns and cities that resulted from Mohammad Reza Shah's programs contributed to an explosion of the urban population. In the 1950s, urban areas accounted for 31 percent of the population; by the late 1970s, that number had increased to about 50 percent. The urban population became stratified into an upper class, a propertied middle class, a salaried (managerial) class that included the bazaar, and a wage-earning working class.

Monetary and Fiscal Policy

The Iranian fiscal year begins on March 21 and runs through March 20 of the following calendar year. The budget, presented to the Majlis by the Planning and Budget Organization, consists of three sections: ordinary, plan, and defense allocations. Because of conflict between the Revolution's stated opposition to the massive defense expenditures of the shah and the high cost of the war with Iraq that began less than one year after the Revolution, as of late 1987 there had been no fiscal year in which defense expenditures were not severely understated for domestic political reasons. As a result, attempting to set forth actual figures on the money supply, especially as a function of fiscal policy, was almost pointless.

The Post-1979 Period

The disparity between the economic promises of the shah's regime and the results as perceived by the majority of Iran's citizens contributed to a revolutionary climate in the late 1970s. When the revolutionary regime came to power in 1979 (on the heels of the economic downturn of the late 1970s), it claimed that modernization and Westernization had nothing to offer Iran, as the recession had made evident. Islam, not economic planning, was cited as the basis for correcting the perceived ills of Iranian society stemming from the alleged excesses of the shah. The regime came to power criticizing Mohammad Reza Shah's failed agricultural policies and promising self-sufficiency and economic independence. The government adopted an emphasis on agriculture as the foundation of its program. To consolidate power quickly among the rural poor, the Khomeini regime capitalized on popular resentment of the shah for having largely ignored the agricultural sector.

All six of the development plans designed under the shah aimed at economic development; the Sixth Development Plan, intended for 1978-83, was never implemented because the Revolution occurred in early 1979. The First Development Plan of the Islamic Republic (1983-88) proclaimed that its goals were to establish Iran's economic independence through self-sufficiency in foodstuffs and to reduce the country's dependence on oil exports.

The first "republican" plan focused on five points: expanding education, representing the interests of the mostazafin (the disinherited), achieving economic independence, diversifying the economy to lessen the dependence on oil and gas exports, and developing agriculture. The development plan did not include a factor for defense expenditures. Criticism of this plan resulted in its revision in 1984, although the changes were not approved by the Majlis until January 1986. The revision included an increase in the investment in agriculture (from 15.5 to 16.7 percent of the national budget) and a smaller investment in non-oil industry (the share fell to 52 percent). Projected oil revenues in this version of the plan were based on the lower oil price prevailing in 1985.

The budget for the first republican plan was US$166 billion, but the allocation of funds was delayed because of political and economic pressures. The political pressures came from newly empowered groups and individuals interested in using the social disruption caused by the Revolution to create their own financial empires, free of state control. The war with Iraq also affected funding for the first republican plan. Oil revenue shortfalls caused the first republican plan to be revised again in early 1987. The shortfalls, in combination with the expenses associated with the Iran-Iraq War, resulted in nearly half the budget being allocated to military goods. Imports of consumer products were cut in half, and projects under the development plan were given low priority. Austerity measures and increased unemployment resulted.

Gauging the relationship between government economic policy and actual operation of the economy subsequent to the Revolution of 1979 is difficult because official economic policy has been obscured by religious and ideological themes. Iran's financial system began adhering to Islamic principles after the Revolution, a process that accelerated in the 1980s. Although the Planning and Budget Organization prepared budgets, in coordination with several other ministries, the Majlis, the majority of whose members were Muslim religious leaders, was responsible for ratification.

The budget presented a financial outline within which outlays were planned for military purposes, education, and other government activities. There was an increasing discrepancy between budget estimates for the war and actual costs. Whereas the government claimed in 1982 that 13 percent of the total budget was spent on defense, independent analysts claimed that the figure rose from 11.5 percent of the budget in 1979 to 46.9 percent in 1982. However unreliable the Iranian claims about defense spending, one thing was increasingly clear: the Iranian government dedicated virtually all foreign exchange resources, including both advance drawings on revenues and uncollectible receivables (which were counted as assets) to prosecution of the war.

Inflation was a serious issue in the mid-1980s. The increase in prices, which was beyond the control of the monetary authorities and the Central Bank--founded originally in 1960 as Bank Markazi Iran and renamed Central Bank (Bank Markazi) of the Islamic Republic of Iran in December 1983--began in the 1970s with the rapid rise in oil revenues and equally rapid increases in government expenditures. The latter had a multiplier effect on the money supply and added to the demand for goods and services, thereby inducing price rises. The monetary authorities attempted to minimize the multiplier effect by increasing the cost of borrowing and tightening credit. Imports increased as a result of lower duties, relaxed quotas, and an increase in government purchases of foreign goods. Bottlenecks at the ports and elsewhere in the transportation system limited the capacity of imports to satisfy demand, however.

Efforts to reduce inflation date to 1973, when a serious price control program was initiated. The government took additional measures to curb inflation in May 1980 by linking the rial to the Special Drawing Rights (SDRs) of the International Monetary Fund (IMF) instead of the United States dollar and by encouraging investment in the private sector and growth in non-oil industries. In addition, subsidies on basic goods were increased to keep their prices down. Nevertheless, a 30- percent inflation rate persisted, a black market rate on the United States dollar flourished, and foreign exchange controls continued.

Inflation was continually understated by the government. The government asserted that the inflation rate had fallen from 32.5 percent in FY 1980 to 17 percent in FY 1983 and to 5.5 percent in FY 1985; independent analysts, however, claimed that a more accurate inflation rate for 1985 was 50 percent. As essential goods grew scarcer in the wartime economy, import controls fed inflation. Prices of basic foodstuffs and consumer goods increased faster than the Central Bank admitted. The increasing cost of rental property in urban areas and continued subsidies for consumers on basic foods reflected a serious inflationary problem in the mid-1980s.

To the surprise of many, the Majlis increased the FY 1986 budget in March 1986, even though oil revenues were projected downward. The increase went mainly to finance military spending and the steel and nuclear industries. The rising costs of the war, coupled with falling oil prices in 1986, led to the use of non-oil exports to generate revenue because oil income was no longer a guaranteed source of foreign currency. To finance short-term debts, Iran drained its small reserve of foreign currency by allowing advance drawing on revenues.

The FY 1987 budget also reflected the priority of the war effort. The government again promised to curb inflation, to continue to subsidize basic foodstuffs, and to make available to the import sector a revolving fund of US$7 billion, presumably for consumer use.

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