Subsidy is a financial incentive by the government to the consumers and/or producers. According to P. A. Samuelson and William D. Nordhaus, “A payment by a government to a firm or household that provides or consumers a commodity”.
A subsidy can be used to support businesses that might otherwise fail, or to keep prices below what they would be in a free market or to encourage activities that would otherwise not take place. For producers/suppliers ‘subsidy’ is the financial support/grant generally by the government to private firms (which may be called investment grants) and to state-owned firms (covering losses).
Types of Subsidies
There are many forms of subsidies given out by the government, including welfare payments, farm subsidies, housing loans and student loans. For example, if a domestic industry, like farming, is struggling to survive in a highly competitive international industry with low prices, a government may give cash subsidies to farms so that they can sell their product at the low market price but still achieve financial gain.
Subsidies provided by the government are classified on different bases for example on the basis of the recipients of the subsidy (e.g., consumer or producer) or on the basis of the source of the funds (government, consumer, general tax revenues, etc). In economics, one of the most important ways to classify subsidies is the mean/way of distributing the subsidy. We briefly introduce the major forms of government subsidies as follows:
i) Direct subsidies
Direct subsidies involve a direct cash transfer to the recipient by the government, for example an unemployed person or an agricultural corporation. These are the most simple and perhaps the least frequently used forms of government subsidy. During the 19th century, as the American frontier (boarder line) was moving westward, the federal government gave extensive grants of land and construction funds to the railroads. In the 20th century, governments in Europe, North America, and Japan give direct payments for ship construction and some forms of public transportation.
ii) Indirect subsidies
Indirect subsidy is a broad term that would cover any form of subsidy that does not involve a direct transfer. These are the most widespread, if less visible, forms of support/aid provided by the government to private enterprise and other institutions. Indirect subsidies may take such forms as favorable tax policies, loans, import quotas, and price supports. For example, if the Government of Nepal persuades India or China to limit their new chocolates exports to Nepal, Nepalese chocolates industry would benefit.
iii) Tax subsidy
A tax that is below its optimal level generates a “tax subsidy.” Under this form of subsidy, the recipients get the benefits through the tax system, usually through the income tax, profit tax or consumption tax systems. Examples may include tax deductions for workers in certain industries, accelerated depreciation for certain industries or types of equipment or exemption/omission from consumption tax (sales tax or value added tax).
Subsidies provided through tax breaks are described as “corporate welfare.” A tax break is a reduction in the normal rate of a particular class of taxes targeted towards an individual or group of companies. Bigger tax breaks are provided to larger companies which are planning to open a new factory (e.g., shop) around a location. Locations provide these tax breaks because they often feel that the benefits of job creation will more than the decline in tax revenues. Governments of all levels may do this to encourage employment in under-developed areas. Tax subsidies are given as a protection to smaller producers to help them compete with larger companies, to help correct international trade imbalances, to support industry, believed important to national security and to help industry compete with other countries and these are common practice throughout the world.
However, there is debate/dispute on whether such subsidy should also apply to firms that create excessive social cost in the form of environmental degradation and public health costs. The most effective way of compensating for the problems as traditional economic theory suggests is to internalize the cost (by regulations, or other means).
iv) Labor subsidies
A labor subsidy is any form of subsidy provided by the government to pay for labor costs. Examples may include labor subsidies and tax deductions for workers in industries, such as the film and/or television industries. Wage subsidies provide a financial incentive to eligible/authorized employers when considering the employment of job seekers with disability or with other barriers to employment. Wage subsidies are payments made to employers to help cover the costs of paying wages at least for short run. They also aim to increase the competitiveness of job seekers, including those with disability. During economic recession, government provides labor subsidies to employers.
v) Production subsidies
Governments in certain case (for example to encourage the development of a particular industry) may provide direct production subsidies – cash payments for production of a given goods or services. Normally, production subsidies are easily identifiable, such as minimum price policies. Indirect production subsidies may be less easy to identify, such as infrastructure subsidies.
vi) Perverse subsidies
Famous environmental economist Norman Myers has argued on “perverse subsidies”. The term “perverse” can be applied to a subsidy by its opponents if they believe that it encourages adverse/undesirable actions with social costs. Possible examples, suggested by Norman Myers are German subsidies on coal mining and American petrol (gasoline) subsidies.
vii) Infrastructure subsidies
Infrastructure subsidies may refer to a form of indirect production subsidy. The provision of infrastructure (at public expense) may effectively be useful for only a limited group of potential users, such as construction of roads at government expense for a single logging company. The implication is that those users or industries benefit disproportionately from the provision of that infrastructure, at the expense of taxpayers.
In some cases, the government may need to improve the public transport by subsidizing those transportation agencies that provide the public services so that the services can be affordable for everyone. This is the best way of helping different groups of disabled and low income families in the society.
viii) Export subsidies
Various taxes or other subsidy measures may be used to promote exports of favored – industries. In other cases, tax measures may be used to ensure that export subsidies are justified as a means of compensating for the subsidies or protections provided by a foreign state to its own producers.
ix) Trade protection
Measures used to limit imports from other countries may form/represent another type of hidden subsidy. The economic argument is that consumers of a given product are forced to pay higher prices for a given goods than they would pay without the trade barrier; the protected industry has effectively received a subsidy. Such measures include import quotas, import tariffs, import bans and others.
x) Consumption subsidies
Customers would pay only market prices for goods and services if economic competitions were totally unhindered/unhampered and all markets were free and unregulated. Competition would serve/work to keep prices low and quality high. But this situation rarely exists because of a wide range of government policies that affect the selling prices and the quantities of most items produced and offered for sale.
The provision of public goods (e.g., health and education services through consumption subsidies is an example of a type of subsidy recognized/identified as ‘efficient’ by economics. In some cases, consumption subsidies may be targeted at a specific group of users, such as large utilities, residential home-owners and others.
xi) Purchasing subsidies
Government everywhere is relatively large consumers of various goods and services. Subsidies may occur in this process by choice of the products consumed, the producer, the nature of the product itself, and by other means, including payment of higher-than-market prices for goods purchased.
xii) Subsidies due to the effect of debt guarantees
Another form of subsidy is due to the practice of a government guaranteeing a lender payment if a particular borrower defaults (fails to pay). For example, this occurs in the United States, in certain airline industry loans, in most student loans, in small business administration loans and in mortgage (home equity) backed bonds. A government guarantee of payment lowers the risk of the loan for a lender and since interest rates are mainly based on risk, the interest rate for the borrower lowers as well.
xiii) Price subsidy
Price subsidy is a form of government intervention resulting in a deviation/discrepancy of an actual price facing consumers and producers from a specified “optimal/appropriate” benchmark price level. Government price are common/widespread in developed, emerging, and low-income countries. They reflect public choices in favor of certain economic outcomes and/or efforts to overcome market failures. For example, almost all governments subsidize the costs of education and health services for the mass of their populations. Food and energy subsidies are relatively large in many emerging and low-income countries. Many governments subsidize the cost of transport. Agricultural subsidies are relatively large in number of developed countries. Other common subsidies include those for utilities, public services, and pharmaceutical products.
