A subsidy refers to an economic benefit from government to individuals or business firms. A subsidy may lower the price of a product or service to individuals or raise the price received by those who produce it. It may also benefit producers by lowering the cost of production. Governments—federal, state, and local—subsidize a wide range of economic activities in the United States. Well-known subsidies include government assistance to farmers, food stamps, college student loans, and economic incentives (such as tax breaks) by state and local governments to attract sports teams and manufacturing or research facilities.
II. Types of Subsidies
A. Money versus In-Kind Subsidies
B. Business Subsidies versus Subsidies to Individuals
1. Business Subsidies
2. Subsidies to Individuals
III. Effects of Subsidies
A. Why Do Subsidies Lead to Overproduction and Overuse?
B. The Ethanol Subsidy
IV. Why Are Subsidies Often Harmful?
V. Why Not Just Abolish Bad Subsidies?
Subsidies began in Great Britain in the 1500s with a grant of money by the British Parliament to the king to finance military expenditures. The money was raised by a special tax. The subsidy concept has long since been generalized and now refers to any economic favor by government to benefit producers or consumers. Though some subsidies may benefit the public at large, many subsidies today do not and frequently, quite appropriately, are referred to as political pork or corporate welfare.
What are the main kinds of subsidies in the United States? How do some of the familiar and not-so-familiar subsidy programs work? Why do subsidies typically lead to too much of the subsidized activity being produced and used? Subsidies generally benefit a small group at the expense of the general population, and many are harmful to the general public. How, then, do harmful subsidy programs get enacted into law in a democratic society that makes decisions on the basis of majority vote? The following sections consider these questions and clear up some of the confusion about subsidies.
Types of Subsidies
Subsidies take many different forms and can be classified in different ways.
Money versus In-Kind Subsidies
A subsidy or so-called transfer from the government to an individual or business firm may be in the form of money or in-kind benefit. Well-known money transfers include agricultural subsidies, veterans’ benefits, and Medicaid. Common in-kind benefits include food stamps, school lunches, rent subsidies, medical assistance, and other programs that do not involve the exchange of money. In some cases, an in-kind subsidy program may require the recipient to pay some of the cost. For example, the school lunch program is said to be means tested: depending on the parents’ income, some students receive free meals, while students from families having higher incomes must pay, but the price paid is below the cost of the meal.
Business Subsidies versus Subsidies to Individuals
Federal, state, and local governments subsidize a wide range of producer activities. Farmers, for example, may receive financial assistance when crop prices are low or crop yields are lowered due to drought, hail, or other unfavorable weather conditions. Governments sometimes subsidize large corporations such as auto or steel companies. Assistance may be direct, as in the case of a financial bailout, or it may be indirect, including tariff s and import quotas that limit domestic sales of competing goods from foreign countries. Quite often, a government subsidy is targeted to a specific business firm. State and local governments may attempt to lure a corporation to locate a manufacturing facility within its borders by providing property tax holidays or other financial incentives. For example, South Carolina, Alabama, and other states have used tax breaks to induce foreign auto companies, including Toyota and Mercedes, to locate manufacturing facilities within their states. Similarly, local governments often subsidize the construction of sports facilities to lure sports teams.
Similarly, large industries may induce the federal government to restrict competition from foreign firms producing similar products. Subsidies of this type include import tariff s on autos, steel, textile products, and agricultural products. An import tariff on autos, for example, means that Ford, General Motors, and other domestic auto producers can charge somewhat higher prices for their products in the United States (even though, under current conditions, they must also offer economical models and provide low financing).
The federal government also subsidizes the export of products from the United States to other countries. For example, the export of agricultural products has been subsidized for more than 50 years. The best known program, known as Public Law 480, was first enacted in 1954. The program was begun to reduce stocks of food that the government acquired through its farm subsidy programs. The program reduces the cost of U.S. food in foreign countries. Some of the food is sold to foreign buyers with long repayment periods at low interest rates, which is a monetary subsidy. Some of the food subsidies are in-kind: the U.S. government donates food products to people in foreign countries in response to devastation caused by floods, earthquakes, famine, and so on. Still other agricultural export subsidies go to private companies and to state and regional trade groups to promote sales of U.S. farm products in foreign countries.
With the exception of subsidies for disaster aid, all export subsidies are inconsistent with free trade between countries. Programs that subsidize exports of U.S. agricultural products help to insulate U.S. farmers from world market prices and often work against the interests of low-income farmers in less developed countries. Moreover, U.S. export subsidies tend to cause recipient countries to retaliate by creating their own export subsidies and thereby foster increased protectionism by producer interests in those countries.
Subsidies to Individuals
Federal, state, or local governments may subsidize a product to increase the use of the product subsidized; such subsidies generally target lower-income consumers and are no less common than producer subsidies. Some consumer subsidies targeting low-income individuals, including food stamps and the school lunch program, have been operating for decades.
Other consumer subsidies of more recent origin are much less dependent on the individuals’ incomes. For example, a recently enacted federal program provides an income tax credit for the purchase of hybrid cars—cars with both electric motors as well as internal combustion engines—which is available to all taxpayers. In this case, purchasers of hybrid cars may reduce their federal income taxes by a specified amount in the year that the car is purchased. For example, some buyers of hybrid cars, if purchased during 2006, were able to reduce their 2006 federal income taxes by as much as $3,150.
The hybrid car subsidy ostensibly was begun to reduce U.S. dependence on imports of petroleum. The long-term prospect for hybrid cars remains in doubt, and the huge tax credit required to make hybrids competitive with conventional gasoline-powered cars suggests that the subsidy may not be socially beneficial. It also raises a question as to whether future increases in technology will make hybrid cars competitive with conventionally powered autos. The crucial public policy problem is that temporary subsidies to enable a new technology to become established often become permanent subsidies, even when the new technology does not pan out.
Effects of Subsidies
Why Do Subsidies Lead to Overproduction and Overuse?
When production of an activity is subsidized, producers increase output. When a business enterprise is operating under competitive conditions—in which it has little ability to influence the market price—it will continue to produce an additional unit of the product as long as the expected return is greater than the cost of producing the unit. For example, if the cost of producing another widget is $10, but the widget can be sold for more than $10, it is profitable to produce the widget. But if it costs more—say, $12—than it can be sold for—say, $10—it is neither profitable nor socially beneficial to produce it. The profit and loss system in this way provides a check on wasteful production.
However, if the government subsidizes production, a business firm may find it profitable to produce and sell too much. In the above example, a subsidy of $3 per widget makes it profitable to produce and sell another unit for $10, even if it costs $12 to produce: $10 from the buyer plus $3 from the government is more than the cost of production. In this case, the government subsidy overrides the loss signal—the resources used in production are worth more than the value of the product! Agricultural subsidies are a good example. Government subsidies to farmers lead to overproduction. This also may be the case for ethanol, a substitute fuel for gasoline. The ethanol subsidy also illustrates how government subsidies generally are supported by vested interests. It is shown in the following section how small groups are able to maintain their transfer programs, regardless of whether they are beneficial to the public at large.
The Ethanol Subsidy
The far-reaching energy legislation enacted by the U.S. Congress in 2005 illustrates a number of issues related to producer subsidies. With higher petroleum prices and increased uncertainty about oil production in the Middle East, there was increased interest in biomass-derived fuels. Biomass refers to all bulk plant material. One of the first provisions of the 2005 legislation to take effect mandated an increase in the production and use of ethanol, currently made from corn or sugar. Gasohol, a mixture of gasoline and ethanol, is the primary fuel of this type.
Ethanol production recently has become a much more important public policy issue in the United States. However, interest in ethanol as an auto fuel is not new. Congress enacted legislation providing for subsidies for ethanol and other biomass-derived fuels more than 30 years ago, following the Arab oil embargo of 1973. The subsidy was in the form of exemptions from federal excise taxes, which have been in the range of 50 to 60 cents per gallon of ethanol. The subsidy amounted to more than $10 billion between 1979 and 2000. In 2005, more than 4 billion gallons of ethanol were used in gasohol in the United States out of a total gasoline pool of 1.22 trillion gallons. Corn farmers became staunch supporters of the ethanol program—no surprise because it increases the use and market price of corn.
Most energy experts believe that using corn to make ethanol is not an economically feasible substitute for gasoline. Although ethanol is sold to the public as a way to reduce dependence on oil, the net amount of oil saved by gasohol use, if any, is small. Indeed, widely cited research suggests that it may take more than a gallon of fossil fuel to make one gallon of ethanol. The growing, fertilization, and harvesting of corn and the fermentation and distillation processes that convert corn to ethanol require enormous amounts of fossil fuel energy. Although there is no consensus among energy experts as to whether ethanol production reduces dependence on fossil fuel, there is little doubt that ethanol subsidies are driven far more by congressional lobbying and farm-state politics rather than by the fact that it is a practical, long-term alternative to petroleum.
Why Are Subsidies Often Harmful?
Government subsidies were originally viewed as a grant of money or special privilege advantageous to the public. More often, however, as in the case of farm programs, subsidies work against the interests of the public at large because they lead to too much production; that is, the cost of production exceeds the value of the product produced. Moreover, the very process through which special interest groups gain an economic advantage through government legislation creates additional waste. Typically, as in ethanol production, a subsidy can be traced to so-called privilege-seeking behavior by those who stand to gain. Privilege seeking occurs when individuals or groups, such as corn farmers or sugar producers, attempt to influence the political process for their own financial benefit.
Why is privilege-seeking behavior harmful from the standpoint of the public at large? It is neither easy nor cheap to influence the political process—to obtain a government favor. Individuals and groups spend large amounts of time and money on campaign contributions, lobbying, and so on to obtain government subsidies. The time and money to influence the political process to obtain legislation that restricts competition is wasted, at least from the standpoint of consumers and taxpayers generally. The valuable resources used to obtain the subsidy could have been used to produce additional goods and services that would have benefited the public at large.
The sugar program is a prime example of how privilege-seeking behavior can lead to bad public policy. The sugar price support program raises sugar prices to U.S. producers of sugar cane and sugar beets by restricting imports of sugar from Brazil and other countries that can produce sugar more cheaply than the United States can. U.S. import quotas limit the amount of sugar coming into the United States from other countries and keep the domestic price of sugar in the United States higher than the world price of sugar—it has sometimes been twice as high. The cost of the sugar subsidy is borne largely by U.S. consumers and manufacturers of sugar products, who must pay much higher sugar prices than they would have to pay if there were no sugar program. This sugar tax, in the form of higher retail sugar prices, according to the General Accounting Office, costs U.S. consumers some $2 billion per year.
Who benefits from the sugar subsidy? It benefits relatively few U.S. farmers—growers of sugar beets, sugar cane, and corn—and domestic manufacturers of sugar substitutes. It should not be surprising that sugar interests donate large amounts of money to political candidates. The Florida cane-growing company Flo-Sun contributed $573,000 to candidates in recent elections. American Crystal, a sugar beet cooperative in the Red River Valley of North Dakota and Minnesota, donated $851,000 in the 2004 elections.
The sugar subsidy benefits corn farmers as well as sugar producers. How do corn farmers benefit from the sugar subsidy? The sugar price support program not only raises the price of sugar, it also spurs the development and production of sugar substitutes because it makes them more competitive with sugar. For example, U.S. consumption of corn-based sweeteners now is larger than that of refined sugar. The sugar subsidy is defended by lobbyists representing both corn farmers and producers of corn-based sweeteners. The added support for the sugar subsidy helps to maintain what almost all objective analysts agree is a bad public policy.
Why Not Just Abolish Bad Subsidies?
Why is it that getting rid of a harmful subsidy is easier said than done? A subsidy program may be proposed for a variety of reasons that are generally misleading and often erroneous. These arguments made by subsidy proponents quite often divert attention from the actual reason. For example, the sugar subsidy, which virtually all objective analysts agree raises the sugar price, is sold to the public as a way to stabilize the sugar market or prevent swings in sugar prices.
Consumers, of course, benefit when prices are low some of the time instead of being high all of the time, as they are under the sugar price support program. In reality, the sugar subsidy can be chalked up to favor seeking by producers of sugar and sugar substitutes.
The sugar program is a classic example of how a government program may last a long time, even though the number of consumers and taxpayers harmed is far, far larger than the number of individuals and business firms benefiting from the subsidy. The direct beneficiaries of the U.S. sugar subsidy, for example, are highly concentrated on the approximately 10,000 domestic producers of sugar and sugar substitutes. Each sugar cane and sugar beet farmer may benefit by thousands of dollars from the sugar subsidy. For example, a U.S. Department of Agriculture study reported that each one-cent increase in the sugar price was estimated to average $39,000 per sugarcane farm and $5,600 per sugar beet farm (Lord 1995).
The sugar subsidy program also is highly beneficial to the industry producing high fructose corn syrup, the sweetener used in many soft drinks. It should not be surprising that Washington lobbyists for corn refiners are highly effective advocates for the sugar subsidy. Archer Daniels Midland Corporation (ADM), a large agribusiness firm, for example, is a driving force behind the sugar lobby in the periodic congressional battles over sugar legislation. Although ADM does not directly produce sugar, it does produce high fructose corn syrup. As the sugar price increases, so does the demand for and price of high fructose corn syrup and other sugar substitutes.
The sugar subsidy creates a price umbrella under which ADM can profitably operate to produce the corn sweetener substitute. If there was no price support program for sugar, sugar prices in the United States would be much lower, and ADM probably would not be able to produce high fructose sweetener at a price low enough to compete with sugar. Since the benefits of the sugar subsidy are highly concentrated on a relatively small number of sugar farms and agribusiness firms, such as ADM, it is in their financial interest to make sure that well-paid lobbyists exert a lot of pressure in Congress to maintain the sugar subsidy.
While the benefits of the sugar subsidy are highly concentrated on a small number of producers of sugar and sugar substitutes, the cost of the sugar subsidy is divided among 300 million users of sugar in the United States. The average consumer uses about 100 pounds of sugar per year. Even if the sugar producer subsidy doubles the retail sugar price, the cost to the individual consumer is quite small (almost certainly less than $100 annually). What is the implication? Individuals supporting the sugar subsidy can afford to spend huge amounts of money lobbying Congress to maintain the sugar program, but individual consumers cannot afford to spend much time or money fighting the sugar program because the amount of money each spends on sugar is just too small. This is the main reason the United States sugar subsidy has lasted for decades, even though it is harmful not only to consumers buying sugar but to manufacturers using sweeteners in candy, cookies, and other food products as well.
The term government subsidy originally referred to a grant of money from the British Parliament to the king to finance military expenditures. Subsidy now refers to a wide range of government favors to business firms or individuals. Current subsidies often face widespread criticism, especially corporate welfare, a derisive term for subsidies made to large business corporations.
A subsidy program may be enacted to benefit individuals or business enterprises. Common subsidy programs to individuals include federal and state education subsidies, food stamps, rent subsidies, medical subsidies, school lunch subsidies, and subsidies to reduce energy use in autos and home heating and cooling systems. Business subsidy programs include subsidies to farmers, agribusiness firms, steel producers, auto producers, textile producers, sports teams, and so on.
While a subsidy may sometimes be warranted—that is, it is advantageous to the public at large—typically, this is not the case. Quite often, the cost of the output exceeds its value—too much is produced from the public’s point of view. What explains the prevalence of harmful government subsidies? Most public subsidies can best be explained by favor seeking by narrowly focused producer and consumer groups who successfully further their own interests through the legislative process at the expense of the public at large. In other words, programs presumably enacted to further the public interest frequently transfer wealth from individual consumers and taxpayers to special interest groups—including the auto industry, airline industry, steel producers, textile producers, farmers, and ship builders—even when they are harmful to the public. Ethanol and sugar subsidy programs are prime examples.
In a democratic society operating on a one person–one vote basis, how can a small group of individuals or business firms obtain legislation that benefits them at the expense of the public at large? Economists, using public choice theory, a new subfield of economics, only recently have begun to understand this phenomenon. If the benefits of a subsidy are highly concentrated on a small group and the costs are widely dispersed over the entire population, as is often the case, the subsidy may be enacted and last for a long time. Consequently, the burden of proof for any subsidy should be on those who defend it. Citizens in a democratic society should question current and proposed government programs that confer benefits on particular business firms or individuals at the expense of the rest of society.
E. C. Pasour Jr.
- Hyman, David N., Public Finance: A Contemporary Application of Theory to Policy, 6th ed. Orlando, FL: Dryden Press, 1999.
- Johnston, Mark C., Free Lunch: How the Wealthiest Americans Enrich Themselves at Government Expense. New York: Portfolio, 2007.
- Lord, Ron, Sugar: Background for 1995 Legislation. Washington, DC: U.S. Department of Agriculture Economic Research Service, 1995.
- Pasour, E. C., Jr., and Randal R. Rucker, Plowshares and Pork Barrels: The Political Economy of Agriculture. Oakland, CA: Independent Institute, 2005.
- Peterson, E. Wesley F., A Billion Dollars a Day: The Economics and Politics of Agricultural Subsidies. Malden, MA: Wiley-Blackwell, 2009.
- Sorkin, Andrew Ross, Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis—and Lost. New York: Viking, 2009.