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We all come across the term subsidies more often. But, what it is? What is its main objective? Are there any economic effects due to subsidy and is it good or bad? We will find out here.

 1. What is a Subsidy? What are the main Objectives of Subsidies?

Answer: The most general definition – It is assistance to an economic sector or any business for producers. Subsidies lead to changes in demand/ supply decisions by creating a wedge between consumer prices and producer costs.

Many of these subsidies are set in place by the Government for producers or distributed as subventions in an industry to prevent the decline of that particular industry or for an increase in prices of its products or simply to encourage it to hire more labour (as in the case of wage subsidy)

These are often aimed at:

1. Inducing/ Encouraging higher consumption/ production
2. Offsetting market imperfections including internalisation of externalities;
3. Achievement of social policy objectives including redistribution of income, population control, etc.

2. What are the Economics effects of Subsidies?

Answer:  

Almost every economic textbook says the economic effects of subsidies can be broadly grouped into Allocative effects, Redistributive effects and Fiscal Effects.

1. Allocative effects: Helps to draw more resources (where the subsidies are provided)
2. Redistributive effects: Mostly depends on the elasticity of supply and demand of the same good. It is one of the means of administering the subsidy.
3. Fiscal effects: Large part of subsidies are budgeted, therefore, it directly affects fiscal deficit. It can also affect indirectly by diverting the resources from tax-yielding sectors to low tax-revenue potential.
4. Trade effects: In one way, subsidies may reduce domestic supply which will lead to an increase in imports. On the other hand, it may help domestic producers to be more competitive with international markets and prices. So, it may increase or decrease imports.

Now comes one of the important questions

3. Whether Subsidies are bad? 

Answer: If you ask an economist then he would answer Yes Subsidies are bad. I would like to quote here an article by Kenneth P. Green on energy policy. It explains why subsidy in any form is a bad policy.

First, subsidies breed corruption. They don’t create incentives for honest people that already have a market-worthy product — such people can already sell their goods into the market easily.

Rather, subsidies create a fertile garden for rent seekers who are unable to sell their goods competitively in a free market, and prefer to tap the coercive and redistributionist force of government to lever their uncompetitive good into the market at the public’s expense.

Rather than contribute to overall social welfare by giving consumers the best goods at the least cost, or even maximizing the efficient use of people’s taxes, rent-seekers undermine social welfare by foisting inferior or over-priced goods onto the market while taking money from people that could be used for other important purposes.

This is a particular problem in countries with relatively weak property rights regimes, and countries with legal institutions insufficient to prevent it.

Second, subsidies are usually inequitable. High gasoline taxes create an incentive that favours new fuel-efficient cars–in a sense, creating a subsidy for high-mileage vehicles. But only people in higher economic brackets can afford new cars, and poorer people are left to drive less efficient vehicles, and spend more money on gasoline taxes.

Third, subsidies pave the way for adverse consequences that inevitably result when planners decide that their few hundred heads are wiser than the nearly infinite number of nuanced economic decisions made by their millions of constituents. 

He further states that,

Subsidies subvert the efficient functioning of the market, which is our only effective mechanism for matching supply with demand. Free trade of a given good is, as economics tells us, the only way to determine efficiently how much of that good is desirable at a given price.

 ( Source: https://www.aei.org/articles/the-road-to-energy-hell-is-paved-with-good-intentions/)

In 2011, Delivering the P N Haksar Memorial lecture here, Subbarao, Former Governor of RBI, said, “In charting a roadmap for fiscal consolidation, we need to be mindful of the quality of fiscal adjustment– which is to weed out unproductive expenditure and protect growth promoting expenditure,” he said.

Sharing his thoughts on subsidies in his address on ‘rejigging the Elephant Dance: Challenges to Sustaining the India Growth Story, Subbarao said, “There are bad subsidies and there are good subsidies”.

“Bad subsidies like fuel subsidy, subsidy on LPG may be Rs 300 but every time you buy LPG you are getting subsidy to the extent of Rs 300. Not only you, Mr Birla, Mr Ambani, every time they buy a cylinder, they will also get subsidy,” he said.

“Then there is fertiliser subsidy…soil degradation happens because of fertiliser subsidy and thereafter irrigation subsidy,” he said.

Subbarao said there were good subsidies as well, like giving cycles to girls to come to school and constructing toilets for girls in schools located in villages. “These are good subsidies,” he asserted.

(Source: http://archive.indianexpress.com/news/subsidies-are-bad-d-subbarao/880519)

So there are both good and bad subsidies. The Subsidies which help to improve the economy in terms of production and human capital can be considered good subsidies. But, most of the subsidies are bad this may be due to ineffective management and political compulsions.