Subsidies and Taxes

When markets are deemed to be failing, governments or governing bodies tend to intervene to put things right. In most cases it is safe to say that any intervention in the market is done with sound aims and with the best possible intentions. The problem is that intervention into markets can often create other problems that may not have been foreseen or at least not to the extent that they eventually occur. The main method of intervention has been through taxation and subsidy as the tools to correct the perceived market failure.

Subsidies

A subsidy is essentially a simple idea; give a producer an incentive to produce more than they would normally do. The typical approach is to give the producer a certain amount of money per unit of production. The industry where this has been most obvious is in agriculture where the Common Agricultural Policy is held up as an excellent example of how subsidies can work but have numerous side effects, but the principle also extends to other areas - housing, for example. In the latter case, the problem of rising house prices means that many people just starting work or starting family life find it difficult to 'get on the housing ladder' because there is not much low cost housing available. Some councils have granted planning permission for new housing on the understanding that it is offered for sale for local people only and not at prices above a certain limit. Others are looking for a public subsidy to ensure that low cost housing is made available for those that need it.

When are subsidies appropriate?

The Common Agricultural Policy was devised in the years after the Second World War. The years were one of disruption, re-construction and shortage with rationing widespread. A key post-war strategy was to increase output of agricultural production and to attain a greater degree of self sufficiency in agricultural production. So with this example and that of housing quoted above we can conclude that the market failure is an insufficient amount produced to meet consumer need - a Pareto inefficient allocation or allocative inefficiency - to use the appropriate terminology.

Taxation

Taxation can be seen as the opposite of a subsidy; in this context we are referring to the taxes that are imposed on producers to change their behaviour or, through the fact that they will pass on some of the tax to the consumer in the form of higher prices, change the behaviour of consumers in the desired direction. In most cases, taxes are levied because the market failure is that too many of the goods in question are being produced and this over-production is seen as imposing some form of cost to society. Pollution, congestion, the use of de-merit goods are all examples. The intention, as before, is to amend the behaviour of consumers and producers to reduce the amount of the goods in question being produced and consumed.

It should not come as any surprise that the ideas can be very closely linked to the concept of externalities - subsidies bring positive externalities, taxation reduces negative externalities. But the whole thing is not that simple as we shall see. The Activity provides a walk through guide to analysing the impact of subsidies and taxes.

Some Useful Facts

Total subsidy bill in the EU = $100billion (£60 billion)
Subsidy per cow:
- EU - €803 (£549)
- US - $1057 (£634)
- Japan - $2,555 (£1,533)
Cost of growing sugar beet in Europe is two times higher than in countries such as Brazil and Zambia
25,000 cotton growers in the US receive an average of $230 (£138) per acre in subsidy - a total bill of just under $4 billion (£2.4 billion) from the US Government. The cost of growing cotton in the US is 3 times that in Mali in Africa. In West Africa, 11 million people are dependent on cotton for their livelihoods.
Duty on petrol - 47.1p per litre of unleaded low sulphur petrol and diesel, VAT 11.6p per litre. Duty as a percentage of the average retail price of petrol (85p) = 55.4%; total tax as a percentage of retail price of 85p = 69%.
Duty on cigarettes - 22% of the retail price + 9.68 pence per cigarette - a total of £2.93 for a packet of 20 cigarettes at an average retail price of £4.25 per pack which means that the duty is 69% of the price.

Sources: 'Cut farming subsidies', says CBI chief (BBC article), WTO chief leads cotton review (BBC article) and Kicking the subsidies (Guardian article)

"Increasing the unit price of tobacco products is effective in increasing the cessation of tobacco use and in reducing consumption. Comprehensive literature reviews of analyses of aggregate sales data and individual level survey data result in median price elasticity of demand estimates that cluster around -0.4. Therefore, a 10% increase in the price of cigarettes will result in an approximate 4% reduction in consumption. It's important to note that half or more of the impact on overall demand is the result of reductions in prevalence that largely reflect cessation."

Source: Treatobacco.net

Begin the Walkthrough

Subsidies:

Image: Will subsidies lead to increases in sights such as this in the countryside and if so what will be the long term effects?