Subsidy Primer

Chapter 3: Subsidy types

Grants and other direct payments
 
The most basic form of a subsidy, and the one that still defines a subsidy in some dictionaries, is a cash payment or grant. Although few grants are paid out in currency any more (most are paid via cheque or bank transfer), it is still common to refer to them as "cash" grants, payments or subsidies.

Normally, a grant refers to a time-limited payment, either in connection with a specific investment, or to enable an individual, company or organization to cover some or all of its general costs, or costs of undertaking a specific activity, such as research.
 

Other direct payments may be linked to the volume of production or sales. In previous centuries, and still in Australia, these types of subsidies were called bounties. They are far from archaic, however. In some states of the United States, for example, companies producing liquid biofuels receive direct subsidies for every gallon of ethanol they produce. Cash payments to producers are also sometimes linked to prices. The main form is a deficiency payment, which makes up the difference between a target price for a good (typically an agricultural commodity) and the actual price received in the market.

Various cash subsidies are paid to workers. Canada, for example, provides targeted wage subsidies to assist individuals to prepare for, obtain and maintain employment. Many countries provide grants in order to encourage people who are out of work to undergo training in new skills, or to relocate.
 
Consumers also benefit from direct payments or vouchers, particularly for the purchase of necessities, like food, medicine or heating fuels. Alternatively, a government may regulate the consumer price for a good or service, and instead pay a subsidy to the supplier of that good or service, to cover its losses.

 
 
Tax concessions

In countries with well-developed tax systems, subsidies provided by reducing companies' tax burdens are commonplace. Examples include tax exemptions (when a tax is not paid), tax credits (which reduce a tax otherwise due), tax deferrals (which delay the payment of a tax) and a host of other instruments. In common language these preferential tax treatments are called tax breaks or tax concessions; public-finance economists refer to them as tax expenditures. They should not, however, be confused with general tax reductions.

Generally, when a government provides a tax break its budget is affected in much the same way as if it had spent some of its own money. The exception is a tax credit, which is worth more to a corporate recipient (and costs a government more) than a direct payment of an equivalent nominal value, as a direct payment raises a company's taxable income and therefore is itself taxable.
 
Besides adding complexity to tax systems, tax concessions are often criticized by economists as being less transparent than grants, and more resistant to change. Several national governments, and even a few sub-national governments, produce annual tax expenditure budgets. But the information contained in these "budgets" is often reported at a highly aggregate level. Information on the value of tax breaks received by particular industries or companies is usually much more difficult to find.
 
When creating a new tax break, lawmakers sometimes set a limit on how long it may be used. But many tax breaks, once incorporated into the tax code, continue indefinitely. In contrast with a grant or similar subsidy, which has to be re-approved with each budget cycle, a tax break requires an active decision by lawmakers to eliminate it.
 

 
 
In-kind subsidies
 
The phrase "in-kind" means provided in a form other than money. Typical in-kind benefits provided by governments are subsidized housing, specific infrastructure (like a road servicing a single mine or factory), the services required to maintain that infrastructure, and various services to help exporters. They may be considered subsidies if they involve expenditure (or foregone revenue) by a government and they confer a specific benefit on the recipient. However, government provision of general infrastructure - e.g., highways and ports - is often excluded from the definition of an in-kind subsidy, as is the case in the WTO's general agreement on subsidies, the Agreement on Subsidies and Countervailing Measures.
 

The value of an in-kind benefit depends on the price charged for the resource, good or service. When a government undercharges for something, the unit subsidy is usually considered equal to the difference between the price paid and the market price. When it charges a market price, the transaction is considered commercial, and not a subsidy. Often, however, the government is a monopoly supplier of a good or service - i.e., there is no private market against which the government's prices can be compared - which increases significantly the difficulty of determining whether a subsidy is involved.

One important variant of an in-kind subsidy is privileged access to a government-owned or controlled natural resource. Primary industries benefit greatly from such access - e.g., to public lands for mining or grazing livestock, to state forests for logging, to rivers for irrigation, and to foreign seas (through so-called "access agreements") for fishing - for free or at a below-market price. International disputes over the subsidy element of privileged access to natural resources have been among the most contentious and long-running.
 
 
Cross subsidies

A cross subsidy is a market transfer induced by discriminatory pricing practices within the scope of the same enterprise or agency. Typically it exists when a government-owned enterprise, such as a public utility, uses revenues collected in one market segment to reduce prices charged for goods in another. Some definitions also include similar practices carried out by private firms, as when an integrated airline allocates part of the costs of its activities in a highly contested geographical or product market (e.g., the transport of freight) to another market (e.g., passenger transport) that is better able to bear those costs. For example, some airports cross-subsidize costs associated with serving airline passengers through sales on duty-free goods.

One of the most common forms of cross subsidy is that between consumers of electricity and consumers of irrigation water. Managers of large hydro-electric works that store and channel water for irrigation as well as generate electricity have to decide how to allocate the costs that are common to both activities (notably, the construction and maintenance of the dam and reservoir) between farmers and buyers of electricity. Government regulations will often dictate that an even smaller portion of the costs be allocated to irrigation than would be efficient according to established pricing principles.

Not all instances of price discrimination are evidence of cross subsidies, however. For example, differences in the volume (if there are economies of scale in delivery) and interruptibility of service, among other factors, can lead to different price schedules for different classes of customers.

 
 
Credit subsidies and government guarantees

Many subsidies that have budgetary implications - that is, can create financial obligations for governments in the long run - never actually appear in budgetary statements. These "hidden" subsidies are common whenever a government takes on the role of a banker or insurer to a company or industry.

When a government loans money to a company at a lower rate of interest than a commercial bank would offer, or requires less collateral to back up its loan, defers repayment or allows for a longer period to pay off the loan, the company saves money.

Governments also sometimes guarantee loans taken out by companies or individuals through commercial banks. That means that the government assumes the risk of default on the loan, rather than the bank, which in turn means that the bank can offer the borrower more favourable lending terms, such as a lower rate of interest.

Governments also serve as an insurer of last resort for private investments. All OECD governments with nuclear power plants, for example, are signatories to an agreement that limits the financial liability of power-plant owners in the event of a catastrophic accident. Similarly, many governments would be stuck with part of the bill following the failure of a large hydro-electric dam. For this type of support, years may pass before a government incurs any actual costs. But when an accident does occur, the financial burden (not to mention human cost) can be huge.
 
 
Hybrid subsidies

Economic systems can be likened to ecological systems. In the steaming jungle that defines the borderland between private industry and government, camouflage and parasitism are common adaptive responses to competition. Subsidy hybrids, particularly instruments that exploit the tax system to lower the costs of private investment, are an inevitable result of those evolutionary forces.
 
At the base of the evolutionary ladder are tax-free government bonds. A bond is a financial instrument that promises its holder a fixed annual dividend over a specified period of time, typically 10 to 20 years. National governments issue bonds to help finance their general activities. Municipalities, sub-national governments and their agencies (e.g., air-pollution control districts) also issue bonds, more commonly tied to specific projects, like water-treatment plants. The dividends paid to holders of such bonds are not taxed. Since tax-free status raises the net return on investment, particularly for bond holders in high marginal income-tax brackets, the bonds can offer a lower rate of interest than would have to be offered to buyers of private, commercial bonds in the same risk category.
 
Tax-free bonds are used also in some places to finance private investment: a corporation borrows money from a private lender, the bond buyer, which is issued by a public authority to become tax free.
 
Higher up the evolutionary ladder are instruments like tax increment financing (TIF), a peculiar form of subsidy found in the United States. Tax-increment financing enables a city to split off future additional property tax revenues associated with a designated development and to provide a loan to the company undertaking that development, using the future incremental tax revenues as collateral. In effect, this revenue stream is diverted away from normal property tax uses, such as the funding of schools, and into the TIF district.

 
 
Derivative subsidies
 
Subsidies have a tendency to beget other subsidies. Some of these are described below:
 
Sympathetic support: When support is used to influence the direction of technological developments, it often does so in a manner designed to benefit domestic producers. Many examples of this can be found in the energy sector, such as when governments support the construction of coal-fired "demonstration" power plants that are dependent on coal from high-cost domestic mines rather than on imported coal, or for biofuel refineries that use domestic feedstocks.
 
Compensatory or countervailing support: When support leads to higher input prices for downstream consumers, especially those that derive a significant proportion of their sales from exports, compensation is often provided in order to keep them buying domestically produced raw materials. Subsidies to food processing industries and to biofuel producers are common examples.
 
Subsidy clusters: As the subsidy expert Doug Koplow has observed, when support -or failure to consider opportunity costs - leads to lower prices for natural resources, a chain reaction can take place, whereby new investment occurs to take advantage of the cheap input. Often downstream consumers receive additional incentives from governments to do so. Hence aluminium plants are attracted to major hydroelectric projects, which are then followed by airframe manufacturers, and so forth.

Taken together, these derivative subsidy forms lend support to the notion that bad subsidies tend to chase out good ones - what the agricultural economist C. Ford Runge has called "Gresham's law of subsidies". Political economy also suggests that the "good" subsidies will over time be politically outmanoeuvred by the established groups to redirect public spending to themselves.

 
 
Subsidies through government procurement

The WTO Agreement on Subsidies and Countervailing Measures (ASCM) recognizes that a subsidy can exist when a government purchases goods "and a benefit is thereby conferred." The benefits the drafters of the ASCM had in mind were those resulting from purchases that take place under circumstances that do not accurately reflect normal market conditions.
 
Governments practice preferential purchasing routinely, expressly favouring domestic over foreign suppliers of similar-quality goods - e.g., by paying domestic suppliers higher prices or offering special financing arrangements. The conflict of interest faced by governments is under?standable. They are expected by taxpayers to be savvy buyers, but are also under constant pressure to support domestic producers.
 
The magnitude of government procurement is enormous. A study from 2000 estimated that each year OECD countries spend USD 4, 733 billion procuring goods and services, particularly for state-run health services, public works, and the military. Much of these purchases are made at market prices, but it is believed that a significant fraction of them include an element of subsidy.
 

The WTO has been trying to establish ground rules for government procurement since the 1980s. The latest rules are set out in the Agreement on Government Procurement (AGP), signed in 1994. Being a "plurilateral" agreement it applies only to its signatories, which are mainly OECD economies. By establishing recommended procedures for tendering, negotiating and awarding government contracts, it outlines a desirable system of government procurement. However, monitoring and enforcement of the AGP is weak, and there are many ways in which governments can bypass its disciplines, such as by excluding certain types of purchases (e.g., for the military) or setting thresholds - higher than the lower limits contained in the Agreement itself - below which the AGP does not apply.
 
 
 
Market price support
 
Transfers of money to producers are typically divided into two broad categories: those provided at a cost to government, such as grants and tax concessions, and those provided through the market as a result of policies that raise prices artificially. The latter, called market price support (MPS), may derive from a domestic price interventions (for example, a minimum-price policy), and is usually supported by foreign trade barriers such as a tariff or quantitative restriction on imports. The OECD defines MPS formally (for agriculture) as "an indicator of the annual monetary value of gross transfers from consumers and taxpayers to agricultural producers arising from policy measures creating a gap between domestic producer prices and reference prices of a specific agricultural commodity measured at the farm-gate level."
 
MPS is an element that is included in many studies of support to particular goods or sectors, and is added together with other subsidies to yield an estimate of total support.
The concept of market price support is simple enough. By maintaining an import tariff on a good, for example, a government raises the price of that good above what it could sell at in the absence of the tariff. From the producers' standpoint, the revenues they will receive would be similar to those they would receive were the government instead to pay them an equivalent premium per unit produced. The main difference is that MPS raises domestic prices, and may therefore dampen demand compared with a budget-financed price premium, especially if there are close substitutes that, as a result of raising the price of the targeted good, become relatively cheaper. In such situations, such as for coal for power generation, governments have sometimes solved the problem of changed relative prices by constraining the ability of consumers to shift to the competing product.
 
From the government's perspective, the advantage of providing support indirectly, through a market intervention, is that it is less transparent, and the transfers do not appear in its budget. Rather than taxpayers, consumers bear the burden. For this reason, MPS is considered by economists to be one of the most market-distorting forms of support provided through government policies. Unfortunately, it is also still one of the largest elements of total support, especially in agriculture.