Is Subsidies are Bad?

We all come across the term subsidies more often. I would like to pen down here about the basic things about subsidies.

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

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

Many of these subsides are set in place by the Government for producers or distributed as subventions in an industry in order to prevent 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 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:  Economic effects of subsidies can be broadly grouped into

1. Allocative effects: these relate to the sectoral allocation of resources. Subsidies help draw more resources towards the subsidised sector
2. Redistributive effects: these generally depend upon the elasticities of demands of the relevant groups for the subsidised good as well as the elasticity of supply of the same good and the mode of administering the subsidy.
3. Fiscal effects: subsidies have obvious fiscal effects since a large part of subsidies emanate from the budget. They directly increase fiscal deficits. Subsidies may also indirectly affect the budget adversely by drawing resources away from tax-yielding sectors towards sectors that may have a low tax-revenue potential.
4. Trade effects: a regulated price, which is substantially lower than the market clearing price, may reduce domestic supply and lead to an increase in imports. On the other hand, subsidies to domestic producers may enable them to offer internationally competitive prices, reducing imports or raising exports.

            Source: Wikipedia

Now comes one of the important question

3. Whether Subsidies are really bad? 

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

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: http://www.american.com/archive/2012/august/subsidy-powered-vehicles

In 2011, Delivering the P N Haksar Memorial lecture here, Subbarao, 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://ww.inwdianexpress.com/news/subsidies-are-bad-d-subbarao/880519

So there are few subsidies which are good, but, most of the subsidies are bad may be due to ineffective management and political reasons.