Commentary 11th Feb 2014

Explainer: Industry subsidies

The new Coalition government greeted the New Year with a clear resolve to produce a May budget that would cut the deficit significantly in the coming financial year and, most possibly, the one after that.

Since taking office in September, the federal cabinet has had to take a hard look at each of the items on the budget it has inherited, and high on its culling list is direct financial assistance to private firms. So far, subsidies to the auto industry have been halted and Ford and Holden are now in the process of terminating their Australian manufacturing operations by 2016 and 2017, respectively. Qantas is still awaiting the outcome of its request for government support, and fruit canner SPC Ardmona's bid for $25 million in federal government assistance has been rejected. "The age of entitlement is over, the age of personal responsibility has begun," Treasurer Joe Hockey said last week as he warned Queensland farmers and those in the food processing industry not to expect a multibillion-dollar rescue package to help relieve rising debt caused by drought and/or cheap imports.

Mr Hockey's remarks underscore the pressures facing the government as it tries to balance rising unemployment with a need to cut government spending. It's a hard choice, and Mr Abbott's and Mr Hockey's jobs are far from enviable, but it has become apparent that the government has chosen closing off the budget deficit as its most immediate task at hand, while not much is said about creating or indeed preserving jobs. In this spirit, private sector subsidies are among the first to go.

I have written in a previous piece why a dogged preoccupation with budget cuts is misleading. But is there a compelling economic argument or basis for the removal of subsidies? Will this necessarily improve economic performance?

The disenchantment with subsidies can be traced from modern neoclassical economics, which says that in a perfectly competitive environment, a market that is left to itself will achieve equilibrium price and quantities that reflects the most efficient allocation of resources possible. As such, it maximises social welfare. For a perfectly competitive market setting, there exists no role for government as only the natural forces of demand and supply are allowed to determine outcomes.

In terms of output, perfectly competitive markets provide no wastage – no excess inventory; no spoiled farm goods; no unemployment – since the cost at which each good or service is produced matches exactly the amount consumers are willing to pay for it.

Nobel laureates Kenneth Arrow and the late Gerard Debreu established these doctrines more than 50 years ago about the existence and efficiency of competitive price. It is in this context that government interventions, including taxes and subsidies, are seen to be distortionary and inefficient. Accordingly, subsidies lead to inefficient markets and reduce social welfare. Subsidies should therefore be strenuously avoided.

Given that the conditions required for free markets to operate efficiently are rarely met in the real world, and given the astuteness of policymakers with real-world conditions (or so I would like to think), one is inclined to question the unreserved adherence to this economic thinking, as though it was a religious dogma or mantra. Joseph Stiglitz of Columbia University won his 2001 Nobel prize in economics based on numerous works that demonstrated market inefficiencies in various contexts. In these works, he showed that markets are far from perfect – market imperfections and distortions exist when buyers are uninformed; when sellers do not fully disclose; when the number of firms are small; when public goods exist; when property rights are weak; during times of stress such as in wars, droughts or famines; etc.

In this context, the economic question then becomes: if subsidies are distortionary and reduce welfare in perfectly competitive markets, are they necessarily so in markets that are not competitive? In other words, given that in practice markets are often more imperfect than not, is there a generally accepted economic argument for their removal?

The answer is no.

Canadian economist Richard Lipsey and Australian mathematical economist Kelvin Lancaster were the first to provide a direct answer to this question through their theory of second best.

In terms of output, perfectly competitive markets provide no wastage – no excess inventory; no spoiled farm goods; no unemployment – since the cost at which each good or service is produced matches exactly the amount consumers are willing to pay for it.

Dr Rebecca Valenzuela

Department of Economics

In welfare economics, the theory of second best concerns what happens when one or more optimality condition cannot be satisfied. In their 1956 paper, Lipsey and Lancaster showed that in an economy characterised by many market imperfections, there is no guarantee the removal of subsidies will improve social welfare. The theory implies that we cannot necessarily conclude that subsidies will reduce social welfare unless we know the relative magnitudes of the costs and benefits.

Now, in the real world, the relative sizes of the costs and benefits of subsidies are almost impossible to quantify, particularly when subsidy systems are complex (that is, some subsidies are more visible than others), and the associated benefits and costs can cover both direct and indirect types. In any case, the theory of second best suggests that if there are irremovable distortions in some sectors of the economy, economic performance or social welfare may be higher if free-market pricing principles are deliberately violated in other sectors of the economy.

In other words, subsidies can be used to work for the overall good of the economy.

We don't have to look far to illustrate this point. In Australia, cash subsidies were heavily relied on during the reform period of the 1980s and 1990s, to temporarily assist producers and consumers alike as the economy went through a limited period of structural adjustment. Subsidies were likewise used by the Australian government in 2008 to cushion the economy from the impending fallout from the global financial crisis. In this instance, there was a one-time cash giveaway for all taxpayers at the end of that year, while tax breaks, grants and other regulation-based subsidies were offered to companies on a more ongoing basis.

Subsidies are, however, not meant to be permanent fixtures. Ongoing subsidies lessen the incentive to be efficient, innovative, and to develop new products – there is no argument about that.

The continued use of subsidies is also known to widen a government's budget deficit, which implies higher interest rates and may in turn dampen long-term economic performance.

This is the contentious point that the government has chosen to focus on.

Regarding imperfections in the market, Australia is a small economy and is highly interdependent with those in the world economy – with the welfare of its industries, banks and people easily affected by economic shocks and eventualities in Europe, Asia and the United States. Domestically, too, we are currently transitioning from mining-led to non-mining-led growth that is tentative and uncertain.

The urgency of closing off the budget deficit through this structural adjustment period and against the backdrop of a still contracting world economy seems misguided on the part of the government. Certainly, budget cuts in both the public and private sector need to take a back seat to retaining existing jobs and keeping unemployment low.

More particularly, the abrupt removal of subsidies from well-established industries is unnecessarily callous because they cannot guarantee improved economic performance, but unnecessarily risk livelihoods and living standards.

Indeed, withdrawing government support for industry may do more harm than good for the economy overall. Economic inequality is most likely to increase – and this is yet another reason why the removal of subsidies may not enhance economic performance.

Previous economic downturns have told us that the pain of economic adjustment will not fall evenly across the population. The more well off members of society – capital owners with large assets and huge savings – will have no problem weathering this storm. But for most of us – wage-dependent households and small business owners – we are bound to carry a disproportionate share of this adjustment burden. Indeed, our best individual efforts at continued self-development and hard work to keep steady employment will not mean much if employers are shutting down or moving offshore.

Subsidies may be used by governments to redistribute income from the rich to the poor and this can be particularly helpful in today's context. Subsidies to struggling businesses will enable firms to retain more workers and hence be an avenue for income redistribution in this very specific way.

Such redistribution can enhance economic efficiency in certain situations as first shown by Harvard economists Alberto Alesina and Dani Rodrik, who first analysed the effects of income inequality on growth. In a 1994 paper they argued that in more unequal societies, economic growth is lower because the demand for fiscal redistribution financed by distortionary taxation is higher. Additionally, income inequality also fuels social discontent and increases socio-political instability, which then reduces investment and stifles growth.

Put differently, a more equal society is more conducive to growth – and subsidies can be used as an effective tool for redistributing income or resources when markets are not able to do so efficiently. In effect, subsidies can enhance economic performance or increase aggregate output in this way.

Lest it is misconstrued, my goal here is not to argue for or against the removal of subsidies. The main point I make is that there is no compelling economic theory to support the assertion that removal of subsidies enhances economic performance in the real, imperfect-market world. The removal of subsidies is not a one-size-fits-all policy, and there is nothing in economic theory that supports this policy unequivocally. The government should therefore be more cautious in exercising this policy tool.

More generally, I reiterate my point on the dogged determination to achieve a budget surplus at all costs: it is not worth it.

Pursuing a surplus within the shortest possible time is unnecessarily compromising livelihoods, living standards, and economic opportunities for most stakeholders in the economy. This is a huge misstep: it undermines the long-term economic strength and viability of our nation.

Dr Rebecca Valenzuela works in the Department of Economics at Monash University.

This article has appeared in The Age.

By Rebecca Valenzuela

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    Dr Rebecca Valenzuela

    Department of Economics Monash Business School

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