What’s Wrong with Subsidies?

Matt Fagerstrom

Matt Fagerstrom

Matthew Fagerstrom is an economics and political science student at Villanova University. He is currently working alongside a professor on a study of wealth inequality. His favorite areas of economics are the minimum wage and monetary policy.
Matt Fagerstrom

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We have already explored the troubles involved in setting up systems of tariffs, so let us now turn our attention to another form of industry support, namely subsidies. The argument in favor of subsidies is that certain industries are vital in the American (or any other) economy but not necessarily profitable on their own, or at least, not profitable enough, with one example of this being the farm industry, which receives around $20 billion in subsidies a year. Farms are subsidized because if the prices of crops fall too low, then farmers would be run out business and the ability of the American economy to feed itself would be in jeopardy.

However, the interesting thing about farm subsidies is that they are not put in place to keep agricultural prices low, and thus to make them more affordable to American consumers, but rather, they used to buy up surplus crops if the price goes too low, meaning that American tax dollars are being used to restrict the supply and thus increase the price of American agricultural products, enriching farmers at the expense of everyone else, another case of broken windows. Of course, the natural counter is that America must be able to feed itself and so it is important that farmers are well compensated for their work, but America is a net exporter of food, meaning that we currently sell a lot more food than we buy, so the prices would have to drop quite severely for us not to be able to feed itself, and that is, of course, granting the assumption that we must have autarky in agricultural, which is a debatable assertion in and of itself. One last note about farm subsidies themselves, and then I will move on to subsidies in general. Farm subsidies, by and large, are not going to small mom and pop farms, but are going to Monsanto and Con Agra, multibillion dollar industries who do not need to be assisted on the public dime.

Now, what is problematic about subsidies in general? The problem is that they are just another case of broken windows, but in a slightly different way. With a subsidy, money is taken from the taxpayer and then given to a business, either to lower their costs, that is, increasing their revenue, or to entice businesses to open that otherwise would not have existed. Prima facie, this seems like a win for the economy, since businesses are now more profitable and can run when they previously would have closed or are opening when they would have stayed mere ideas in the heads of entrepreneurs. However, there is no choice in an economy that occurs without tradeoffs. The choice to subsidize one industry or business means that this money must come from somewhere else, and this money comes from taxation or inflation, the same with all other revenue. Let us confine our examination to taxation due to length constraints. If money is taken via taxation, it is being removed from already existing businesses or, more accurately, the employees and shareholders of already existing businesses. What this means is that businesses that exist and are profitable are being used to prop up and create businesses that would not have been profitable without the subsidy. Essentially, money is being shuffled from its most efficient use to less efficient uses, with money being removed along the way to pay for the government bureaucrats who run the offices that dole out the subsidies. Ex ante, this necessarily reduces social welfare because money is being removed from its most productive and valued uses and given to uses that are valued by the political class. Under a system of subsidies, instead of rewarding those entrepreneurs who can most ably serve the consumer, those who are the most adept at lobbying the government for fund are rewarded, which is a different skill set entirely.

There is only so much wealth in a society at any given time, and while this amount of wealth can be increased through productive processes, simply taking money from Peter to pay Paul is not going to increase the economic output of a society, since resources on a free market are allocated to their most efficient uses due to the structure of the price system. Taking money from a productive enterprise and giving it to a non-productive enterprise, which is what subsidies do, lessens the total wealth in society because money is now being spent in the pursuit of less valued outputs. Society faces a tradeoff. If the choice is between having a watch factory and a car factory, one cannot see which factory the consumers wanted and then subsidize the other to get both, one will simply have a crippled watch factory and a dependent car factory instead of two healthy factories.

Allow me to illustrate with an example. Suppose we have an economy where a factory produces about 1000 computers per annum, and each computer sells for $100 of profit, giving them a total profit of $100,000 per annum, which they use to buy new parts for computers, expanding their business by 100 computers a year (we are also supposing that it costs $1000 to make a computer and they sell for $1100). In this case, the economy grows by 10% per year. Now let us suppose that a well-meaning but economically illiterate congress passes a law that taxes the computer factory 20% of profits to give to a shoe factory. Now, the shoe factory has $20,000 in taxpayer money, while the computer factory has $80,000 in profit instead of $100,000, so they can only expand production by 8% instead of 10%. Whatever the shoe company gained had to come from money that was already in circulation somewhere else in the economy, which is a loss to those who preferred the previously existing pattern of production.

The argument that subsidies should be used to lower prices runs into a similar problem. Since the subsidy represents a given sum of money being taken from taxpayers and given to a producer, the only way in which subsidies can lower prices is that the price is paid partly in tax and partly in purchase. In other words, the way that the price is lowered is that part of the price of the subsidized good is paid before even buying the good in the form of a tax used to prop up the producer of the good or service, and the rest is the lower price which is seen but does not exist in reality, since the price is not actually lower at all. Subsidies cannot create wealth at all, they can all alter the way in which wealth exists by giving it from those who are producing to those who demand a handout from the government.

One final problem with subsidies is that if the business was actually profitable and productive on the free market, the good or service would already be produced by those entrepreneurs who have seen the unfulfilled need on the market and rushed to satisfy it. If an investor hears a proposal for a business and then turns it down, or the would-be entrepreneur cannot get a loan, then and only then would he turn to the government, meaning that the businesses and industries getting subsidies are not those that would be the most productive on the free market, but would be those goods where either demand does not exist or where the business model is so unprofitable that no investor would put up his or her money for the project or no bank would loan money to the potential entrepreneur. Essentially, the taxpayer would be paying to prop up a business that would soon be in the red without government support and would not produce goods that satisfy a need that the market actually has. For these reasons among many others, subsidies should and must be opposed.