Subsidies and market interventions

February 21, 2013, 2:37 pm
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By Pen Waggener (Flickr: Economic Landscape) [CC-BY-2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

Introduction

Government interventions encompass a wide range of regulatory, fiscal, tax, indemnification, and legal actions that modify the rights and responsibilities of various parties in society. Interventions can increase or decrease costs to particular groups, effectively acting either as a subsidy or as a tax. Some of these policies increase societal welfare, while others subsidize powerful groups in society, sometimes making societal imbalances worse. This article provides a general overview of many types of subsidy policies, and describes how to calculate net subsidies to a particular sector.

 

Subsidy basics

caption Energy industries receive a wide range of government subsidies. (Source: U.S. House of Representatives)

Subsidies represent government policies that benefit particular sectors of the economy. Government subsidies are common in most countries and benefit many industries. When these subsidies reduce the prices of natural resources or natural resource-intensive products, they encourage additional pollution and habitat destruction. An overview of subsidy basics will make the more detailed information easier to understand.

Subsidies are not just cash. A great deal of market activity involves controlling and sharing the risks and rewards of economic activities. Subsidies are government-provided goods or services, including risk-bearing, that would otherwise have to be purchased in the market . Subsidies can also be in the form of special exemptions from standard required payments (e.g., tax breaks).

Defining the baseline. Subsidies must often be measured against some baseline. What would taxes owed have been in the absence of this special tax break? How much would industry have had to pay in interest to build that new facility if the government had not guaranteed the loan? Our baseline assumes standard corporate tax rates and no special agency programs to finance or absorb market risks for particular energy-related endeavors.

Subsidy targeting. One issue related to defining a baseline is that of narrowly targeted subsidies versus more broadly targeted programs that benefit one form of energy as well as some other industries. Industry representatives inevitably conclude that only subsidies directly targeted at a particular fuel should count as benefits to producers or consumers of that fuel. In fact, many other subsidies tilt the energy playing field towards a particular fuel even if other fuels or non-energy industries also benefit. It is useful to consider a handful of common subsidy targeting approaches.

  • Single sector. The clearest and easiest subsidies to identify and allocate are those directly targeted to the particular industry, such as government financing of oil-related research and development programs through the U.S. Department of Energy.
  • Multiple sectors. Other subsidies are beneficial to a number of economic sectors. For example, the oil, gas, and hard rock minerals industries are all eligible for the percentage depletion allowance, a tax break that allows them higher than normal tax deductions. Since many other energy sources do not benefit from this provision (and the rates vary even for those that do benefit), the policy contributes to inter-fuel market distortions.
  • Geographic region. Most state/provincial and local subsidies are targeted to particular geographic regions (i.e., the state/province or locality). To the extent that natural resource-intensive industries are located in the region receiving the subsidy (for example, corporate tax rate reductions in a large, oil-producing region), policies can encourage incremental pollution and the development of “subsidy clusters” that rely on continued subsidization to survive.
  • Factor of production. Some subsidies are targeted at a particular factor of production (e.g., labor, capital) instead of specific industries. Although broadly available to all industrial sectors, subsidies affecting factors of production can cause market distortions nonetheless. Accelerated depreciation provisions, for example, allow any industry using capital equipment to deduct the capital from taxes more quickly than the anticipated service life of the capital asset. These provisions give capital-intensive energy types a competitive advantage over types that require less capital investment, such as some demand-side management options. In addition, sector-specific depreciation rules in the tax code can create additional distortions between different capital-intensive energy sectors.

Externalities are extra. While environmental externalities such as pollution or habitat damage certainly constitute subsidies to industry, many subsidy studies do not analyze them. The uncertainty regarding their value is larger than that for most direct subsidies. As a result, analysts sometimes leave them out in order to focus attention on the many ways that direct government subsidies help polluting industries. Properly functioning markets would both eliminate internal subsidies to a particular fuel and include a tax equal to the remaining externalities. However, it is also likely that reform of direct subsidies alone would generate many beneficial market shifts.

caption Some of the fees paid by the oil and gas industry pay for government activities such as oil spill cleanup. Pictured here is beach washing after the Exxon Valdez oil spill. (Source: Exxon Valdez Oil Spill Trustee Council)

Treating offsets. In addition to providing subsidies, the government also levies fees on certain resources. For example, while subsidies act to distort energy markets in favor of oil, certain fees may have the opposite effect, and are properly treated as offsets to subsidies. Where fees represent standard treatment of all industries, they are not considered subsidy offsets. Where a fee is levied only on a particular fuel or only on a narrow grouping of sectors, it must be evaluated further. Oil is a useful example. Within the United States, many of the fees on oil, such as gasoline taxes, are actually earmarked to pay for government activities such as oil spill cleanup or the remediation of contamination from underground gasoline storage tanks. If the levies pay for oil-related government activities, then they are treated as user fees rather than subsidy offsets and they are credited against the oil-related government program spending that they support. To the extent that a particular fee is levied only on a few industries (including oil) and receipts do not support an oil-related purpose, it is referred to as a special tax. Special taxes are extra charges on oil that do not pay for activities related to the industry. Thus, they offset subsidies by decreasing oil’s competitive advantage. While special taxes should be subtracted from gross subsidy values, user fees should not be. The decisions can be a bit complicated, but are illustrated in this graphic.

Linkage between subsidy levels and resource prices in the marketplace. In the aggregate, subsidies throughout the world to any particular form of energy will tend to depress prices and thereby encourage overconsumption of the resource. However, not every individual subsidy has an impact on energy prices. Many subsidies to domestic producers, for example, simply keep these producers competitive with less expensive imports (which are themselves subsidized through a variety of mechanisms). Subsidies that have little or no effect on commodity prices will not likely change consumption patterns for the affected fuel. However, removing even these subsidies will affect the market behavior of that fuel's producers. Their removal will also save taxpayers billions of dollars.

Cost to taxpayers versus value to recipients. The cost of a subsidy to taxpayers does not necessarily equal the value of the subsidy to recipients. Many government loan programs, for example, allow corporations to borrow funds at the lower interest rates obtained by the U.S. Treasury. Such loans do not directly cost the taxpayer but they have an incremental benefit to the industry that we try to measure here called the "intermediation value". In contrast, government programs may be inefficient and unproductive. Thus, while the programs cost the taxpayer a great deal of money, industry may value them at much less than their direct cost.

Common forms of government interventions in energy markets

  • Access. Policies governing the terms of access to domestic on-shore and off-shore resources (e.g., leasing).
  • Cross-Subsidy. Policies that reduce costs to particular types of customers or regions by increasing charges on other customers or regions.
  • Direct Spending. Direct budgetary outlays for an energy-related purpose.
  • Government Ownership. Government ownership of all or a significant part of an energy enterprise or supporting service organization.
  • Import/Export Restriction. Restrictions on the free market flow of energy products and services between countries.
  • Information. Provision of market-related information that would otherwise have to be purchased by private market participants.
  • Lending. Below-market provision of loans or loan guarantees for energy-related activities.
  • Price Controls. Direct regulation of wholesale or retail energy prices.
  • Purchase Requirements. Required purchase of particular energy commodities, such as domestic coal, regardless of whether other choices are more economically attractive.
  • Research and Development. Partial or full government funding for energy-related research and development.
  • Regulation. Government regulatory efforts that substantially alter the rights and responsibilities of various parties in energy markets, or exempt certain parties from those changes.
  • Risk. Government-provided insurance or indemnification at below-market prices.
  • Tax. Special tax levies or exemptions for energy-related activities.

Commonly Asked Questions About Subsidies

Are all subsidies bad?

Subsidization occurs whenever the government uses its power to redistribute wealth or access. Provision of subsidized health care, food, or other basic needs for the poor is certainly a subsidy. However, the provision of such services has a strong moral justification and virtually no environmental side-effects. These are clearly of good subsidies, at least in intent (as the structure may not adequately support the noble goal). Yet, beneficiaries of all types of subsidies inevitably extol the virtues of the particular program they get funding/support from. A certain degree of skepticism is needed. Even when the poor do receive some government support, access to subsidies is often a function more of political power than of true need. As a result, a disproportionate share of support flows either to wealthy individuals or to powerful corporate interests. This magnifies disparities between rich and poor, and often slows the evolution and development of new industries (which may be much more environmentally sound than the status quo). When these subsidies are not well targeted and expensive, substantial public resources are diverted from programs that could be of great benefit to the truly poor in society.

Why do subsidies matter?

Subsidies matter for two basic reasons. First, they divert resources to favored activities, industries, or people based on political objectives. These objectives may have to do with political power, needs to "buy-off" particular groups, or unrealistic assessments of available technologies, rather than from any desire to achieve social goals such as welfare or education. Second, subsidies mask the relative price of different goods and services. In energy, for example, heavily subsidized electrical transmission can mean that the much higher price of electricity in rural areas is obscured. As a result, important entry points for alternative energy sources—such as where off-grid renewables cost less than the combined cost of conventional power generation plus distribution—are lost. In most countries, there are hundreds or thousands of subsidy policies that have been implemented incrementally over decades. In combination, these policies make it extremely difficult to see the true underlying market dynamics associated with alternative products or services. All too often, the existing subsidies also work counter to the goals of other parts of the government, such as protecting the environment.

How big are subsidies?

Since government subsidies technically result from any transfer of public tax funds to narrower private interests, one metric of gross subsidization is the government share of gross domestic product, which ranges as high as 40 or 50 percent of gross domestic product (GDP) in some countries. This measure is not particularly helpful for two reasons. First, public spending in a particular year represents only a small portion of the influence governments have over private economic conditions. Subsidized credit and insurance programs, as well as regulatory loopholes, mean that the distortionary impact of subsidization can be many times higher than the government share of GDP. Working in the opposite direction, however, is the fact that not all subsidization causes social problems. Subsidies that harm human health or the environment are often classified as "perverse subsidies." This definition would include policies that subsidize environmentally-intensive or destructive sectors such as energy, mining, farming, fishing, timber, transport, and construction. There are no systematic measures of how big perverse subsidies are globally, but rough estimates suggest they easily run into the hundreds of billions of dollars per year.

Further Reading

Glossary

Citation

Koplow, D., & Track, E. (2013). Subsidies and market interventions. Retrieved from http://www.eoearth.org/view/article/156301

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