The Pros and Cons of Subsidies

Given the central role of fiscal expenditures in agriculture, and the fact that many of them constitute subsidies to the sector, it is useful to develop guidelines to help decide when they are justified. One of the most universal justifications for a subsidy is poverty of the beneficiaries. However, before accepting this argument as a basis for programs and policies in the sector, it is necessary to ask how well the subsidies are targeted on poorer households. Normally, considerable efforts are expended to target direct food assistance at poor households, but agricultural programs themselves tend to be surprisingly regressive in their incidence over income groups, as illustrated in the box about Honduras.

The reasons for a disproportionate distribution of benefits to larger farms are fairly obvious. In the case of price supports, for example, a larger farmer is likely to have a truck for sending freshly harvested grain to the government's collection point, whereas most small farmers do not. By the same token, large farmers are likely to know the officials in charge of the price support program, and probably the Minister himself, and so it is a simple matter for them to pick up the phone and arrange for their shipments to be received promptly. In contrast, small farmers often tell tales of waiting days at the collection point for their grain to be received, and of sometimes having to leave without consummating a sale. In the same vein, large farmers can offer lunch and other benefits to agricultural extension agents who visit their farms in a timely manner and who spend as much time as necessary providing technical advice.

The lesson of these kinds of experiences is that in practice it is very difficult to target generalized agricultural programs on poorer farmers unless special measures are taken.

In reviewing the arguments for and against subsidies, it is useful to start by recalling a basic result of economic theory: that interventions which affect market prices (for outputs or inputs) invariably lead to a loss of economic welfare. While producers and consumers each may gain, the loss to society is greater than the sum of the gains. This is called the 'static welfare loss'. While it is an abstract principle, its effect in practice is to lead to reduced economic growth rates, because resources are no longer allocated to their most efficient uses. There are more compelling arguments of a practical nature, both for and against subsidies, and so the theoretical argument will not be pursued in this context, but it is well to bear it in mind, for it too has empirical relevance.

Major arguments against the use of subsidized public expenditures include the following:

• Subsidies tend to be allocated to the least competitive industries, for they are usually the ones that press the government hardest for favors. Subsidies rarely are allocated to industries and products that have a comparative advantage.

A survey in Honduras funded by the European Commission and the French Government provided quantitative information about the incidence of benefits (implicit subsidies) in three major agricultural programs. Among several farm size strata, it was found that only 0.2% of the smallest farms (<2.5 ha) sold their grain harvests at the official support price, whereas 13.1 %o of the largest farms (>50 ha) sold at that price. In other words, the largest farms had a sixty-five times greater (13.1/0.2) chance of access to the support price. Regarding credit, the survey asked if the respondent had been denied credit from the State agricultural bank for lack of loan guarantees. Of the smallest farms, 75.8% said 'yes', while among the largest only 12.0 %> said 'yes'. Regarding extension services, it was asked if the service was timely and whether it was good, fair or poor in quality. For the Ministry of Agriculture's service, 39 %> of the smallest farms (this time, <10 ha) said it was both timely and good. Of the largest farms, 72.7%o so responded. For the Agrarian Reform Institute's service, the dispersion in such replies was even greater: 20.2 % of the smallest farms and 81.7% of the largest farms. (Source: G. Gálvez et al., Honduras: Caracterización de los Productores de Granos Básicos, Secretaría de Recursos Naturales, Honduras, November 1990.)

Accordingly, over time subsidies tend to shift the economy's allocation of productive resources toward those industries which are inherently least competitive, thus prejudicing a country's long-run growth prospects.

• Once established, a subsidy is hard to eliminate. Economic and political interests arise in its defense, and so the cost to the government may continue for many years and even increase.2

2. 'The study of the history of agricultural policies shows that many existing distortionary agricultural policies in OECD countries have been implemented initially as "temporary measures" to overcome a specific (time-limited) problem. If we have learned anything, it is that agricultural programs tend to create their own constituency and tend to persist long afterwards, because for political economy reasons they are very hard to remove once they have been implemented'. Reprinted from Food Policy, 24(1), Johan F. M. Swinnen and Hamish R. Gow, 'Agricultural credit problems and policies during the transition to a market economy in Central and Eastern Europe', pp. 44-45, Copyright (1999), with permission from Elsevier.

• The fiscal cost of subsidies implies a higher tax burden or a reduction in government expenditures elsewhere. In an era of increasing fiscal stringency all over the world, this is a primary consideration.

• The presence of subsidies tends to keep high-cost producers in business, disguising the need for improvements in productivity (reductions in costs), thus contributing to making the economy less competitive internationally and its products more costly to domestic producers and consumers.

• A government policy which relies significantly on subsidies tends to encourage producers to invest time and resources in soliciting further favors from the government (rent-seeking behavior), rather than emphasizing efforts to increase the productivity of their own operations.

• In practice, the benefits of subsidies often tend to be regressive, that is, they accrue in a disproportionate manner to upper-income groups rather than to the poor in society.3

• The existence of subsidized modes of operation may reduce the possibilities of developing institutions that do not rely on subsidies and hence could be more viable in the long run. For example, the availability of subsidized credit through government banks may make it difficult for private banks or microfinance institutions to develop lending operations in the same areas.

• Sometimes, legislated subsidies are not backed up with sufficient government funding, and producers may hold back decisions on productive investments in the expectation of eventually obtaining the subsidy, and yet in some instances it may never materialize, and so the promise of the subsidy may have the perverse effect of delaying investments in the sector.4

• A more subtle but pervasive drawback of subsidies is that they tend to encourage an anti-economic mentality among the beneficiaries, which has the effect of hampering the development of efficient institutions and ways of operating. Again, an example is found in subsidized credit, which sometimes fosters a lax attitude about repayment obligations on the part of farmers, and this syndrome in turn makes it more difficult for them to become clients of commercial banks.

In light of these strong arguments against the use of subsidies, their justification has to be very solid indeed if they are to be employed as an instrument of policy. Nevertheless, there do exist cases in which the arguments in favor of subsidies are also compelling. The principal arguments in support of subsidies are the following:

• The role of subsidies in poverty alleviation finds virtually universal acceptance. The important questions in this regard are (a) how to target such programs effectively at the poor, and (b) how to find ways to assist the poor that will increase their own capacity for future economic improvement, and not just alleviate the most pressing current symptoms of poverty. The latter approach leads to a continuing need for the assistance, and promotes an attitude of dependence on the assistance on the part of the

3. This effect has been confirmed recently in the case of Egypt: 'Subsidized bread is available for virtually every household in Egypt at a fixed price in unlimited quantities. . . . Cooking oil and sugar are made available to consumers in monthly quotas through ration cards, covering close to 70 percent of the population. . . . In practice, there is no strong correlation between household income and access to subsidies through the ration card system'. Reprinted from Food Policy, 26(1), Hans Lofgren and Moataz El-Said, 'Food subsidies in Egypt: reform options, distribution and welfare', p. 67, Copyright (2001), with permission from Elsevier.

4. This effect was observed in Colombia in 2002, where the unrealized hope of obtaining access to the program called 'Incentives for Rural Competitiveness', which could potentially have represented a 40% reduction in investment costs, caused deferral of a decision to invest in a major irrigation project whose funding had been guaranteed through the financial instruments of the National Agricultural Commodity Exchange (Bolsa Nacional Agropecuaria).

recipients. The former approach permits an eventual phasing-out of the assistance. This principle is widely recognized but sometimes difficult to put into practice.

• Cases of environmental and economic externalities provide another justification for subsidies, on both theoretical and practical grounds. Farmers who plant trees or build terraces to control soil erosion provide benefits not only to themselves, but to others in the same watershed, and so there exists an argument for society's sharing of the costs of such investments. The same argument holds for larger-scale tree planting for the purpose of sequestration of greenhouse gases.

• Temporary subsidies may be necessary at times to facilitate a transition to a less-subsidized regime of policies. A recent example on a large scale has been the use of subsidized privatization vouchers for the public in Eastern Europe, in order to bring to an end the continuing drain on the fiscal budget that was caused by State ownership and management of productive enterprises.

• In emergencies, such as those caused by natural disasters, benefits are usually provided to those who are affected without expecting repayment. However, care must be taken in using this instrument. For example, in many legal systems, declaration of an emergency in cases of, say, drought may exempt farmers from the requirement to repay their production loans, even if the crop loss is not total, and this, in turn, may cause difficulties for banks and discourage them from expanding their future operations in agriculture. A debate over precisely this issue developed in Nicaragua during the drought that was apparently caused by the El Niño phenomenon in the fall of 1997.

• Subsidies can be used to compensate for cases of imperfect information. A common example concerns the case of farmers in remote areas who do not have reliable information about market prices, and therefore the government underwrites the cost of regular radio broadcasts of price data. For radio broadcasts to this group of clients, it may be difficult to find advertisers willing to cover the costs. • Other kinds of market failure may require intervention with subsidies. However, care must be exercised. Often, regulation is a more appropriate response, and not all instances of market failure require government action. The phenomenon of 'asymmetric information' between lenders and borrowers (regarding a borrower's ability and willingness to pay) has received much comment in the literature,5 and a common policy response is to develop a financial regulation framework that favors the growth of microfinance. However, in some cases the response has taken the form of subsidizing rural branches of banks, to encourage them to move closer to their potential rural client base.6 Education and training are classic examples where government financial support is justified because an educational provider in the market cannot capture all of the broader benefits (externalities) to society, as mentioned in the quotation from D. Gale Johnson in Chapter 2.

These lists of the pro and contra arguments concerning subsidies are not necessarily exhaustive of the subject, but additional arguments should be scrutinized carefully before being added to the lists. In most practical decision situations, consulting the above lists should help clarify the advantages and disadvantages of a proposed subsidy.

The lists can be interpreted to develop guidelines applicable in specific circumstances. For example, subsidies for particular crops or agroindustries definitely should be avoided. They

5. See, for example, Karla Hoff and Joseph Stiglitz, 'Introduction: Imperfect Information and Rural Credit Markets - Puzzles and Policy Perspectives', The World Bank Economic Review, 4(3), September 1990, pp. 235-250.

6. Mark Wenner observes that 'Temporary subsidies to defray the costs of establishing branch networks may be provided', in M. Wenner, Rural Finance Strategy, Sector Strategy and Policy Paper Series, Sustainable Development Department, Inter-American Development Bank, Washington, DC, USA, December 2001, p. 14.

create the problems indicated in the 1st, 2nd, 4th and 5th arguments against subsidies. The only exception that may be justified is a transitional subsidy to facilitate the privatization of an agro-industry (according to the 3rd argument in favor of subsidies), especially when large numbers of farmers become shareholders in the privatized entity.

On the other hand, subsidies for poverty alleviation do not have to be unrestricted. They can take the form of cost-sharing for productivity-enhancing services for small farmers. An example that increasingly finds favor in various countries is the provision of vouchers or other forms of subsidies to poor farmers for the purchase of private extension services, in a context in which better-off farmers pay the full cost of such services.

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Responses

  • Liya
    What are the pros and cons of sibsidy?
    11 months ago
  • juha
    What are the pros and cons of the subsidy program in egypt?
    9 months ago
  • Lucius
    Are among the most successful in obtaining subsidies.?
    9 months ago
  • marco
    What are the arguments in agicltural control and subsidies?
    6 months ago

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