A subsidy, often viewed as the discussion of a tax, is an instrument of fiscal policy. Derived from the Latin word ‘subsidium’, a subsidy factually implies coming to support from behind. Subsidies are useful for both economy and citizens as well. These have a long-term impact on a financial system like green revolution etc. These are only for the reason that farmers receive good quality of grain on subsidized prices.
Subsidies, by means of creating a block between consumer prices and producer costs, lead to changes in demand or supply decisions. These are often aimed at:
- Suggesting higher consumption/ production
- Balancing market deficiency including internalization of externalities;
- The success of social policy objectives including redistribution of income, population control, etc.
Transfers and Subsidy
Transfers which are directly income supplements need to be distinguished from a subsidy. An unconditional transfer to an individual will add to his income and will distribute it over the entire range of his expenditures.
A subsidy, however, refers to a particular good, the relative price of which has been lesser because of the subsidy with a view to changing the consumption/ distribution decisions in favor of the subsidized goods. Even when the subsidy is hundred percent, i.e. the good is supplied free of cost, it should be distinguished from an income-transfer (of an equivalent amount) which need not be spent completely on the subsidized good.
Mode of Administering a Subsidy
The range of alternative means of administering a subsidy are:
- Subsidy to producers
- Subsidy to consumers
- Providing Incentives Instead of Subsidizing
- Production/sales through public enterprises
A subsidy can be spread among individuals according to a set of selected criteria, e.g. merit, income-level, social group etc. Two types of errors arise if we do not do the proper targeting, i.e. exclusion errors and inclusion errors. In the previous case, some of those who deserve to receive a subsidy are disqualified. While, in the second case, some of those who do not deserve to receive subsidy get integrated with the subsidy programme.
Effects of a Subsidy
We can generally group the economic effects of a subsidy into:
- Allocative effects: these relate to the sectoral distribution of resources.
- Redistributive effects: these generally depend upon the flexibility of demands of the relevant groups for the subsidized good as well as the flexibility of supply of the same good and the mode of administering the subsidy.
- Fiscal effects: subsidies have obvious fiscal effects since a large part of subsidies originate from the budget. They in a straight line increase fiscal deficits.
- Trade effects: a regulated price, which is to a large extent lower than the market clearing price, may reduce domestic supply and lead to an increase in imports.
- The subsidies may also lead to unmanageable or unplanned economic effects. They would result in inefficient resource allocation if forced on a competitive market or where market imperfections do not give a good reason for a subsidy, by diverting economic resources missing from areas where their marginal productivity would be superior. For instance, a price control may lead to lower production and shortages and thus generate black markets resulting in profits to operators in such markets and economic rents to private people who have right to use to the distribution of the good concerned at the controlled price.
Subsidy Issues in India
Subsidies have greater issues than before in India for several reasons. In particular, we can trace this rise to the following:
- The vastness of governmental activities
- Somewhat weak determination of governments to recover costs from the respective users of the subsidies, even when this may be desirable on economic grounds, and
- Usually low-efficiency levels of governmental activities.
Methodology for Estimation of Subsidies in India
Different approaches and conventions have changed regarding measurement of the magnitude of subsidies. Two major conventions relate to measurement through (i) budgets and (ii) National Accounts.
The comparative distribution of the benefits of a subsidy may be studied with respect to different classes or groups of beneficiaries such as consumers and producers. Thus, the various examples of subsidies are:
- food subsidy
- public irrigation
- Subsidies to elementary
- Subsidies for health
Solved Example for Tou
The government gives subsidies in various sectors. Which of the following are the special effects of subsidies?
- increases inflation
- increases fiscal deficit
- decreases export competitiveness
Pick the correct answer using the codes given below.
- a) 1 and 2 only
- b) 2 only
- c) 2 and 3 only
- d) 1, 2 and 3
Ans. b) 2 only. There is no straight relation between subsidies given and inflation. It may increase inflation (eg. subsidies on LPG helping people save more, as a result, increasing their capacity which can cause demand-pull inflation.) or decrease inflation by making easy to get to low cost subsidized goods. Subsidies certainly increase the fiscal deficit. Subsidies increases do not decrease the export competitiveness of goods, as a result, it decreases their cost of production.