The hidden logic of industry subsidies

The Conversation

The sudden cessation of the Federal Government’s subsidies to solar hot water installations illustrates why subsidy-seekers mostly prefer industry assistance to come in hidden forms, rather than cash.

When the cash cost of the subsidy is shown in the budget, it is transparent and contestable. The Departments of Treasury and Finance are always on the look out for ways of cutting or re-allocating public spending. Senate Estimates Committee may question the wisdom and efficacy of the subsidy. Even Cabinet members may see an opportunity to free up some money for their own proposals, if they can kill off those of their colleagues.

Secret hidden subsidies

The alternatives to a tax-payer-funded subsidy include subsidy via regulation (like Mandatory Renewable Energy Targets) or via cross-subsidy (like generous feed-in tariffs for solar energy from rooftop panels). The costs of these are hidden and do not go through government budgets.

In Australia, we are fortunate to have the Productivity Commission’s annual Trade and Assistance Review. This reports the Commission’s estimates of the cash-equivalent costs of such hidden subsidies. It sometimes slips in comments about the strength or weaknesses of the cases for subsidy. (Declaration: I worked for the Commission from 2002-2008.)

As part of the economic reforms of the 1980s and 1990s, many hidden subsidies were converted to visible, cash subsidies. The expectation was they would be subject to more informed and sceptical examination.

The major form of subsidy at that time was the import tariff: the size of cash-equivalent subsidy provided by the tariff was many times the tariff revenue received. In fact, the maximum subsidy is obtained from a tariff so high that it excludes all imports and, therefore, yields no tariff revenue at all.

To ease their transition to lower rates of tariff protection, some industries, and especially iron and steel and motor vehicles, were granted cash subsidies for a limited period of structural adjustment. Some special temporary assistance was also given to labour, for retraining and the like.

No one likes to lose a subsidy

There is often a larger lobbying effort put into retaining a subsidy than was made in obtaining it in the first place. When an industry, like solar hot water, receives assistance, the existing firms and suppliers and workers immediately reap most of the benefits that flow to producers.

For existing firms, the value of the subsidy is capitalised into share prices. The subsidy, however, attracts new firms (and workers) to the industry, who gain less than did the existing players. The newcomers have to “buy their way” into the industry by purchasing existing firms, or by investing in plant and equipment, or by changing jobs and maybe location.

So when the subsidy is removed, these newer firms and workers suffer capital and other losses, without having gained much from the creation of the subsidy. Common experience and behavioural economics tell us that people react more to losses than they do to similar-sized gains: the lobbying efforts to prevent removal is often more fierce than the effort to obtain the subsidy in the first place.

It was the genius of the Hawke-Keating governments, with the support of the Coalition, to devise ways of staging a massive reform effort: a wide reform program created serious winners as well as losers.

Who gets subsidies and why?

There is no simple general theory of subsidies: who gets them, how much, for how long, and in what form? But some widely accepted ideas throw some light.

Governments generally wish to do good, but sometimes make mistakes about the rationale of subsidies or their likely effects. At other times, governments do things mostly to attract the gratitude of some voters or supporters (meaning, those who contribute to the party in various ways, including cash), even if this comes at the greater cost to the society and economy.

A century ago, Arthur F Bentley, an American journalist/political scientist, wrote that all politics was the politics of interest groups. Since then, this idea has been fleshed out, including by the Public Choice School of economists, who apply ordinary economics to public decision processes.

The underlying ideas are simple: interest groups are most successful if their membership is relatively small (compared with the usually unorganised collection of people who will lose if the interest group is successful); if what is at stake if large, individually; and if the members have cheap and effective ways of communicating within and outside the group.

So we would expect rural-based groups to be much more active about economic issues that loom large in their wellbeing — for example, subsidised, high quality services — than urban folk would be in opposing such claims. Producers are more likely effective in seeking subsidies than are consumers.

Amongst the many Australian industries, those more likely to obtain subsidies are those very important in a small number of locations, rather than those widely spread geographically. But are these generalisations, and there are many exceptions.

Similarly, it is a useful generalisation that very inefficient subsidies — the most costly, and least justifiable — are less likely to be enacted and sustained. Sometimes removal is triggered by the revelation of cost and ineffectiveness.

If a subsidy is good for everyone, it’s more likely to succeed

What motivate members of interest groups may be moral or social issues, or naked financial interest. Interest groups of the last kind are generally more effective if they can convince themselves and others that they are really pursuing the public interest and that their private gains are incidental. The solar hot water industry would argue that it provides a service that benefits the country and indeed the world.

Of course, subsidies can contribute to the general wellbeing of Australians. Subsidies to good school education help to create better citizens. Subsidies to “public good” research help create good ideas (disclosure: I worked in universities for 35 years). Transitional adjustment assistance helps to remove political barriers to efficient reforms.

By their nature, such beneficial “spill overs” are hard to estimate, because they are not simple marketed goods and services. There are many exaggerated claims made about these benefits; some are honest, but some are not.

Jonathan Pincus is a visiting professor, School of Economics at University of Adelaide

This article was originally published on The Conversation – theconversation.edu.au. Reproduced with permission.