Subsidy

Article bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

Subsidy Meaning

A subsidy in economics refers to direct or indirect financial assistance from the government to an individual, household, business, or institution to promote social and economic policies. Its goal is to lower the cost of producing goods, commodities, and services, making them more affordable to the general population and stimulating production, distribution, and consumption.

The government provides subsidies as cash, grants, and interest-free loans (direct) or tax exemptionsTax ExemptionsTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more and low-interest loans (indirect) to entities for activities in the public interest. Sometimes known as a government incentive, the amount of it varies with the products or services. Examples of sectors usually considered for subsidies include fuel, agriculture, export, transportation, education, housing, mining, research, etc.

Key Takeaways

  • A subsidy in economics is a type of financial aid provided by the government to individuals, households, businesses, or institutions, directly or indirectly, to promote social and economic activities.
  • Different forms of subsidies granted to entities for activities in the public interest include cash, grants, interest-free loans, tax exemptions, low-interest loans, etc.
  • It aids in increasing production, distribution, and consumption of goods, commodities, and services by lowering their costs, making them more accessible to the general public while improving economic efficiency.
  • Subsidies for export, oil, agriculture, transportation, housing, education, research, and healthcare are some most popular types.

How Does Subsidy Work?

A subsidy is a phrase that has been around since the 1300s. The term originates from the Latin ‘subsidium,’ which means auxiliary force, reserve force, or aid. It implies financial assistance or concession that a government gives to specific sectoral activities benefitting the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. The subsidy is, however, criticized for giving the receiver an unfair advantage.

How Subsidy Works?

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With subsidies, the government makes an effort to promote industrializationIndustrializationIndustrialization refers to the transformation of a manual labor-based economy to a machine labor-driven industrial society.read more and improve the social and economic status of the public. It not only protects industries from global competition but also from imploding by lowering their operating expenseOperating ExpenseOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more. Furthermore, these grants help create more opportunities for people and entities around. However, these incentives account for a significant portion of government spending because of the substantial sums.

A subsidy by government offered to businesses enables them to keep prices of certain products lenient so that people can afford them. For instance, if a domestic company sells a product for $10 while its international competitor sells the same for $6, consumers will buy items from the latter.

In this case, the government analyzes the loss incurred by the domestic firm and grants it $5. It will, thus, reduce the cost of the product to $5, which is even lower than what the foreign firm offers. As a result, the sale of that particular product is balanced, restoring the national economic condition.

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Forms Of Subsidy

The subsidy definition is not limited to a country’s economic progress. Instead, it serves as a valuable financial incentive for people to undertake many innovative ventures that benefit society. Based on their mode of offering, these can be direct or indirect:

  1. Direct Subsidies: These entail payments of money to a person, business, or organization for the economic development of any state. Also, these assist the transportation sector financially, such as shipping, aviation, and road, given their roles in defense and foreign policies.
  2. Indirect Subsidies: These involve tax breaksTax BreaksA tax break is a tax benefit or tax concession allowed by the government to encourage businesses to increase their investments, ultimately boosting the economy. It comes in a variety of ways, such as claiming tax deductions or excluding profits from tax returns.read more and price reductions for essential items. Moreover, the government directly purchases goods from private manufacturers at a price significantly higher than the free-market rate. The government, thus, keeps product prices high by manipulating the market. In some cases, the government can offer items at a lower price than the open market.

In addition, the government can provide subsidies in the form of unemployment compensation, corporate stock purchases, and student loans at reduced interest rates.

Subsidies benefit every sector and society in which the government grants them. Also, these can compensate for market failuresMarket FailuresMarket failure in economics is defined as a situation when a faulty allocation of resources in a market. It is triggered when there is an acute mismatch between supply and demand. As a result, prices do not match reality or when individual interests are not aligned with collective interests.read more and externalities, resulting in increased economic efficiencyEconomic EfficiencyEconomic efficiency in microeconomics refers to the state that manifests optimum resource allocation, the minimum cost for producing goods and services, and maximum outcome.read more. It does, however, have negative economic consequences. When governments provide funding to various manufacturers and market segments, the money originates from the general public, either directly or indirectly. The government structures these incentives in a way that results in more taxes or higher product prices.

Types Of Subsidy

As previously said, subsidies come in various forms, depending on the producer and the consumer. The former assists producers by offering direct market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more support or payments to production factorsProduction FactorsFactors of production define resources used to produce or create finished goods and services, the sale and purchase of which keeps the market economy afloat.read more. On the other hand, the latter reduces consumer prices for products and services. However, common types of subsidies are:

Subsidy Types

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Export Subsidy

As the name suggests, this subsidy boosts exports by granting funds to companies exporting items to foreign countries. Exporters keep track of their exports and report them to the government, which compensates them with grants. It, thus, helps improve the regional balance of payments.

Notably, the World Trade Organization has imposed some restrictions on export subsidies. However, it permits the Export Credit Guarantee Program and the Dairy Export Incentive Program, both run by the U.S. Department of Agriculture, to encourage farmers to become more productive and competitive.

Oil Subsidy

Governments in some countries offer this incentive to promote petroleum production to maintain domestic fuel supplies. Oil companies receive these grants to keep oil prices under control and affordable. These have taken up a sizable portion of the U.S. annual budget since the First World War.

Agriculture Subsidy

The government provides subsidies to farmers to help them overcome disastrous environmental effects, boost their income, protect the domestic food supply, and influence agricultural commodity pricing. This subsidy came into existence during the Great Depression of 1929Great Depression Of 1929The Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more and the Dust Bowl of the 1930s.

A subsidy for farmers ensures that there would be no overproduction and that supply does not exceed demand. In some instances, authorities purchase extra harvests from farmers at a price higher than market value and store them for future use or distribute them to the poor worldwide.

Housing Subsidy

The subsidy on home loan, usually granted as interest rate rebates and down-paymentDown-paymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more assistance, guarantees housing for all. Furthermore, low-interest loans help support the building industry by encouraging low-income families to become homeowners.

Healthcare Subsidy

These subsidies assist the middle-class and poor in receiving healthcare coverage under programs like Medicare, Medicaid, Children’s Health Insurance Program, etc. In addition, the government offers grants to fund medical research and developmentResearch And DevelopmentResearch and Development is an actual pre-planned investigation to gain new scientific or technical knowledge that can be converted into a scheme or formulation for manufacturing/supply/trading, resulting in a business advantage.read more.

Subsidy Examples

1. Electric Cars

Recently, Russia announced subsidizing electric vehicles by covering 25% of their purchase price to boost domestic demand and manufacturing while reducing carbon emissions. The decision has come following the revelation of figures from 2020, which depicted that only 11,000 of the 45 million cars used in Russia were electric cars.

2. Solar Panels

Subsidies for solar installations have resulted in a record-breaking expansion in the U.S., which may continue for the next three years. As such, these installations grew to 46% in the first quarter of 2021, totaling over five gigawatts (GW). By the end of 2021, the government plans to have installed 24.4 GW, which is a 24% increase over the previous year. This increase reflects a rise in demand from diverse sectors striving to achieve long-term environmental goals.

3. Farming

European Union (EU) countries have signed a deal on June 25, 2021, to reform the farming subsidy scheme to make the bloc greener. It came following three-year-long negotiations over the EU Common Agricultural Policy to help smaller farms combat climate change and protect them against losses due to pandemics. As a part of the deal, effective from 2023, small farmers will get incentives to adopt environment-friendly agricultural methods, such as wetland restoration and organic farming, to minimize greenhouse gases emissions.

4. Insurance

The U.S. government has introduced a 100% COBRA subsidy as a part of the $1.9 trillion American Rescue Act. It will allow nearly two million laid-off individuals to seek a temporary extension for their healthcare insurance. Under this initiative, the government will cover the entire cost of premiums for eligible workers from April 1, 2021, through the end of September 2021.

Pros And Cons of Subsidy

Subsidies may benefit specific socio-economic activities for public welfare, but they may also harm the general public due to large sums of money going to the corporate sectors. Let us take a look at the benefits and drawbacks of a subsidy:

Pros

  • Boosts exports and sectoral activities to benefit the domestic economy
  • Controls inflation
  • Empowers marginalized and poor people
  • Encourages research and development
  • Increases production and consumption
  • It brings social and economic efficiency
  • Maintains supply of goods
  • It makes essential items affordable
  • Minimizes costs of doing business and helps introduce quality good or service
  • Promotes industrialization through tax exemptions
  • Protects businesses from failure or losses or global competition
  • Reduces unemployment 

Cons

Frequently Asked Questions (FAQs)

What is Subsidy?

In economics, subsidies are a government’s financial help or concession to individuals, businesses, or institutions for sectorial activities that benefit the economy. Government incentives given to entities for public-interest operations include cash, grants, interest-free loans, tax exemptions, low-interest loans, and so on.

Is subsidy good or bad?

Subsidies are beneficial to every sector and society where the government uses them. These can also compensate for market flaws and externalities, leading to enhanced economic efficiency. It, thus, promotes industrialization and improves the social and economic well-being of the public. In return, the government may levy more taxes or raise product prices to reduce the burden on public spending.

What are the advantages and disadvantages of subsidies?

Here are some pros and cons of subsidies:
Pros
Empowers marginalized and poor people
Increases production and consumption
It brings in social and economic efficiency
It makes essential items affordable
Minimizes costs of doing business
Reduces unemployment
Cons
Enhances tax rates for businesses and the general population
Causes a supply shortage as a result of stringent limits that impede a balanced demand-supply chain
Allocates resources to less productive uses
Stifles competition
Results in political corruption
Lowers prices, which fuels demand and, in turn, raises prices

This has been a guide to Subsidy and its Meaning. Here we discuss how does it work, along with examples, forms, types, pros, and cons. You can learn more from the following articles –

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