Subsidies: Some Work, Others Don't

• Author: Benedict J. Clements and Ian Parry
• Pages: 56-57

56 FINANCE & DEVELOPMENT | September 2018

ART: THE NOUN PRO JECT / MA SSUPA KAE WGAHYA

Subsidies: Some Work, Others Don’t

Some government subsidies make sense, but often there are downsides

Benedict J. Clements and Ian Parry

NORWAY EXEMPTS OWNERS

of electric vehicles from

paying highway tolls. In Au stralia, the government

pays part of the wages w hen businesses hire young

people, indigenous Austral ians, or older workers.

Singapore oers tax brea ks to companies that estab-

lish global or regional headqua rters in the country.

All these a re examples of subsidies—scal tools

governments use to encourage economic devel-

opment, help disadvantaged groups, or advance

other national objectives.

Subsidies take many forms. Governments some-

times keep prices articially high, which is the case

with subsidies intended to boost the incomes of

farmers. ey may oer services, such as a uni-

versity education or a subway ride, at below cost.

ey may pay some of the interest on loans used

to nance construction of a road or a power plant.

Or they may grant relief from taxes on certain

products or technologies.

When do subsidies make sense? ey can be a

good policy tool when used to correct so -called

market imperfections; t hat is, when competitive,

private markets fail to del iver socially desirable

outcomes. For example, subsidies can encoura ge

businesses to invest in research and development

that benets not only their rm, but the industr y or

society as well. ey c an also help start-ups survive

an initial period of losse s until they grow large

enough to be protable (although governments

need enough information to determine whether

rms will succ eed when they grow larger).

Impact on inequality

But there are drawbacks. C onsider energy subsidies,

which are often intended to help low-income house-

holds. ese can be a dra in on government resources

if they are avail able to everyone, including those

who are relatively well-o. A targe ted cash transfer

aimed at poor households costs fa r less. Subsidies can

also exacerbate ine quality if they disproportionately

benet those producing or consuming the most. For

example, across Af rica, Asia, Latin America, and

the Middle East, the top 20 percent of households

capture on average seven times a s many of the bene-

ts of energy subsidies as do the bottom 20 perc ent

(Coady, Flamini, and Sears 2015).

Another drawback: sub sidies that do not address

market imperfect ions can distort prices, causing a

misallocat ion of scarce labor and capital that under-

mines growth. Propping up petroleum price s, for

example, may arti cially keep rms aoat in energ y-

intensive sectors and damp investment in a lter-

native energy. Producer subsidies in agriculture,

which increase prices received by fa rmers above

prices for imported food products, also reduce

incentives for improving eciency. In the European

Union, these subsidies averaged 20 percent of

gross farm receipts in 2014–16, according to a

2017 report by the Organisation for Economic

Co-operation and Development.

Some subsidies can be harm ful, such as those for

fossil fuels. ey a re not only expensive but also at odds

with environmental objectives, such a s reducing deaths

caused by local a ir pollution or meeting commitments

under the 2015 Paris Climate Cha nge Agreement to

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