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What can go wrong when subsidies are given?

20/03/2024
Jacopo Priori

A quick overview of the main effects related to subsidies distribution, to have a clearer understanding of how they work and how they can impact society.

Over the last decade, more than 75% of the Dutch government expenditure consisted of subsidies and other transfers. These subsidies and transfers are often directed toward social security programs, public and private enterprises, international organisations, and other government units. They can take the form of cash transfers, goods and services provision, tax and loan incentives, and price support. 

Subsidies and other transfers, % of expense (World Bank, 2024)

Why do governments spend so much on them? They are essential, for example, for governments to respond to recessions or unforeseen shocks like COVID-19, and they also provide a stable income to households and firms that are experiencing difficulties chronically. Furthermore, subsidies are good policy tools to correct market failures as they can internalise externalities. What is meant by that? There can be competitive market equilibria where the private and public benefits are not aligned and only a public intervention can lead to an optimal outcome. It is the case of public financing to R&D firms’ programs, as these programs might be inconvenient for a firm to carry out, but once the cost that the firms face is lowered and the programs take place, the public benefit of a possible scientific discovery can be higher than the subsidy cost. 

Many times though, subsidies do not lead to the results that were expected. This is naturally an issue as it might mean that public resources are wasted, hence why it is fundamental to be aware of the possible negative effects. Rent-seeking is a common reaction of individuals and firms in relation to the distribution of subsidies. An unemployed person can, for example, avoid finding a job to keep enjoying the unemployment benefits without having to work. Similarly, a firm can purposefully not reach an established level of productivity, in order to continuously be financed by its government and use the transfer in some other way. This behaviour of manipulating governmental incentives to increase the wealth of a single entity can damage society as the resources might not be redistributed efficiently. To avoid these results precise checks of compliance are needed, together with setting the subsidies to a level that does not distort incentives.

When a good is subsidised or freely provided, arbitrage can occur. Between distributor and receiver and also between receiver and another individual, the good can be exchanged at a higher price than it was established initially, in order to make a profit from the transaction. A government could, for instance, distribute antimalarial bed nets to its population at a subsidised price through local retailers, to incentivise its population to stay protected from malaria. If those retailers illegally increase the price that people face, fewer people are likely to redeem the bed nets and the policy will have a smaller positive effect compared to the expected one.

Another effect that can play a role, is the sunk-cost effect. When a person buys a good and pays a lot for it, it seems intuitive that they will use it appropriately, while if it costs very little the person might be less compelled to use it properly. This can work with the provision of education too, if made available for free it might not be taken as seriously by students as if it would cost a lot and require many sacrifices for their families.

There is an additional reason why offering goods at a lower (subsidised) price might not work as expected: anchoring. People can get used to such lower prices and create so-called reference-dependent preferences. If they remain “anchored” to that lower price and later the subsidy is taken off, they might not be willing to pay for the new increased price. This new price might still be convenient for them but their preferences have now changed.

Moreover, subsidies can be subject to improper use. The subsidised antimalarial bed nets mentioned before have been used on several occasions as fishing nets or even to build football goals. The receivers were not aware of the potential the nets have to improve their living condition if used properly and thought it was more convenient to use them in other ways. This is why, especially in developing countries where people tend to be less educated, it is crucial to also convince the receiver of the subsidy of all of the benefits it entails.

When calculating the effects a subsidy can have, non-monetary costs are often overlooked. Subsidised electric vehicles might cost as much as comparable petrol vehicles, but one has to consider the fact that they need to be plugged in every specific amount of kilometres and that it takes a few hours to fully charge them. If offered the same price then, it might not be convenient to buy the EV as it is costlier (in terms of time spent waiting for the car to be charged).  

Many other times, though,  subsidies can also have positive effects other than the prescribed ones. In the case of experience goods (e.g. water purifiers), for instance, people might buy them as they are offered at a cheaper price and after using them they might understand all the benefits the goods bring to them. After learning about their worthiness, if the subsidy is taken off they might be willing to pay more than what they did initially as they recognise it is a convenient investment for them, their willingness to pay increased.

Due to the many interactions that occur in our societies, what can also happen are spillovers. Taking the case of subsidised public transport, you might initially still prefer to commute to work by car, but after talking to your colleagues they convince you it is not that bad to use the metro and make you realise how cheaper it is, so you might start using public transportation too. Spillovers can also have the opposite effect: as most of your colleagues and many others like them are now commuting to work by metro, the streets are less trafficked and it is much better for you to go to work by car than taking crowded public means of transport.

The occurrence of all these effects strictly depends on the nature of the subsidy and its related regulation. Economics research that investigates case by case and that calculates precisely the size of these effects is fundamental to formulating great policies and maximising the benefits associated with subsidies.
 

References

• World Bank. (2024). Subsidies and other transfers (% of expense) - United States, Netherlands, European Union. https://data.worldbank.org/indicator/GC.XPN.TRFT.ZS?contextual=default&end=2022&locations=US-NL-EU&name_desc=true&start=2014