Appendix 2 The Nature of Price Subsidies

Juan Cordoba, Robert Gillingham, Sanjeev Gupta, Ali Mansoor, Christian Schiller, and Marijn Verhoeven
Published Date:
December 2000
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36. A price subsidy reduces the consumer price of a good or service below what it would be in the absence of the subsidy (consumer subsidy) or increases the price received by a producer above its market level (producer subsidy). In practice, consumer subsidies are often implemented with price controls, resulting in shortages of the subsidized item. Producer subsidies, on the other hand, are often administered through producer support prices. When support prices are set too high, there is an oversupply of the subsidized item.

37. Explicit price subsidies are recorded in the government budget as expenditures, although not necessarily under the category “subsidies.”15 Explicit subsidies can take many forms. In the case of a consumer subsidy, a public agency can make direct payments to producers to compensate them for charging lower prices for their output. Alternatively, the government can directly provide goods and services free of charge or at below-market prices through a public distribution system.

38. Implicit price subsidies are not easily identifiable in the government budget, but can show up as (1) losses of the banking system (e.g., owing to below-market interest rates or directed credits); (2) losses of state-owned enterprises, owing to setting prices below cost recovery levels; (3) differential tariffs for various consumers (e.g., by charging industrial users a higher tariff for electricity and water); (4) tax expenditures (e.g., tax exemptions, concessions, and deferrals); (5) below-market procurement prices, which act as a tax on producers and a subsidy for consumers; (6) equity participation in state-owned enterprises without an expectation of a market return or net lending to them at preferential interest rates; (7) regulations that alter market prices or restrict market access (regulatory subsidies); and (8) distribution of donor-provided commodities at below-market prices. All these subsidies affect the government budget, although some (tax expenditures, equity participation, and net lending) more directly than others.

39. A price-subsidy policy can be helpful in pursuing social and economic goals. Price subsidies can be designed to correct market imperfections. For example, the provision of basic education and childhood immunizations free of charge or at reduced tariffs can promote broad-based human and economic development. Subsidies can also be used to address domestic market imperfections in domestic factor and product markets of traded goods. In that case, a subsidy policy is preferable to imposing tariffs (Bhagwati and Ramaswami, 1963). Other price subsidies, such as for basic commodities, can provide food security and improve the well-being of the lowest-income individuals and households in a society. Transitory subsidies may be the only means of cushioning against sharp losses of purchasing power (e.g., following the CFA franc zone exchange reform, and in the wake of the 1997 financial crisis in Indonesia).

40. In practice, price subsidies have also been motivated by other goals, including providing subsidies to nonpoor special interest groups (e.g., in 1999, only 21 percent of kerosene subsidies reached the poorest 30 percent of households in Indonesia).

41. Even when price subsidies achieve their intended objectives, their economic and social benefits have to be weighed against their costs:

  • Explicit and implicit price subsidies burden the government budget and can aggravate the country’s fiscal position. Government spending on subsidies averaged 1.6 percent of GDP in a group of 65 advanced, developing, and transition economies in the mid-1990s.16 Such spending was relatively high in industrial countries (1.8 percent of GDP), especially in the European Union. On the other hand, in developing countries, spending on subsidies averaged 0.9 percent of GDP, and in transition economies, 2.3 percent of GDP.17
  • Price subsidies reduce allocative efficiency by distorting relative prices. Consumer price subsidies often are associated with overconsumption or underprovision of the subsidized item, and producer subsidies with excess production. The welfare cost of such price distortions (i.e., the excess burden of price subsidies) increases faster than the rate of subsidization. In addition, price subsidies have been associated with smuggling (e.g., subsidized wheat and wheat flour in Yemen and subsidized petroleum products in Nigeria have all been smuggled out of these countries) and waste (e.g., subsidized bread was used as animal feed in Belarus, Jordan, Ukraine, and the Russian Federation, and wheat flour was used to mark soccer fields in Peru). In some cases, subsidizing of inappropriate commodities has led the poor to consume a less nutritious diet (e.g., in the Dominican Republic, the poor’s intake of calories and protein fell when they substituted less nutritious subsidized chicken for rice, beans, and oil plantains). In the European Union, estimates for 1978–95 suggest a net income loss of between 0.3 percent and 2.7 percent of GDP from the Common Agricultural Policy. The inefficiency of this policy is also reflected in its high cost; in 1980, the budgetary cost of transferring $1 to a farmer was, on average, close to $2 (Rosenblatt and others, 1988).
  • The methods used to finance subsidies—higher taxation or higher deficit financing—further worsen resource misallocations.
  • The capture of benefits of subsidies by middle- and upper-income households raises issues of equity and fairness. Moreover, price controls—used frequently to implement price subsidies—often result in black markets that limit the access of the poor to scarce items.
  • Subsidies for certain activities—agriculture, energy consumption, and timber exploitation—can contribute to environmental degradation. For example, subsidies for certain activities, including cattle raising, under the Polamazonia Program in Brazil in the 1970s adversely impacted the environment in the Amazon (Davis, 1977).

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