Subsidies: Meaning, Types and Basic Concepts

The word subsidy is derived from the Latin subsidium, meaning ‘troops stationed in reserve’, and essentially implies ‘coming to assistance from behind’. In most common parlance, Subsidy means grant. This grant may be in the form of either cash or kind and is generally given to promote an economic policy or social policy.

Subsidy is generally understood to be a grant extended by the Government, however, that is not a very strict definition. The various forms of subsidy include direct subsidies such as cash grants, interest-free loans; indirect subsidies such as tax breaks, premium free insurance, low-interest loans, depreciation write-offs, rent rebates etc. Subsidies have been provided widely throughout the world as a tool for realizing government policies.

Types of Subsidies

There are six primary categories of subsidies as follows, divided by purpose:

• Export subsidies,
• Subsidies contingent upon the use of domestic over imported goods,
• Industrial promotion subsidies,
• Structural adjustment subsidies,
• Regional development subsidies,
• Research and development subsidies.
• By beneficiary, there are two primary categories:
• Subsidies that are not limited to specific businesses or industries (non-specific subsidies), and
• Subsidies those are limited to specific businesses and industries (specific subsidies).

Apart from the above, the subsidies can also be divided into broad subsidies and narrow subsidies. The most common forms of subsidies are those to the producer or the consumer. Producer/Production subsidies ensure producers are better off by supplying market price support, direct support, or payments to factors of production. Consumer/Consumption subsidies commonly reduce the price of goods and services to the consumer.

Difference between Subsidies and Taxes

Subsidies are the opposite of taxes because government gives money to individuals or firms, instead of collecting money from individuals or firms. A subsidy in its simplest form is a negative tax – a reverse flow (transfer) from the government to the public – or an income/consumption supplement for individuals. Further, Subsidies, like taxes, may thus be lump sum, proportional (ad valorem or specific) or progressive. Subsidies are as much an economic tool as are taxes to facilitate smooth functioning of the economy.

Subsidies are commonly used by governments to promote general welfare (eg. housing, education, sustenance). However, they can also be used as tools of political and corporate cronyism or to erect barriers to trade.

Difference between Subsidy and Transfer Payments

Transfer payments refer to the payments that are made without any exchange of goods or services. The generally result in the redistribution of income. A subsidy is a type of transfer payment. Other examples are welfare expenditures and social security contribution by the government in pension schemes.

Estimation of Subsidy on Public Goods, Merit Goods and Non-Merit classification

The estimation of the subsidies is done by the standard classification into public, merit and non-merit goods. A brief description of the same is given below:

Public Goods

• Public good is a good in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others. Examples of public goods include fresh air, national defense, flood control systems, public transport and street lighting. Since these services are available to all, they are normally characterised by nonrivalry and non-excludability in consumption. Since these services are available to all citizens, they do not exclude anyone. Thus, such goods cannot be priced and hence are not included in the calculation of subsidies.

Merit Goods

• Merit goods are those goods whose consumption leads to positive externalities. This implies that when a merit good is consumed, the public benefit is greater than the private benefit. For example, vaccination against a contagious disease is a merit good. Similarly, other merit goods are environmental protection and minimum level of education (primary education), for all. The social benefit resulting from these goods/services is much greater than the sum of private benefits to individual consumers. This is because these goods contain elements of ‘externality’ beneficial to the society as a whole. Other examples of merit goods are roads and bridges, flood control and research pertaining to agriculture, space, atomic energy, etc. The availability of benefits in the form of externality justifies the subsidies on these goods.

Non-Merit Goods

• The non-merit goods are those goods whose consumption leads to negative externalities. In consumption of such goods, the benefit of subsidies provided on such goods accrues to the individual consumers. In case of non-merit goods, the cost of providing the commodity/service to the society is higher than the price fixed for providing it to the consumer. These subsidies result in the transfer of benefits to the individual consumer in a number of ways as follows:
  • Cash subsidies – Providing food or fertilisers to the consumer at prices lower than those at which the government procures the commodities.
  • Interest or credit subsidies : Loans given at rates lower than market rates. This takes the form of concessional credit to small scale industries or priority sector loans to individuals to buy a taxi, an auto-rickshaw or to set up some small enterprise by buying some equipment.
  • Tax subsidies: Tax exemption of medical expenses, postponing collection of tax arrears
  • In-kind subsidies: Provision of free medical services though government dispensaries, provision of equipment to physically handicapped persons.
  • Procurement subsidies: Purchase of foodgrains at an assured price which is intended to be higher than the prevailing market price.
  • Regulatory subsidies: Fixation of prices of goods produced by the public sector at less than the cost with a view to providing inputs to industry or helping certain other categories of consumers. Examples are making steel, coal or other minerals available to industry, providing electricity to farmers at a rate much lower than the cost.

Why the economic case for subsidising “merit goods” is the strongest?

Going in line with the above description, the Public goods such as defence, general administration etc. is not amenable to usual pricing mechanisms and therefore subsidies are not relevant for this category.  The Merit goods which inter alia include primary education, public health, sewage and sanitation, many social welfare schemes, soil and water conservation, agricultural research, flood control and drainage, roads and bridges and scientific research have positive externalities and that is why the economic case for subsidising “merit goods” is the strongest.

In case of the non-merit goods such as food, fertiliser and education beyond elementary level; the element of externality is limited. Government may justify such subsidies on the basis of such grounds as mentioned in the Directive Principles of Constitution of India or to other social and equity objectives.

The provision of subsidies on non-merit goods has come in for sharp criticism since in their case; the benefits accrue to the individual while the costs are borne by the society. Moreover, in several cases, instead of the intended beneficiaries, the benefits are appropriated by better-off sections. For example, it is alleged that benefits of the provision of cheap electric energy to farmers are, by and large, appropriated by rich and affluent farmers. Similarly, better off sections may take advantage of a generalised scheme of public distribution of food grains or other essential commodities.

Budgetary Subsidies

The subsidies which are provided in the Budget are budgetary subsidies. The estimation of budgetary subsidies are computed as excess of the cost of providing a service over the recoveries from the service. These costs are taken as the sum of the following:

• Revenue expenditure on the concerned service;
• Annual depreciation on cumulative capital expenditure for the creation of physical assets in the service; and
• Interest costs of the cumulative capital expenditure, equity investment in public enterprises, and loans given for the service concerned including those to public enterprises.

Direct and Indirect Subsidies

Direct subsidies are given in terms of cash grants, interest-free loans and direct benefits. The direct subsidies boost the purchasing power of the beneficiary and may help in raising the standard of living. In case of agriculture, direct subsidies help the farmers to purchase required inputs from markets. Proper identification of beneficiaries is a big challenge in disbursement of direct subsidies. Indirect subsidies are given in terms of tax rebates, insurance premium, low interest loans, depreciation write offs etc. The cheap loans provided to farmers for agriculture is an example of indirect farm subsidy.