In Table 6.1, Table 6.2 and Table 6.3 EC data are used in order to give some idea of the volume and composition of subsidies in EC countries. There are other classifications of subsidies which could be useful and also comparisons with other variables. For example one might classify the subsidies given in a particular country according to the geographical destination of payments and then find some variable with which to compare it which would indicate the relative importance of aid in each region.
Can you think of two additional comparisons which would indicate the economic importance of subsidies?
The purpose of a subsidy is to fulfil one or more aims of government policy and the justification for any particular form and amount of subsidy requires that the expenditure incurred promotes these aims better than any alternative use of the expenditure (including lower taxes). This way of appraising an expenditure project will seem familiar to any student who has studied a textbook on finance, and it seems worth investigating whether there is a parallel between appraisal of projects in the private and public sector.
Consider a firm which adds to its capital stock in the expectation that this will promote its aim of maximising profits. It will undertake the investment, at the margin, if the present value of the expected benefits exceeds the present value of the investment outlays. It will choose some interest rate with which to discount future benefits and costs which reflect the return on the alternative use of funds used for investment.
Now consider a case where the government offers a subsidy to a firm for a capital project which will increase the output of the firm in the future. In deciding whether to offer a subsidy for a capital project to be undertaken by a private firm which is expected to yield future increases in income and employment, is it appropriate for the government to discount future benefits, and, if so, what problems are encountered in arriving at an appropriate discount rate?
We have seen in Section 6.2.1and Example 6.12 that governments have a particular interest in financing high-risk projects usually involving substantial investment, of which a prominent example is found in aircraft development. At the same time, while sharing the risks, governments have sought to take a share in the benefits. Thus, while there must be an element of subsidy in financing a project which a firm would not otherwise undertake – though obtaining accurate information on this point is clearly difficult – an attempt can be made to minimise the amount of subsidy required by inventing a formula which offers the government a return on the investment, when a return is made. Thus in the case of launching aid, one such formula has been that it should only be given if there is at least a 50 per cent chance that the total aid will be recovered. This sounds like a sensible rule of thumb, but is it? It would be if such a rule enabled the government to rank alternative projects according to the expectation of recovering the subsidy. Our question offers a hypothetical example which enables you to put this rule of thumb to the test.
The government is considering two launching aid projects (see Table 6.4) with a view to determining whether they would pass the ‘50 per cent probability recovery’ rule. In each case, outcomes are ranked according to the degree of recovery of funds, and probabilities are attached to the occurrence of each outcome. The question you have to answer is: if the government applies its ‘rule of thumb’, will it select only those projects where expected repayments are at least equal to the subsidy? (Hint: Calculate the expected level of over- or under-recovery of the subsidy for the two projects.)
| Outcome | Excess recovered | Probability of outcome | |||||
| PROJECT A | 1 | +£10m. | 0.1 | ||||
| 2 | +£1m. | 0.4 | |||||
| 3 | −£1m. | 0.4 | |||||
| 4 | −£10m. | 0.1 | |||||
| PROJECT A | 1 | +£10m. | 0.1 | ||||
| 2 | +£5m. | 0.4 | |||||
| 3 | −£4m. | 0.3 | |||||
| 4 | −£10m. | 0.2 | |||||
It should be clear from Figure 6.1 and Section 6.4 that, in achieving the level of output and associated employment changes through an output subsidy, there are important side-effects, notably the change in the economic circumstances of different interest groups. Two examples may be given. First, if the subsidy is financed out of taxation, taxpayers will pay more. Second, foreign suppliers will not be able to sell as much to the domestic market. Policy makers both at home and abroad will be aware of these effects, and this may lead to action which makes the stable situation represented in Figure 6.1 a mis-description of what is likely to happen. Whether or not the situation is stable, governments will wish to consider alternative courses of action to achieve the same end, with a view to minimising the side-effects. One alternative strategy would be to introduce a tariff on output supplied by overseas suppliers.
Assume that a tariff is imposed which raises domestic price sufficiently to allow the domestic firm to increase output to the same level as that produced by an output subsidy. In what respects will the effects on the interest groups domestic consumers, taxpayers, overseas suppliers – differ from the subsidy case? What side-effects relevant to the success of the tariff policy measure might operate? (You may find it useful to redraw Figure 6.1, substituting a rise in the price per unit of output caused by the tariff for a subsidy per unit of output.)
