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An Overview of Subsidies & How They Are Taxed

An Overview of Subsidies & How They Are Taxed

What is a subsidy?

A subsidy is a benefit given to a business, an individual, or an organization, usually by the government. It can be in the form of direct subsidy(such as cash payments) or indirect subsidy (such as tax exemptions). The subsidy is usually awarded to remove some kind of burden and is often considered in the public's general interest. It is awarded to promote a social good or an economic policy.


How does a subsidy work?

A subsidy is generally a form of payment, offered directly or indirectly, to the beneficiary's natural or legal person. Subsidies are generally seen as a preferred type of financial assistance because they reduce an associated burden previously borne by the beneficiary or promote a particular action by providing financial support.

Subsidies have an opportunity cost. Consider the agricultural subsidy again during the depression: it had visible effects and farmers saw their profits grow and employ more workers. Invisible costs include what would have happened to all those dollars without subsidy. The money from the subsidies was to be taxed based on individual income, and consumers were again affected by rising food prices at the supermarket.


Types of subsidies

A subsidy usually supports specific sectors of a nation's economy. It can help industries in difficulty by reducing their burden or encouraging new developments by providing financial support for efforts. These areas are often not effectively supported by the actions of the wider economy or may be affected by the activities of rival economies.


Direct subsidies vs. indirect

Direct subsidies involve an actual payment of funds to a particular person, group, or sector. Indirect subsidies do not have a predetermined monetary value or involve actual money payments. These may include price reductions for necessary government-supported goods or services. This allows you to purchase the items you need below the current market price, generating savings for those the subsidy is designed to help.


Government Subsidies

There are many forms of government subsidies. Two of the most common individual benefits are social assistance benefits and unemployment benefits. The purpose of these types of subsidies is to help people who are suffering financially. Other subsidies, such as reduced interest rates on student loans, are offered to encourage people to continue their studies.

With the Affordable Care Act (ACA) enactment, several U.S. households have become eligible for family size and income benefits. These benefits are designed to reduce the direct costs of insurance premiums. In these cases, the benefit funds are sent directly to the insurer to whom the premiums are due, reducing the amount of payment required by the household.

Business subsidies are provided to support an industry struggling with declining international competition, making domestic businesses unprofitable without a subsidy. Historically, most subsidies in the United States have been directed at four sectors: agriculture, financial institutions, oil companies, and utilities.


Advantages and disadvantages of subsidies

There are several reasons for subsidizing public subsidies: some are economic, some are political, and some are derived from the theory of socio-economic development. Development theory advocates that some industries need protection from foreign competition to maximize domestic profit.

Technically speaking, a free market economy is subsidized; the introduction makes it a mixed economy. Economists and politicians often discuss the merits of subsidies and, by extension, the extent to which an economy should be mixed.


Advantages

Pro-subsidy economists say sector subsidies are essential to help sustain businesses and the jobs they create. It is often argued that subsidies are justified to provide an optimal level of social goods and services that lead to economic efficiency.

In present-day neoclassical economic models, there are circumstances in which the actual supply of a good or service falls below the theoretical equilibrium level: an unwanted shortage, which creates what economists call a market failure market.

One way to correct this imbalance is to subsidize the depleted goods or services. The subsidy reduces the cost to producers of bringing the good or service to market. If the right level of subsidy is assured, all other things being equal, the market failure is expected to be corrected.

In other words, subsidies are necessary when a market failure results in very low production in a given area. In theory, this would bring production back to optimal levels.

Some say that goods or services provide what economists call positive externalities. A positive externality is obtained when an economic activity indirectly benefits a third party.

However, since the third party is not directly involved in the decision, the activity will only take place to the extent that it directly benefits those directly involved, leaving potential social gains on the table.

Many subsidies are put in place to encourage activities that produce positive externalities that would otherwise not be provided at the socially optimal threshold. The counterpart of this type of subsidy is the taxation of activities that produce negative externalities.

Some development theories argue that governments in the least developed countries should subsidize domestic industries in their early stages to protect them from international competition. This is a popular technique currently found in China and several South American countries.


Disadvantage

Meanwhile, other economists believe that free-market forces must determine whether a business survives or fails. If that fails, those resources are used more efficiently and cost-effectively. They argue that the subsidies given to these companies only support the inefficient allocation of resources.

Free market economists avoid subsidies for several reasons. Some argue that subsidies unnecessarily distort markets, impeding efficient outcomes and diverting resources from more productive to less productive uses.

Similar concerns arise from those who suggest that economic calculations are too imprecise and microeconomic models are too unrealistic to correctly estimate the impact of a market failure. Others argue that government spending on subsidies is never as effective as government projections. They say the costs and unintended consequences of subsidies are rarely worth it.

Another problem, opponents point out, is that subsidizing contributes to corrupting the political process. According to political theories of regulation and revenue seeking, subsidies exist as part of an unholy alliance between big business and the state. Businesses often look to the government for protection from competition. In turn, companies make donations to politicians that benefit their political careers.

Even if a subsidy is created with the purest of intentions, without collusion or self-interest, it increases the profits of those who receive beneficial treatment. It thus creates an incentive to push for it to continue, even after the need or the utility is exhausted. This can allow political and commercial interests to create mutual benefits at taxpayers' expense and/or competing businesses or industries.


What is the contrast between direct and indirect subsidies?

Direct subsidies involve the actual disbursement of funds to a particular person, group, or sector. Indirect subsidies are those that have no predetermined monetary value or that involve actual payments of money. This may include price reductions for needed goods or services that the government may support.


Summary

  • A subsidy is a direct or indirect payment to a person or company, usually by the government, in the form of a cash payment or a specific tax cut.

  • In economic theory, subsidies can compensate for market failures and externalities to achieve greater economic efficiency.

  • However, subsidy critics point to problems in calculating optimal subsidies, overcoming hidden costs, and preventing political incentives from making subsidies more expensive than profitable.


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Dennis Jao
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