Subsidies to lower living standards

Friday, Aug 16, 2013, 05:06 AM | Source: The Conversation

John Freebairn

Proposals by the two main political parties to provide selected subsidies to particular regions and industries, unless justified to correct a market failure, are a quick way to reduce productivity and living standards for the majority of the population. Subsidies to northern Australia in the form of concessional corporate tax rates and government funding of dams, roads and other infrastructure not passing a benefit cost assessment, shifts limited resources from more valued uses in southern Australia to less valued and lower productivity uses in northern Australia. Subsidies to particular industries, including co-investments to motor vehicles and interest rate subsidies for some primary producers, delay inevitable changes to industry structure and lock in limited capital, labour and technology resources in less productive uses from shifting to emerging industries which are more productive.

Consider, as an example, some of the effects of the proposal to reduce the corporate tax rate of 30 per cent for companies operating in northern Australia to 20 per cent. A billion dollars invested in southern Australia needs to have a pre-corporate tax net present value rate of return of $1.3 billion if invested in southern Australia. But, with the lower rate of 20 per cent, these same funds need to have a pre-corporate tax net present value of $1.2 billion. As a result, smart after-tax investors will shift funds from southern Australia, which earn $1.3 billion for Australia, to an alternative activity in northern Australia to earn just $1.2 billion. Australia as a nation, and the living standards of its people, fall by $100 million.

Further, preferential subsidies to particular regions and industries provide incentives and rewards for the favoured regions and industries to spend funds on lobbying for bigger and better subsidies. These rent seeking outlays often are good investments for the favoured sector, and sometimes return far more than investing the funds to produce better products at lower costs. But, rent seeking involves a reallocation of limited resources from society productive activities elsewhere in the economy, with a loss of average living standards.

In particular circumstances of market failure, and especially where there are external benefits, a subsidy may improve society productivity and living standards. A good example of external benefit is investment in research and development. Here, the investing firm gains some benefits, but also some of the higher productivity ideas and technology can be copied and modified by other firms and industries. In an ideal world, a subsidy for R&D, perhaps a direct government grant or a tax concession, equal to the magnitude of the marginal external benefit would in effect internalise the external benefit.

Subsidies sometimes are justified by politicians as a way of meeting society equity objectives. Certainly those in the subsidised industry or region gain higher incomes with a subsidy. However, not all who benefit would be regarded as disadvantaged, and some who warrant government assistance to meet minimum society equity objectives do not gain enough from the subsidy. Australia has an extensive system of social security benefits and a progressive income tax system which more directly and effectively provides government assistance to the disadvantaged.

The Conversation

University of Melbourne Researchers