Econ 101: Old MacDonald Had a Subsidy

     The $307-billion, five-year farm bill recently passed both houses of Congress with more than the two-thirds majority necessary to override a presidential veto. The Cato Institute has estimated that the last 20 years of farm programs have cost the taxpayer more than $1.7 trillion, and there is no end in sight to the direct payment subsidies to be given to certain farmers. This mammoth piece of legislation ought to lead us to ask the question: why should the government give certain groups subsidies?

     Economists generally agree that the market system will yield the most efficient allocation of resources. There are, however, certain instances where the price system fails to capture all the costs and benefits of an activity, and in these cases it is possible that a tax or a subsidy can result in a more efficient outcome. A subsidy may be appropriate when some of the benefits of an action are not or cannot be priced.

     For example, the Brazilian rainforest absorbs carbon dioxide from the atmosphere. Some might argue that is good for the balance of “greenhouse gases” on the planet. However, who is paying the Brazilian farmer for this benefit provided by the rainforest on his land? Thus the Brazilian farmer ignores this benefit when deciding to burn down the forest and plant corn that could fetch him a good price. Economists call this a positive externality and when transaction costs are high, as in this case, the market will underproduce rainforest.

     One way to solve this problem is to get an estimate of the reduction in greenhouse gases and then give a subsidy to the Brazilian farmer to keep his land as rainforest. However, there are a number of problems in implementing such a subsidy in real life.

     How are we to pay for the subsidy? If it is through taxation, then taxes create another set of incentives which generally result in a less efficient outcome.

     How can we balance the outcome? If the subsidy is too large, then we get more rainforest than is efficient and too little corn, and we might end up with a worse situation than when we started.

     Subsidies are political, not economic. The largest problem occurs because the system by which subsidies are enacted is not one that provides an incentive to find and implement the correct subsidy. The political system often results in inefficient subsidies where the benefits are concentrated among a few people and the costs are spread out among a lot of people.

     Using the farm subsidy as an example, we know that the benefits are highly concentrated. About 10 percent of the farmers get more than 70 percent of the subsidy, while two-thirds of farmers counted by the Census of Agriculture get no subsidy.

     Now what is the cost of the farm bill to the average taxpayer? There are about 300 million Americans and the bill is about $300 billion over five years. So each American will shell out on average $200 per year for the farm bill.

     The result is that those who have a 50-percent chance of passing a bill that will give them $1 million per year will make a lot of effort to win passage, and those who lose $200 will not spend much effort to thwart the subsidy. In the end, the subsidies will have nothing to do with positive externalities, and everything to do with transferring income from the millions who have little effect on the outcome and a few hundred dollars at stake to those few who get millions of dollars of income and have a large chance of affecting the outcome.

     Subsidies nearly always are the result of what Frederic Bastiat called “legalized plunder” in his 1850 book, “The Law.” They are not only unjust, because they are the government taking from one person and giving to another, but they result in economic inefficiencies and unintended consequences.

Dr. Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.