To Subsidize is to Tax
The social cost of the tax that pays for the subsidy is greater than the gain to the buyers, because the extra buyers are able to to buy it at less than the market price.
November 1, 2008
Fred Foldvary, Ph.D.
Economist

A subsidy lets people buy stuff below the price that would be set in a market. In a free market, prices tend to cover the costs of productions, since a company with persistent losses goes out of business. When buyers don’t need to pay the full cost, this creates a waste of resources, which economists call a “deadweight loss.” That deadweight loss acts as a tax on the economy, imposing the cost of misallocating resources.

Taxes on production have a deadweight loss because the tax is added to the cost of production. The higher price reduces the quantity bought, which reduces production. A subsidy has the opposite effect: there is too much production. At the subsidized price, the gain to buyers is more than offset by the loss to taxpayers. The social cost of the tax that pays for the subsidy is greater than the gain to the buyers, because the extra buyers are those who value the product less than the folks who are willing to buy it at the market price.

On the California ballot in fall 2008 there has been a proposition to subsidize alternative energy. The main energy source that would be subsidized is natural gas. It would be a subsidy to the corporate profits of natural gas producers. There is no good reason for such a subsidy. If the goal is to reduce air pollution, the effective policy would be a pollution charge.

Without a pollution charge equal to its social cost, the buyers of goods that create pollution get a subsidy, as they don’t pay the full social cost of their purchase. One can frame the reduction in pollution as a benefit, but it is really the removal of a cost. The pollution subsidy has a deadweight loss, and the pollution charge removes it.

Many subsidies are implicit, not paid in cash but in gains in income and property value. The biggest subsidy is the gain in land rent and land value caused by governmental public works and civic services. British geo-economist Fred Harrison calls this a “clawback.”

Governmental works such as highways and transit make an area more productive and attractive, and this generates higher land rent and site value. If the landowners do not return this gain to the government, they get a subsidy. That gain is paid by tenant-workers, who get double billed by paying both taxes and higher rent. The tax creates the deadweight loss caused by this subsidy. The way to eliminate this land-value subsidy is to shift public revenue to land rent.

Some environmentalists promote government subsidies to renewable energy. There is a push to tax oil companies and use the funds to finance alternative energy. There have been tax credits for solar panels and hybrid cars. These sound good to those who don’t do the economic analysis. These subsidize waste resources by shifting them from uses with higher value to uses with lower value. It also does not eliminate the subsidy to polluters.

The impulse to subsidize is understandable. Environmentalists want to reduce the use of oil, so many of them promote bribing people to use other sources of energy. Why don’t they instead promote pollution charges and land value taxation? When they promote energy subsidies and reject the removal of the pollution subsidy, they promote economic waste.

Some programs that appear to be subsidies are not really that. When a city taps site values to pay for public transit, this is not a true subsidy. This is like gratis elevator service in a hotel. The free elevator is not a subsidy, since the payment comes from the room charge. The tapping of site value to pay for mass transit is likewise a room charge that efficiently pays for the transport. It would be inefficient to charge the users of an elevator for the transit, since the carrying cost of one more rider is less than what it would cost to collect the charge.

Government should neither tax nor subsidize the use of energy. Instead of taxing the buyers, governments can avoid the deadweight loss by tapping the economic rent or surplus of extracting oil, gas, and other ground resources when they are extracted. Governments should also charge polluters and those who cause congestion.

It is impossible to improve on the efficiency of a truly free market. Economists call this proposition the “first fundamental theorem of welfare economics.” Though framed with qualifications, this theorem is generally true. A subsidy is a tax on economic efficiency.

Private gifts do not generally do economic damage. The damage from a government subsidy is the tax that pays for it, and the reduction in the goods that would have had a higher social value. Neither a taxer nor a subsidizer be. Tapping land rent and charging for pollution are not taxes in substance, but compensation for value and damage.

The next president should say, “Read my lips: no more subsidies.” Those who promote subsidies suffer from the mental disease of statism. Cure yourself by gaining economic understanding.

Find Out More.
Inside information on economics, society, nature, and technology.
Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.