Subsidy Primer

Intervention and Subsidy Basics

Government interventions encompass a wide range of regulatory, fiscal, tax, indemnification, and legal actions that modify the rights and responsibilities of various parties in society.  Click here to view Common Forms of Government Interventions in Energy Markets. Interventions can increase or decrease costs to particular groups, effectively acting either as a subsidy or as a tax. Some of these policies increase societal welfare.  Too often, however, government interventions end up subsidizing powerful groups in society, sometimes making societal imbalances worse.

Most people think of programs such as welfare when the term "subsidy" is used.  This image is unfortunate, since many of the most valuable subsidies do not involve cash transfers at all; and flow at least as often to corporations as they do to individuals.  This section provides a more holistic presentation of how governments support particular sectors of their society. 

Understanding Subsidies

• Subsidies represent government policies that benefit particular sectors of the economy. Government subsidies are common in most countries and benefit many industries. When these subsidies reduce the prices of natural resources or natural resource intensive products, they encourage additional pollution and habitat destruction. They can also create large opportunity costs, an economic term recognizing that money used for program "A" is no longer available for program "B", even though the second option might have helped more people or built a stronger long-term economy.  An overview of subsidy basics will make the more detailed information easier to understand. 

• Subsidies are not just cash. One of the most unfortunate misconceptions about subsidies is that they are simply cash.  In reality, a great deal of market activity involves controlling and sharing the risks and rewards of economic activities. While bearing less risk or getting a larger share of the rewards can greatly improve the economic returns to a private entity, the subsidies themselves may take the form of shifting how risks or rewards are allocated, rather than changing payments to industries directly.  An operational definition of subsidies needs to reflect this feature:  subsidies are government-provided goods or services, including risk-bearing, that would otherwise have to be purchased in the market. Subsidies can also be in the form of special exemptions from standard required payments (e.g., tax breaks).

• Defining the baseline. Subsidies must often be measured against some baseline. What would taxes owed have been in the absence of this special tax break? How much would industry have had to pay in interest to build that new facility if the government had not guaranteed the loan? This is quite important, as subsidy recipients often argue that it is not a subsidy if the government simply lets them keep more of their money (by reducing their taxes).  In reality, of course, unless taxes go down for everybody, reductions in one sector do force others to pay more.  Our baseline assumes standard corporate tax rates and no special agency programs to finance or absorb market risks for particular energy-related endeavors.

• Subsidy targeting. One issue related to defining a baseline is that of narrowly targeted subsidies versus more broadly targeted programs that benefit one form of energy as well as some other industries. Industry representatives inevitably conclude that only subsidies directly targeted at the a particular fuel should count as benefits to producers or consumers of that fuel. In fact, many other subsidies tilt the energy playing field towards a particular fuel even if other fuels or non-energy industries also benefit. It is useful to consider a handful of common subsidy targeting approaches:
  • Multiple sectors. Many subsidies are beneficial to a number of economic sectors. For example, the oil, gas, and hard rock minerals industries are all eligible for the percentage depletion allowance, a tax break that allows them higher than normal tax deductions. Since many other energy sources do not benefit from this provision (and the rates vary even for those that do benefit), the policy contributes to inter-fuel market distortions.
  • Geographic region. Most state/provincial and local subsidies are targeted to particular geographic regions (i.e., the state/province or locality). To the extent that natural resource intensive industries are located in the region receiving the subsidy (for example, corporate tax rate reductions in a large, oil producing region), policies can encourage incremental pollution and the development of “subsidy clusters” that rely on continued subsidization to survive.
  • Factor of production. Some subsidies are targeted at a particular factor of production (e.g., labor, capital) instead of specific industries. Although broadly available to all industrial sectors, subsidies affecting factors of production can cause market distortions nonetheless. Accelerated depreciation provisions, for example, allow any industry using capital equipment to deduct the capital from taxes more quickly than the anticipated service life of the capital asset. These provisions give capital intensive energy types a competitive advantage over types that require less capital investment, such as some demand-side management options. In addition, sector-specific depreciation rules in the tax code can create additional distortions between different capital-intensive energy sectors.
  • Single sector. The clearest and easiest subsidies to identify and allocate are those directly targeted to the particular industry, such as government financing of oil-related research and development programs through the U.S. Department of Energy. However, when studies only counts these problems, they dramatically underestimate the real level of support given to specific industries.

• Externalities are extra. While environmental externalities such as pollution or habitat damage certainly constitute subsidies to industry, many subsidy studies do not analyze them. The uncertainty regarding their value is larger than that for most direct subsidies. As a result, analysts sometimes leave them out in order to focus attention on the many ways that direct government subsidies help polluting industries. Properly functioning markets would both eliminate internal subsidies to a particular fuel and include a tax equal to the remaining externalities. However, it is also likely that reform of direct subsidies alone would generate many beneficial market shifts.

• Treating offsets. In addition to providing subsidies, the government also levies fees on certain resources. For example, while subsidies act to distort energy markets in favor of oil, certain fees may have the opposite effect, and are properly treated as offsets to subsidies. Our basic approach for calculating net subsidies is shown below. Where fees represent standard treatment of all industries, they are not considered subsidy offsets. Where a fee is levied only on a particular fuel or only on a narrow grouping of sectors, it must be evaluated further. Oil is a useful example. Within the United States, many of the fees on oil, such as gasoline taxes, are actually earmarked to pay for government activities such as oil spill cleanup or the remediation of contamination from underground gasoline storage tanks. If the levies pay for oil-related government activities, then they are treated as user fees rather than subsidy offsets and they are credited against the oil-related government program spending that they support. To the extent that a particular fee is levied only on a few industries (including oil) and receipts do not support an oil-related purpose, it is referred to as a special tax. Special taxes are extra charges on oil that do not pay for activities related to the industry. Thus, they offset subsidies by decreasing oil’s competitive advantage. While special taxes should be subtracted from gross subsidy values, user fees should not be. The decisions can be a bit complicated, but are illustrated in this graphic.

• Linkage between subsidy levels and resource prices in the marketplace. In the aggregate, subsidies throughout the world to any particular form of energy will tend to depress prices and thereby encourage overconsumption of the resource. However, not every individual subsidy has an impact on energy prices. Many subsidies to domestic producers, for example, simply keep these producers competitive with less expensive imports (which are themselves subsidized through a variety of mechanisms). Subsidies that have little or no effect on commodity prices will not likely change consumption patterns for the affected fuel. However, removing even these subsidies will affect the market behavior of that fuel's producers. Their removal will also save taxpayers billions of dollars.

• Cost to taxpayers versus value to recipients. The cost of a subsidy to taxpayers does not necessarily equal the value of the subsidy to recipients. Many government loan programs, for example, allow corporations to borrow funds at the lower interest rates obtained by the U.S. Treasury. Such loans do not directly cost the taxpayer but they have an incremental benefit to the industry that we try to measure here called the "intermediation value". In contrast, government programs may be inefficient and unproductive. Thus, while the programs cost the taxpayer a great deal of money, industry may value them at much less than their direct cost.

A Tale of Two Regular Folks and their Encounter With Federal Market Intervention: (Subsidies for the Non-Specialist)

Beth and Bob are two regular people. They live next door to each other, in identical homes. They are both entrepreneurial and work hard at their jobs. Both have second jobs, too - just to make ends meet. There is just one difference: one of them always seems to be slightly better off than the other.

Please note that this example illustrates the basic concepts of existing federal market intervention. It does not depict actual federal programs.

Source: Doug Koplow, Federal Energy Subsidies: Energy, Environmental, and Fiscal Impacts, (Washington, DC: Alliance to Save Energy), 1993, pp. 43-44.