Government has a power that businesses envy. It is the power to coerce payment, better known as taxation. The opposite of a tax is a subsidy. A subsidy is a sum of money given by the government to an industry or business in order to help support it. Government uses taxes and subsidies not only to raise revenue or redistribute income but also to shape people’s incentives and to change the marketplace.
All effective governments have the power to tax. Taxes can be used as a tool of microeconomic policy. For example, if government wants to reduce the production of a certain good, they can tax the producer. This raises the cost of production for the producer and reduces the supply in the market. Prior to the Civil War, thousands of different forms of currency were in circulation as there was no national currency. The war provided impetus for a national currency. In order to ensure the success of the new greenback, Congress taxed all the other forms of currency, which had the effect of removing them from the market. How? Would you issue a dollar if it cost you $1.50?
The government can use taxation to raise revenue without the intention of reducing production. For example, luxury taxes on expensive goods and services raise revenue without necessarily affecting the market. If you’re going to buy an expensive automobile, whether you spend $500,000 or $501,000 doesn’t make a great deal of difference in your purchasing decision.
So-called “sin” taxes (taxes on nonessential but popular products like alcohol and cigarettes) are intended to generate revenue but they are also intended to reduce consumption of products considered undesirable (although not illegal) by the government. High taxes on such goods can lead to black markets in them (more on that later in the book!).
Subsidies are used by government to encourage rather than discourage the production of certain goods and services. Subsidies have the effect of increasing the supply of the good or service and reducing its price. Many farmers and ranchers are subsidized by the government. Subsidizing farm goods ensures that there is always more than enough food and gives American farm exports a price advantage. Sometimes subsidies are given to owners of farmland to encourage them not to produce, allowing an artificially lower production of agricultural goods to keep prices artificially high (good for farmers, not so good for consumers). Critics of farm subsidies argue that it creates inefficiency and misallocates scarce resources.
Many poor countries depend on agriculture as their chief export. A sticking point in WTO negotiations is that industrialized nations want poor nations to open up to free trade, yet industrialized nations are reluctant to end farm subsidies. These subsidies make it difficult for the poor nations to compete.
Although a large number of government subsidies are agriculture related, not all of them are. For example, export subsidies are used by governments to help domestic markets compete internationally. Redevelopment subsidies encourage producers to locate in certain geographical areas.
Some government subsidies are indirect (such as a tax break or low-interest loan guarantee) but are still used to implement economic policies and to affect the market. (Tax subsidies are one reason the income tax code is so complicated!)
Some economists argue that subsidized loans and grants for college students are part of the problem, not the cure. The financial aid system, while well intentioned, has the effect of increasing demand for college. As you know, increased demand leads to higher prices.
Other subsidies are directed at consumers rather than producers (for example, a rent subsidy for a low-income earner). Consumer subsidies are often meant to protect the disadvantaged rather than to affect supply or demand, but such subsidies do affect the market.
Black markets allow illegal trade to occur. Even food subsidies for needy families are subject to black market activity. Some receiving food assistance will willingly trade $2 in food assistance for $1 cash. They benefit because they now have the freedom to purchase what they want. The buyer benefits by purchasing groceries at half price. The problem with the system is that it is inefficient and creates disutility for the recipients. The taxpayer wins under a cash payment system because he is able to give the same value of service at a fraction of the cost. The recipient wins because he is able to buy groceries without the stigma of having to pay using food stamps, and if he so chooses he can buy other things he values more.
The obvious argument against a system like this is that some might not buy food with the food assistance, but instead purchase alcohol, cigarettes, or even illegal drugs. Consider this example: Assume that a person receiving food assistance also has an addiction to cigarettes. She receives $100 in food stamps and immediately sells them on the black market so that she can buy $50 in cigarettes. In the end, she has $50 in cigarettes and no food. Now assume that a person receiving food assistance receives $100 cash. He purchases $50 in cigarettes, but now has $50 left for food. He is better off and the taxpayer is better off. In addition, the cash payment system removes the black market and is much less expensive to administer.