A subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering production costs, subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export markets. According to the World Trade Organization, in mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21 developed nations.4 In response to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009 some developed nations gave $45 billion in subsidies to their automobile makers. While the purpose of the subsidies was to help them survive a very difficult economic climate, one of the consequences was to give subsidized companies an unfair competitive advantage in the global auto industry.
A payment made by the government to producers of a good or service, which is intended to lower their costs.
Agriculture tends to be one of the largest beneficiaries of subsidies in most countries. The European Union has been paying out about €44 billion annually ($55 billion) in farm subsidies. In May 2002, President George W. Bush signed into law a bill that contained subsidies of more than $180 billion for U.S. farmers spread over 10 years. This was followed in 2007 by a farm bill that contained $286 billion in subsidies for the next 10 years. The Japanese also have a long history of supporting inefficient domestic producers with farm subsidies. The accompanying Country Focus looks at subsidies to wheat producers in Japan.
Nonagricultural subsidies are much lower, but they are still significant. For example, subsidies historically were given to Boeing and Airbus to help them lower the cost of developing new commercial jet aircraft. In Boeing’s case, subsides came in the form of tax credits for R&D spending or Pentagon money that was used to develop military technology, which then was transferred to civil aviation projects. In the case of Airbus, subsidies took the form of government loans at below-market interest rates.
The main gains from subsidies accrue to domestic producers, whose international competitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help domestic firms achieve a dominant position in those industries in which economies of scale are important and the world market is not large enough to profitably support more than a few firms (aerospace and semiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry (just as U.S. government subsidies, in the form of substantial R&D grants, allegedly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.
Whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. Rather, they tend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would be better off by $160 billion.5 Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs) would raise world income by $182 billion.6 This increase in wealth arises from the more efficient use of agricultural land. For a specific example, see the Country Focus on wheat subsidies in Japan.
IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS
An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is usually enforced by issuing import licenses to a group of individuals or firms. For example, the United States has a quota on cheese imports. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is given directly to the governments of exporting countries. Historically, this is the case for sugar and textile imports in the United States. However, the international agreement governing the imposition of import quotas on textiles, the Multi-Fiber Agreement, expired in December 2004.
A direct restriction on the quantity of a good that can be imported into a country
COUNTRY FOCUS Subsidized Wheat Production in Japan
Japan is not a particularly good environment for growing wheat. Wheat produced on large fields in the dry climates of North America, Australia, and Argentina is far cheaper and of much higher quality than anything produced in Japan. Indeed, Japan imports some 80 percent of its wheat from foreign producers. Yet tens of thousands of farmers in Japan still grow wheat, usually on small fields where yields are low and costs high—and production is rising. The reason is government subsidies designed to keep inefficient Japanese wheat producers in business. In mid-2000, Japanese farmers were selling their output at market prices, which were running at $9 per bushel, but they received an average of at least $35 per bushel for their production! The difference—$26 a bushel—was government subsidies paid to producers. The estimated costs of these subsidies were more than $700 million a year.
To finance its production subsidy, Japan operates a tariff rate quota on wheat imports in which a higher tariff rate is imposed once wheat imports exceed the quota level. The in-quota rate tariff is zero, while the over-quota tariff rate for wheat is $500 a ton. The tariff raises the cost so much that it deters over-quota imports, essentially restricting supply and raising the price for wheat inside Japan. The Japanese Ministry of Agriculture, Forestry, and Fisheries (MAFF) has the sole right to purchase wheat imports within the quota (and because there are very few over-quota imports, the MAFF is a monopoly buyer on wheat imports into Japan). The MAFF buys wheat at world prices and then resells it to millers in Japan at the artificially high prices that arise due to the restriction on supply engineered by the tariff rate quota. Estimates suggest that in 2004, the world market price for wheat was $5.96 per bushel, but within Japan the average price for imported wheat was $10.23 a bushel. The markup of $4.27 a bushel yielded the MAFF in excess of $450 million in profit. This “profit” was then used to help cover the $700 million cost of subsidies to inefficient wheat farmers, with the rest of the funds coming from general government tax revenues.
Thanks to these policies, the price of wheat in Japan can be anything from 80 to 120 percent higher than the world price, and Japanese wheat production, which exceeded 850,000 tons in 2004, is significantly greater than it would be if a free market was allowed to operate. Indeed, under free market conditions, there would be virtually no wheat production in Japan because the costs of production are simply too high. The beneficiaries of this policy are the thousands of small farmers in Japan who grow wheat. The losers include Japanese consumers, who must pay more for products containing wheat and who must finance wheat subsidies through taxes, and foreign producers, who are denied access to a chunk of the Japanese market by the over-quota tariff rate. Why then does the Japanese government continue to pursue this policy? It continues because small farmers are an important constituency and Japanese politicians want their votes.
Sources: J. Dyck and H. Fukuda, “Taxes on Imports Subsidize Wheat Production in Japan,” Amber Waves, February 2005, p. 2; and H. Fukuda, J. Dyck, and J. Stout, “Wheat and Barley Policies in Japan,” U.S. Department of Agriculture research report, WHS-04i-01, November 2004.
Tariff Rate Quota
Lower tariff rates applied to imports within the quota than those over the quota.
A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota rate of 80 percent might be applied. Thus, South Korea might import 2 million tons of rice, 1 million at a 10 percent tariff rate and another 1 million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal is to limit imports over quota. An example is given in the Country Focus that looks at how Japan uses the combination of a tariff rate quota and subsidies to protect inefficient Japanese wheat farmers from foreign competition