How Government Subsidies Are Supposed to Work - SmartAsset

Subsidies, which are a kind of economic stimulus, are government payments made to businesses. Subsidies can target either specific companies or an entire industry, and they typically apply in one of two ways. In some programs the government supports an industry directly, providing cash payments, tax breaks, or paying for certain costs. In other programs the government supports an industry by making their products cheaper for consumers, often by providing vouchers or breaks on taxes. Through subsidies, a government can encourage a business that would otherwise be unprofitable in the free market. Consider working with a financial advisor to take maximum advantage of government assistance.

How Subsidies Work

Subsidies are one of the most common ways that the government adjusts and manipulates the market.

When the government subsidizes an industry, it does so by either reducing the costs of production or by reducing the costs of consumption. Reducing the costs of production generally involves making it cheaper for businesses to operate, or providing them with direct cash payments. Reducing the costs of consumption generally involves making an industry’s products cheaper, or providing consumers with payments to help buy those products and services.

Subsidies can take many forms. Some of the most common include:

Tax Subsidies – The government reduces taxes for a given industry. This often involves reducing the taxes that companies pay directly (through income tax breaks) or on products essential to their supply chain.
Cash Subsidies – The government directly sends money to companies operating within a given industry. Typically cash subsidies are functionally tax subsidies, since most are distributed as refundable tax credits.
Consumer Subsidies – The government will give consumers some form of payment for spending money on a given industry. This can take a wide variety of forms, but the most common are tax breaks and vouchers. (The income tax mortgage deduction, for example, is a commonly used form of consumer subsidy.)
Purchase Subsidies – The government will buy a large number of products from companies operating in a given industry. This guarantees companies a minimum amount of business.
Loan Guarantees – The government backs up lending in a certain industry. This can happen in a variety of ways, from helping with interest to guaranteeing payment on the loan outright. This allows lending to happen to consumers, who can then buy products. The most common example of this is student loans. Without Department of Education guarantees, it is unlikely that banks would extend the crushing amounts of debt involved with university tuition to students.

Note that while a government can subsidize a specific business, this rarely happens. As a general rule it’s illegal to subsidize a specific business at the expense of its competitors. When this happens it’s typically in the context of defense contractors, where the military works with a limited number of companies for security purposes.

The Most Common Subsidies

Governments subsidize an industry in two major situations.

The first is when they want to encourage a specific type of production that the free market otherwise will not provide. A common example of this is alternative energy production. To combat global warming the government wants companies to develop energy sources such as solar and wind production, but those remain inefficient or expensive compared to fossil fuels. As a result, the government subsidizes companies that develop alternative energy sources. This allows them to compete in a market where they have a product that is financially inefficient (fossil fuels remain cheaper than solar panels) but socially beneficial.

The second situation is when they want to reduce the price of certain products below what the market will provide.

A common example of this is farm subsidies. People need food, so there’s little risk of farms dying out as an industry. However the government doesn’t want the price of food to rise too high. Left up to the free market, that might happen. The government also seeks to protect domestic farmers from international competition. So the U.S. government subsidizes farmers, allowing them to charge less for food and stay in business.

The Purpose of Subsidies

Subsidies aim to encourage private companies to pursue lines of business that the government believes will serve a public good.

While the free market efficiently provides for many things that an economy needs, it often produces results that are either insufficient or contrary to public interest. In some cases, a government will solve this by providing the service directly. For example, in the 19th century it was common for firefighting to be a for-profit service. Eventually city governments decided that all citizens should have the right to live without fear of burning to death in a house fire, so firefighting became a civil service.

In other cases a government will solve the problem by subsidizing an industry. When this happens it means that the government has decided that the service is still best provided by the free market, but that the market will not do so on its own. The government needs to step in and help make it slightly more profitable to do business, one way or another.

The Bottom Line

Subsidies are a way that the government encourages the free market to provide a service that the market otherwise wouldn’t provide. By providing tax breaks, cash incentives and other forms of assistance, the government can make it easier for certain industries to operate.

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One of the most common subsidies is loan guarantees. A key difference between subsidized loans and unsubsidized loans is who pays the interest on the loan.