Microeconomics → Government Intervention → Subsidies | Part 4 of 7
Part 4 of our seven-part subsidy learning pathway. Explore how governments finance subsidies, what they cost taxpayers and the opportunity costs of public spending.
In our previous articles, we met Luke, a dairy farmer who receives a government subsidy of 5p for every litre of milk he sells. We saw how the subsidy encourages farmers to produce more milk and how both farmers and processors can benefit.
But where does the government get the money to pay for it?
One way to think about a subsidy is as a huge collective whipround.
The government uses money raised from taxpayers, or borrowed on their behalf, to support a particular group of people or activity. In Luke's case, public money helps pay dairy farmers for producing milk.
But unlike an ordinary whipround, taxpayers don't individually choose whether to contribute. And that raises an important economic question: why should society collectively pay to support this particular activity?
Where does the money come from?
Suppose Luke sells one million litres of milk a year. At 5p per litre, the government pays him £50,000.
Now imagine that farmers across the country sell one billion litres annually. The subsidy would cost the government £50 million.
The government finances its spending through revenue, including taxes, and borrowing. It collects taxes such as income tax, VAT and corporation tax. It can also borrow by issuing government bonds, known in the UK as gilts.
So although the government pays Luke, the money ultimately comes from public revenue or borrowing.
What if the government borrows the money?
The government could finance the subsidy from existing revenue, raise additional taxes, reduce other spending or borrow the money.
Suppose it decides to borrow the £50 million rather than raise additional taxes immediately. It can pay the subsidy without collecting that amount in extra taxes in the same year.
But borrowing creates a debt. The government must pay interest and eventually repay or refinance what it borrowed. These obligations may be met through future taxes, spending reductions or further borrowing.
Borrowing changes when and how the subsidy is financed. It doesn't make it free.
Does the subsidy make society £50 million richer?
No. Suppose the government collects £50 million in taxes and pays it to dairy farmers. Farmers receive £50 million, but taxpayers have £50 million less to spend or save.
The money has changed hands. The payment itself hasn't created £50 million of additional wealth. Economists call this a transfer of purchasing power.
And remember that farmers aren't necessarily the only beneficiaries. As we saw in Article 3, processors may also benefit through lower milk prices.
So we need to distinguish between who receives the subsidy, who benefits from it, and who finances it.
And we mustn't forget why the government introduced the subsidy. Perhaps it wants to protect farmers' incomes or encourage more milk production. The £50 million is the cost of making the payments, but it doesn't tell us whether the policy has achieved its objective or whether the benefits justify that cost.
Does the subsidy have other economic costs?
Yes, potentially. The subsidy encourages farmers to produce more milk. But producing that milk requires additional feed, labour, equipment and other resources.
Those resources could have been used for something else. Economists call the value of the next-best alternative forgone the opportunity cost.
Of course, the additional milk also has value. The important question is whether its benefits justify the resources used to produce it.
There may be other costs too. The government must administer the subsidy, while taxes used to finance it may affect decisions about working, saving or investing. These effects matter when assessing the subsidy's overall economic impact.
Could the government spend the money differently?
Yes. Instead of spending £50 million on milk subsidies, the government could finance other services, reduce borrowing or support lower taxes.
For example, it might choose to support agricultural research, rural infrastructure or particular farmers directly. That doesn't mean these alternatives would necessarily be better.
But it reminds us that government spending involves choices. Money devoted to one policy cannot simultaneously be devoted to another.
What have we learned?
The government pays the subsidy, but finances it through revenue or borrowing. The subsidy transfers purchasing power between groups; it doesn't automatically create additional wealth.
It can also change how resources are used and create additional costs.
Importantly, the amount the government spends isn't necessarily the same as the economic cost to society.
That leads to our final question: does a subsidy actually improve economic welfare?
Continue the Subsidies Learning Pathway
← Part 3 — Who Benefits from a Subsidy?