# Understanding Government Subsidies: Types, Benefits, and Drawbacks

## What Is a Subsidy?

Subsidies, often provided by governments, are financial benefits awarded to individuals, businesses, or institutions. These benefits can be direct, like cash payments, or indirect, such as [tax reductions](https://www.investopedia.com/terms/t/tax-break.asp). Subsidies aim to alleviate burdens and are typically justified as measures to promote social welfare or specific economic policies.

### Key Takeaways

*   Subsidies are financial benefits typically given by governments to individuals, businesses, or industries to alleviate burdens or promote economic and social policies. They can be direct (cash payments) or indirect (tax breaks, price reductions).
*   Direct subsidies involve actual cash payments toward specific recipients, while indirect subsidies do not involve cash but include advantages such as reduced prices for goods or services.
*   Advocates argue that subsidies support struggling industries, encourage development, and address market failures by increasing production to socially optimal levels.
*   Opponents believe subsidies distort market efficiencies, maintain inefficient resource allocation, and can lead to political and economic manipulation.
*   Government subsidies often spark political debates, as they are seen as either successful in achieving cultural or political goals or as failures that distort economic outcomes by influencing market dynamics.

![Subsidy](https://www.investopedia.com/thmb/fPNeM4ct9sL8T6vPGCFxo1MpMYE=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Subsidy-resized-3e847b1457174be0aaeb0760e42ca2e8.jpg)

*— Investopedia / Xiaojie Liu*

## Understanding the Mechanics of Subsidies

A subsidy is generally some form of payment—provided directly or indirectly—to the receiving individual or business entity. Subsidies are considered privileged financial aid because they reduce burdens or encourage specific actions through financial support.

Subsidies come with [opportunity costs](https://www.investopedia.com/terms/o/opportunitycost.asp). For example, Great Depression-era agricultural subsidies helped farmers earn more and hire workers. However, the funds for these subsidies came from taxes, leading to higher grocery prices for consumers.

## Exploring Different Types of Subsidies

A subsidy typically supports particular sectors of a nation’s economy. It can assist struggling industries by lowering the burdens placed on them or encourage new developments by providing financial support for the endeavors. These sectors often lack proper support from the general economy or face competition from rival economies.

### Comparing Direct and Indirect Subsidies

Direct subsidies are those that involve an actual payment of funds toward a particular individual, group, or industry. Indirect subsidies lack a set monetary value and don't involve direct cash payments. They include government-backed price reductions for essential goods or services. This allows the needed items to be purchased below the current [market rate](https://www.investopedia.com/terms/o/open-market-rate.asp), resulting in savings for those whom the subsidy is designed to help.

### A Closer Look at Government Subsidies

There are many forms of subsidies given out by the government. Two of the most common types of individual subsidies are [welfare](https://www.investopedia.com/terms/w/welfare.asp) payments and [unemployment benefits](https://www.investopedia.com/terms/u/unemployment-income.asp). The objective of these types of subsidies is to help people who are temporarily suffering economically. Other subsidies, such as subsidized interest rates on [student loans](https://www.investopedia.com/terms/e/education-loan.asp), are given to encourage people to further their education. 

The [Affordable Care Act (ACA)](https://www.investopedia.com/terms/a/affordable-care-act.asp) made some U.S. families eligible for subsidies based on income and family size. These subsidies help reduce insurance premium costs by sending funds directly to the insurance company, thus lowering household payments.

Subsidies to businesses are given to support an industry that is struggling against international competition that has lowered prices, such that the domestic business is not profitable without the subsidy. Historically, the vast majority of subsidies in the United States have gone toward four industries: agriculture, financial institutions, [oil companies](https://www.investopedia.com/articles/investing/011216/understanding-how-oil-companies-pay-taxes.asp), and utility companies.

## Weighing the Pros and Cons of Subsidies

Different rationales exist for the provision of public subsidies. Some are economic, some are political, and some come from socioeconomic [development theory](https://www.investopedia.com/terms/d/development-economics.asp). Development theory suggests that some industries need protection from external competition to maximize domestic benefit.

Technically speaking, a free market economy is free of subsidies; introducing one transforms it into a [mixed economy](https://www.investopedia.com/terms/m/mixed-economic-system.asp). Economists and policymakers often debate the merits of subsidies and, by extension, the degree to which an economy should be mixed.

### Advantages

Pro-subsidy economists argue that subsidies to particular industries are vital to helping support businesses and the jobs that they create. Economists who support a mixed economy argue that subsidies can achieve the socially optimal level of goods and services, leading to [economic efficiency](https://www.investopedia.com/terms/e/economic_efficiency.asp).

In contemporary [neoclassical economic](https://www.investopedia.com/terms/n/neoclassical.asp) models, there are circumstances where the actual supply of a good or service falls below the theoretical [equilibrium](https://www.investopedia.com/terms/e/equilibrium.asp) level—an unwanted shortage, which creates what economists call a market failure.

One form of correcting this imbalance is to subsidize the good or service being undersupplied. The subsidy lowers the cost for the producers to bring the good or service to market. If the right level of subsidization is provided, all other things being equal, then the market failure should be corrected.

In other words, according to [general equilibrium theory](https://www.investopedia.com/terms/g/general-equilibrium-theory.asp), subsidies are necessary when a market failure causes too little production in a specific area. They would theoretically push production back up to optimal levels.

> **Important**
>
> Some theories of development argue that the governments of less-developed countries should subsidize domestic industries in their infancy to protect them from international competition. This is a popular technique seen in China and various South American nations at present.

Some say goods or services provide what economists call positive externalities. A positive [externality](https://www.investopedia.com/terms/e/externality.asp) is achieved whenever an economic activity provides an indirect benefit to a third party.

However, because the third party does not directly enter into the decision, the activity will only occur to the extent that it directly benefits those directly involved, leaving potential social gains on the table.

Many subsidies are implemented to encourage activities that produce positive externalities that might not otherwise be provided at the socially optimal threshold. The counterpart of this kind of subsidy is to tax activities that produce negative externalities.  

### Disadvantages

Meanwhile, other economists feel [free market](https://www.investopedia.com/terms/f/freemarket.asp) forces should determine if a business survives or fails. If it fails, those resources are allocated to more efficient and profitable use. They argue that subsidies to these businesses simply sustain an inefficient allocation of resources.

Free market economists are wary of subsidies for a variety of reasons. Some argue that subsidies unnecessarily distort markets, preventing efficient outcomes and diverting resources from more productive uses to less productive ones.  

Similar concerns come from those who suggest that economic calculation is too inexact and that [microeconomic models](https://www.investopedia.com/terms/m/microeconomics.asp) are too unrealistic to ever correctly calculate the impact of market failure. Others suggest that government spending on subsidies is never as effective as government projections claim it will be. The costs and unintended consequences of applying subsidies are rarely worth it, they claim.

Another problem, antagonists point out, is that the act of subsidizing helps corrupt the political process. According to political theories of [regulatory capture](https://www.investopedia.com/terms/r/regulatory-capture.asp) and [rent seeking](https://www.investopedia.com/terms/r/rentseeking.asp), subsidies exist as part of an unholy alliance between big business and the state. Companies often turn to the government to shield themselves from the competition. In turn, businesses donate to politicians or promise them benefits after their political careers.

Even if a subsidy is created with good intentions, without any conspiracy or self-seeking, it raises the profits of those receiving beneficial treatment, thus creating an incentive to lobby for its continuance, even after the need or its usefulness runs out. This potentially allows political and business interests to create a mutual benefit at the expense of taxpayers and/or competitive firms or industries.

## Navigating the Political Landscape of Subsidies

There are a few different ways to evaluate the success of government subsidies. Most economists consider a subsidy a failure if it fails to improve the overall economy. However, policymakers might still consider it a success if it helps achieve a different objective. Most subsidies are long-term failures in the economic sense but still achieve cultural or political goals.

An example of these competing evaluations could be seen in the [Great Depression](https://www.investopedia.com/terms/g/great_depression.asp). Presidents Herbert Hoover and Franklin D. Roosevelt both set price floors on agricultural products and paid farmers to not produce. Their policy goal was to stop food prices from falling and to protect small farmers. To this extent, the subsidy was a success.

But the economic effect was quite different. Artificially high food prices lowered the [standard of living](https://www.investopedia.com/terms/s/standard-of-living.asp) for consumers and forced people to spend more on food than they otherwise would have. Those outside of the farm industry were worse off in absolute economic terms.

Sometimes, subsidies may appear to have run their course or continue to create an artificial market, but there are other factors that keep them in place. Production subsidies by [G-20](https://www.investopedia.com/terms/g/g-20.asp) countries averaged $290 billion per year from 2017 to 2019, with 95% going toward oil and gas. Meanwhile, 2019 global consumption subsidies were $320 billion, driven largely by oil and gas.

The combination of production and consumption subsidies in the oil and gas industry creates overconsumption by artificially lowering the price of fossil fuels; however, these subsidies (on both the production and consumption sides) have lots of political and systemic support and pushback from consumers and energy companies that would be impacted if reform did happen.

In terms of a pragmatic political economy, a subsidy is successful from the point of view of its proponents if it succeeds in transferring wealth to its beneficiaries and contributing to the reelection of its political backers.

The strongest advocates of subsidies tend to be those who directly or indirectly gain from them, and the political incentive to “bring home the bacon” to secure support from special interests is a powerful lure for politicians and policymakers.

## What Is the Difference Between Direct and Indirect Subsidies?

Direct subsidies are those that involve an actual payment of funds toward a particular individual, group, or industry. Indirect subsidies are those that do not hold a predetermined monetary value or involve actual cash outlays. These can include activities such as price reductions for required goods or services that can be government-supported.

## What Is the Position of Subsidy Advocates?

Subsidies exist in mixed economies. Proponents argue that subsidies to particular industries are vital to helping support businesses and the jobs that they create. Proponents further contend that subsidies are justifiable to provide the socially optimal level of goods and services, which will lead to economic efficiency.

## What Is the Position of Subsidy Opponents?

Technically speaking, a free market economy is free of subsidies. Subsidy opponents feel free market forces should determine if a business survives or fails. If it fails, those resources will be allocated to more efficient and profitable use. Opponents argue that subsidies unnecessarily distort markets, preventing efficient outcomes as resources are diverted from more productive uses to less productive ones.

## The Bottom Line

A subsidy given to an individual, business, or institution—usually by the government—can be direct or indirect. They can assist struggling industries, encourage new developments, and promote a social good or policy. Sometimes by helping one sector or group in the economy, they hurt another group, such as a subsidy that helps farmers but increases food prices for consumers. Or they can fail economically but achieve cultural or political goals.  

> **Article Sources**
>
> 1.  Congress.gov, U.S. Congress. “[Public Law 111-148: Patient Protection and Affordable Care Act](https://www.congress.gov/111/plaws/publ148/PLAW-111publ148.pdf).”
>     
> 2.  The Atlantic. “[The Bitter Origins of the Fight Over Big Government](https://www.theatlantic.com/magazine/archive/2019/03/fdr-herbert-hoover-big-government/580456/).”
>     
> 3.  Econlib. “[Hoover’s Economic Policies](https://www.econlib.org/library/Enc/HooversEconomicPolicies.html).”
>     
> 4.  Brookings Institution. “[Reforming Global Fossil Fuel Subsidies: How the United States Can Restart International Cooperation](https://www.brookings.edu/research/reforming-global-fossil-fuel-subsidies-how-the-united-states-can-restart-international-cooperation/).”