James d. Gwartney

Video:
Rent Seeking

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Watch out for Inefficiencies Even From
Useful Subsidies
To non-economists, income look like an effective way to help targeted
beneficiaries. However, economic analysis
indicates that it is actually quite difficult to
transfer income to a group of recipients in a
way that will improve their long-term well-
being. As is often the case in economics,
the unintended secondary effects explain
why this proposition is true.
Three major factors undermine the
effectiveness of income transfers. While
the process may be easiest to see in the case
of direct income transfers like welfare assistance, the same types of forces occur when the
benefits are agricultural subsidies or grants to individuals or corporations.
First, an increase in government transfers will generally reduce the incentive of both
the taxpayer-donor and the transfer recipient to earn income and create value. Many transfer
programs provide for an inverse relationship between the size of the transfer and the income
level of the recipient. As the recipient’s income rises, the amount of the transfer is reduced.
When this is the case, neither taxpayers nor transfer recipients will produce and earn as much
as they would in the absence of the transfer program. As taxes go up to finance greater
transfers, taxpayers have less incentive to make the sacrifices needed to produce and earn, and
more incentive to invest in tax shelters to try to keep the money they earned. Similarly,
ELEMENT 3.8
The net gain of transfer recipients is less, and often substantially less, than the amount of
the transfer.

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recipients will have less incentive to earn because additional earnings will increase their net
income by only a fraction—and in many cases only a small fraction—of their additional
earnings. As a result, economic growth will be slowed.
To see the negative effect of almost any transfer policy on productive effort, consider
the reaction of students if a professor announces at the beginning of the term that the grading
policy for the class will redistribute the points earned on the exams so that no one will receive
less than a C. Under this plan, students who earned A grades by scoring an average of 90
percent or higher on the exams would have to give up enough of their points to bring up the
average of those who would otherwise get Ds and Fs. And, of course, the B students would
also have to contribute some of their points as well, although not as many, in order to achieve a
more equal grade distribution.
Does anyone doubt that at least some of the students who would have made As and Bs
will study less when their extra effort is “taxed” to provide benefits to others? And so would
the students who would have made Cs and Ds, since the penalty for exerting less effort would
be cushioned by point transfers they would not be given if they earned more points on their
own. The same logic applies even to those who would have made Fs, although they probably
weren’t doing very much studying anyway. Predictably, the outcome will be less studying by
everyone in the class, and overall achievement will decline.
The impact of tax and transfer schemes is similar: less work effort and lower overall
income levels. Income is not like “manna from heaven.” Instead, it is something that people
produce and earn. Individuals earn income as they provide goods and services for others
willing to pay for them. We can think of determined by the actions of millions of people, each using production and trade to earn an
individual slice. It is impossible to redistribute portions of the slices they might earn without
simultaneously reducing the work effort and innovative actions that generate the pie in the first
place.
Second, competition for transfers can erode most of the long-term gain of the intended
beneficiaries. Governments must establish a criterion for the receipt of income transfers and
other political favors. If they did not do so, the transfers would bust the budget immediately.
Generally, the government will require a transfer recipient to own something, do something, or

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be something. For example, the recipient of unemployment pay must be out of a job, and a
company must not have more than a certain number of employees to qualify for a small-
business grant or loan. Once the criterion is established, people will modify their behavior to
qualify for the “free” money or other government favors. As they do so, their net gain from the
transfers declines.
Think about the following: suppose that the Polish government decided to give away
300 zloty in cash between 9:00 a.m. and 5:00 p.m. each weekday to all persons willing to wait
in line at the teller windows of the Ministry of Finance. Long lines would emerge. How long?
How much time would people be willing to take from their leisure and their productive
activities? A person whose time was worth 30 zloty per hour would be willing to spend almost
as much as ten hours waiting in line for the 300 zloty cash. But it might take longer than ten
hours if there were enough others whose time was worth less, say 20 zloty or 10 zloty per hour.
Everyone would find that the time spent waiting consumed much of the value of the 300 zloty
transfer. If the proponents thought the program would make the recipients 300 zloty better off,
they would have been wrong.
This example illustrates why the intended beneficiaries of transfer programs are not
helped as much as is generally perceived. When beneficiaries have to do something in order to
qualify for a transfer (for example, wait in line, fill out forms, lobby government officials, take
an exam, endure delays, or contribute to selected political campaigns), much of their potential
gain can often be lost as they seek to meet the qualifying criteria. Similarly, when beneficiaries
have to own something in order to get a subsidy (for example, land with a history of past
production of a particular crop or a license to operate a taxicab or sell a product to foreigners),
people will bid up the price of the asset needed to acquire the subsidy. The higher price of the
asset, such as taxicab licenses, will capture the value of the subsidy.
In each case the potential beneficiaries will compete to meet the criteria until they
dissipate much of the value of the transfer. As a result, the recipient’s net gain will generally be
substantially less than the amount of the transfer payment. Indeed, the net gain of the marginal
recipient (the person who barely finds it worthwhile to qualify for the transfer) will be very
close, if not equal, to zero.
Consider the impact of subsidies (grants and low-cost loans) to college students in the

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United States. These programs were designed to make college more affordable. But the
subsidies also increase the demand for college, which pushes tuition prices upward. A recent
study by the Federal Reserve Bank of New York estimates that about 65 percent of the
increases in transfers to students was passed through in the form of higher tuition prices.
Furthermore, the subsidy programs have contributed to a glut of college students entering the
job market, which has reduced their employment prospects as well as the value of their
degrees. In post-communist transition countries, rapid expansion, combined with low quality
and irrelevance (in many fields) of university education, has resulted in a serious problem of
“overeducation” where graduates end up taking jobs in which they do not need a university
education. Many such graduates remain trapped in low-skilled jobs years after completing
schooling.
There is a third reason for the ineffectiveness of transfers. Transfer programs reduce the
adverse consequences suffered by those who make imprudent decisions, thereby reducing their
motivation to take steps to avoid the adversity. For example, government subsidies of
insurance premiums in areas prone to hurricanes reduce the personal cost of individuals
protecting themselves against economic losses resulting from hurricanes. But there is still a
cost to society. Because the subsidy makes the purchase of hurricane insurance cheaper, more
people will build in hurricane-prone areas, which results in hurricanes doing more damage than
they would otherwise. Unemployment compensation provides another example. The benefits
make it less costly for unemployed workers to refuse existing offers and keep looking for
better jobs. Therefore, workers spend a longer time searching for jobs, which makes the
In understanding poverty and the impact of government programs, it is important to
distinguish between “being in poverty,” which is an official government statistic, and “being
deprived,” which is an intuitive understanding about the quality of life. The United States
declared a “War on Poverty” under President Lyndon Johnson in the mid-1960s. President
Johnson and other proponents of the program argued that poverty could be eliminated if only
Americans were willing to transfer a little more income to the less fortunate members of
society. They were willing, and income-transfer programs expanded substantially. As can be
seen in the chart below (Exhibit 21), transfers directed toward the poor or near poor have risen

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sharply (nine-fold) in real dollars (2017 values) since the 1960s in the United States. The rate
of poverty, however, has remained almost constant.
As President Ronald Reagan once
quipped: “In the sixties we waged a war on poverty, and poverty won.”