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Cui Bono? Who Gains and Who Loses

December 1, 1996


Edward Lotterman Agricultural Economist
Cui Bono? Who Gains and Who Loses

"Cui bono?" was a query used in debate in the Roman Senate. Meaning "to whose benefit," the question cuts to the heart of many proposed legislative measures. Who really benefits when government subsidizes a particular industry? Many people's first response would be, "Well, who cashed the checks?"

Unfortunately, the answer is not that simple: The direct recipient of a government payment is not necessarily the only person who benefits, and in some cases the payee of a government check experiences only modest increases in net incomes relative to the size of the government expenditure. At the same time, people not engaged in the subsidized activity may find their incomes or net worth directly affected by the legislation.

Similarly, the person who writes out a check to pay taxes does not always actually bear the entire cost of the tax. This question, who really benefits or loses from a subsidy or tax, is referred to by economists as "incidence." The concept can be explained by examples from familiar taxes that many people pay, but also by examples from various agricultural subsidy programs over the past 60 years.

It is best to begin with the incidence of taxes, since nearly everyone pays some kind of tax and subsidies are received by fewer people. Once the general principles of incidence are illustrated on the tax side, a few features of farm legislation will be analyzed to show how an analagous disparity exists between the nominal and real recipient of a subsidy.

Who really pays taxes

Who really pay taxes? To many people's surprise, and in some cases disbelief, the person who pays a tax seldom bears the entire cost of the tax. To consumers, it seems clear that they bear the cost of a sales tax on goods or services. After all, sales taxes are itemized at the bottom of invoices or receipts, even though it is the merchant who must actually send a check to some state department of revenue.

Similarly, although the state and federal taxes on motor fuels are not itemized or specified on retail sales, most auto owners believe that they are the ones who ultimately pay the tax, not the gas station owner, refiner or crude producer.

Conversely, many people apparently believe that they do not bear the burden of corporate income taxes, at least if the pervasiveness of election-year calls to "raise taxes on corporations and not on families" are any indication. Many apparently are convinced that corporate income taxes come out of the pockets of some impersonal institution rather than of some individual, or perhaps that the only individuals affected are a corps of fat cats who either own the stock of, or hold executive positions in, large businesses.

The truth, as many undergraduates studying microeconomics or public finance discover, is somewhat more complex. Producers do bear at least part of the burden of excise or sales taxes. They do so because the tax raises the apparent consumer price of the goods they sell, and there is usually some reduction in the quantity demanded when the tax is imposed or raised, and producers' sales go down.

Nowhere is this more apparent than in reactions to proposals to broaden the base of state sales taxes. Sales taxes cover some retail purchases in all district states except Montana. From time to time, as states face funding squeezes, proposals surface in legislatures to lengthen the list of goods or services to which the tax applies. In many states some services, such as the preparing and serving of food in restaurants, is already subject to the sales tax. On occasion, proposals are made to extend this to legal services, another commonly procured type of service. Such proposals seldom get very far in legislatures, where "attorney-at-law" is one of the most common occupations for legislators.

Why would attorneys object to having their services made subject to the sales tax, if consumers are the ones who pay sales taxes? Because they know that producers do bear some of the cost, and that their business and income would suffer if their fees were raised by 4 percent or 6 percent.

Another example is the tax on luxury automobiles, boats and aircraft that was introduced in 1990. Touted as a way to close the federal budget deficit by taxing only the rich, the measure actually did little of the sort. The demand for yachts is such, for example, that the number of large boats sold dropped precipitously after imposition of the tax. Yacht building is labor-intensive, and many workers were laid off by boatbuilders. Wealthy households simply shifted their recreation dollars to other activities that were not taxed, or bought used boats instead. In this case, wealthy people paid little in taxes, less wealthy workers saw their incomes drop, owners of existing boats saw the value of their assets rise. Similarly, dealers in new boats saw their sales drop, but yacht brokers specializing in used boats realized a bonanza. Congressmen from states with boatbuilding firms clamored to have the tax repealed, and it was—for boats and airplanes—after 3 years (auto dealers had to wait until 1996 for a luxury tax phase-out law).

Similarly, the cost of corporate income tax is not necessarily all paid by high-level executives or stockholders. Depending on a variety of factors, the cost of a tax may be borne by the firm's workers, either labor or management, its input suppliers, its owners (shareholders) or its customers. In fact, studies show that in a competitive economy, most of the cost of the corporate income tax is incorporated in the cost of the product, and thus paid by consumers when they buy gas, breakfast cereal, televisions or clothing. It does little to reduce the incomes of executives or shareholders in Exxon, General Mills, Sony or Wal-Mart.

While determining who actually "pays" a tax involves some technicalities, the general lesson is clear. The incidence of a tax, that is who really pays the tax, is not necessarily or entirely the party that actually makes out a check to the revenue authorities.

Subsidies: Cui bono?

This same issue of incidence applies to subsidies, which can be thought of as a negative tax. Subsidies to agriculture in the form of direct payments or higher prices might result in higher incomes for farm operators. But they could also cause an increase in the rents received by landlords or the asset values of landowners, groups that overlap very incompletely with farm operators.

Higher prices might also motivate farmers to use more seed, fertilizer and fuel, thus increasing the incomes of owners of businesses that supply such inputs and perhaps the number or wages of employees of input firms. If higher prices or reduced risk result in net increases in the quantities produced for some foods, consumers may capture some of the benefits of the subsidy.

Increased inputs, particularly when used to produce outputs for which there is no market buyer, can also represent a waste of resources. Land, diesel fuel, seed, labor and fertilizer used to produce wheat that no one will eat at the price received by the producer is simply a misuse of such inputs and a dead-weight loss to society.

Ricardo was right

Legislation is often complex and contradictory, an inevitable result of the political compromises that occur in the legislative process. But over time, the contradictions in U.S. farm legislation became greater and greater, and the true incidence of both benefits and costs became less and less clear.

One thing that held true for virtually all of the period from passage of the Agricultural Adjustment Act of 1933 to that of the Federal Agricultural Improvement and Reform Act of 1995 is that farm land owners, as opposed to farm operators, captured a significant portion of federal subsidies in the form of higher land values. The British classical economist David Ricardo was the first to explain how the annual income from an asset becomes reflected in its market price. From this, if the income from a piece of land increases, whether due to higher product prices or higher subsidy levels, some, if not all, of that increase in income will become capitalized into the price of land itself. Thus, new or higher levels of agricultural subsidies tend to increase the wealth of land owners at the time the subsidy is introduced and not the ongoing net incomes of farm operators.

The mechanism typically runs like this: A price support is introduced that will "cover the cost of production plus a fair profit" in the usual terms of its proponents. What is implied, but not always stated, is that this would be true for the average producer. But in a competitive sector, the most innovative and efficient farmers will find that this support, calculated for the average producer at some point in time, brings them very remunerative returns. They respond by bidding up the price of land in both rental and purchase markets. Land prices and rents rise, and returns to the average producer at the new levels no longer cover "the cost of production plus a fair profit."

Experience with U.S. support programs has demonstrated again and again that the most efficient producers make out very well at support levels that guarantee the "cost of production," including land costs to the average producer, and land values are bid up. If the support level is recalculated to reflect the new, higher "cost of production," the result is a ratcheting effect that escalates production and public expenditure without providing long-term "fair profits" for average or below-average producers.

Consumers got a cut too

At first examination, features of farm bills that tended to raise market prices transferred money from consumers to producers. But farm bills frequently had provisions that acted somewhat more subtly in the other direction. In the 1970s and 1980s, policy researchers increasingly examined the effects of the ways in which farm programs reduced risk for farmers, and the effects of such risk reduction.

Researchers found that farm programs reduced the volatility of farm prices and incomes, thus reducing risk to farmers. This reduction in risk motivated farmers to use increased inputs and make capital investments that they would not have made otherwise. An analogy would be a business's willingness to construct a new building if it can insure it against risks, such as fire and wind, than if it cannot. But when farmers use more inputs or make greater investments, production is increased and consumer prices are lower than they might be otherwise. The farmer as an individual may benefit, but the net effects of the policy on farmers as a group are reduced.

The importance of the consumer benefits of risk reduction relative to the consumer costs of other aspects of farm legislation remains the subject of disagreement among analysts. But it is an example of how complex programs can have very ambiguous effects.

Finally, there are other ways in which consumers might capture some of the benefits ostensibly intended for farmers. To some extent, direct payments such as deficiency payments or payments for annual acreage set-asides kept farmers producing in spite of relatively low market prices for grains. Low grain prices in turn induced livestock producers to raise and sell more animals than they would have if feed prices had been higher. More animals meant that there was more meat in the supermarket, at a lower price, than there would have been if grain producers had not gotten checks from the Department of Agriculture.

Benefits may spill abroad

U.S. consumers are not the only food buyers who benefited from some aspects of farm legislation. Whenever the U.S. subsidized exports of food or agricultural products, consumers in the importing nations generally were able to purchase food at lower prices than they would have otherwise. The U.S. subsidized food exports under a variety of programs nearly continuously from 1954 through 1996. The payments to grain trading companies for the difference between their high domestic purchase costs and lower price received from the Soviet Union in the famous 1972 "Soviet grain deal" would be termed "corporate welfare" in today's jargon, but Soviet consumers and the Soviet government captured much more of the U.S. Treasury's expenditure than did Cargill, Bunge, Continental or any other grain trader.

In the 1980s and 1990s, Moroccan and Tunisian households were able to buy cheap bread and flour because the United States and European Union were engaged in a grain export subsidy trade war. Economists are generally critical of such export subsidies because such a high proportion of the benefit flows to people outside the country. They are also an extremely inefficient and costly way to raise farm incomes.

The flow of benefits to foreigners is not the only reason why economists oppose export subsidies. Such subsidies also hurt producers in other countries who have to compete with subsidized imports or who find demand for their exports limited by the imports. This often hurts very poor people; peasant dairy farmers in Ecuador and Peru were nearly wiped out by subsidized sales of European dairy products in the 1980s. And U.S. subsidized exports of cotton and tobacco in the 1950s in the guise of Food for Peace wrecked economic havoc with cotton producers in the Egyptian delta and with tobacco producers in Cuba, Brazil, Bulgaria and other countries.

Beyond these questions of fairness, of who wins and loses, is that of efficient use of resources. When a government encourages production with high and subsidized prices domestically, then dumps excess production abroad, resources are wasted. Too many resources are devoted to farming in the subsidizing country, and too few in the nonsubsidizing countries in the rest of the world. Ultimately, the world as a whole is worse off.