For my first post, I thought it would be good to give a layman’s explanation into the economics of subsidies, given the prominence of these in our daily lives as Malaysians. The point of this is to put some economics into everyday arguments over this issue and clarify some of the good and not-so-good arguments on either side.
One of the most frustrating arguments I hear about petrol subsidies is this: Malaysia is an oil exporter, so many other oil-exporting countries subsidise their oil, so Malaysia should do so too. By this logic, it would not then be a stretch to argue that as one of the largest exporters of gold, South Africa should then subsidise the “consumption” of gold by its people.
The point here is not whether we can afford it or not (although that is of course a key concern), but whether or not we could put the money to better use. There will be two strands to this argument that most microeconomists use, efficiency (can we achieve the same results at a lower cost?) and equity (is our policy the best at addressing differences between the rich and the poor?).
SUBSIDIES ARE HIGHLY INEFFICIENT
For the economists reading this, the term deadweight loss will probably come straight to mind. To illustrate this point, consider the following example. In Scenario 1, we have 2 goods, apples and oranges. Apples are subsidised, from a market price of RM2 to RM1.50 (i.e. a 50 cent subsidy) while oranges are not (priced at RM2). Say you have an income of RM10 – you would aim to purchase the affordable combination of the two goods which gives you the highest level of satisfaction (or utility, in economic terms); in this instance, let us say that is 4 apples and 2 oranges. Here, the subsidy costs the government RM0.50*4 apples = RM2.
In Scenario 2, let us say the government removes the subsidy and gave you RM2 directly instead. Notice that you can still afford what was your favourite combination earlier, i.e. 4 apples and 2 oranges (which costs RM12). Since you can still get your favourite combination under Scenario 1 (i.e. 4 apples, 2 oranges), you cannot be any worse off under Scenario 2. Additionally, given that your income and relative prices have changed here, you can now also choose a different bundle of goods which can leave you better off (i.e. give you a higher level of satisfaction than from purchasing 4 apples, 2 oranges).
Essentially, this method is what economists call revealed preference. What it states is that replacing the subsidies with lump-sum transfers that do not distort relative prices and choices between goods will lead to a greater welfare improvement for a given cost to the government purse*. The only caveat to this efficiency argument is in the case of a positive externality, whereby the consumption/production of the good has positive effects to third parties not directly involved and we may want to encourage more consumption/production but it is hard to justify most subsidies in the country with this argument. An example of this would be education, which has benefits to society beyond what you receive individually. A subsidy on education might thus be justified.
SUBSIDIES ARE RELATIVELY INEQUITABLE
The second strand of my argument is that subsidies are inequitable compared to various alternatives we might have. Consider fuel subsidies. The direct benefit to the average consumer depends on whether or not they have a vehicle, and the extent to which they use it. Clearly then, the richest 5% of the population are likely to benefit far more than the poorest 5% (who are unlikely to have a fuel-powered vehicle) from a fuel subsidy. The common justification used usually applies to subsidies on necessities; this is because as a fraction of their smaller budget, the poor would benefit more from these subsidies than the rich, making it a more equitable subsidy even if in monetary terms this is not as clear.
Nevertheless, I would argue that direct monetary handouts to the poor can be more equitable than the aforementioned subsidies. With direct monetary handouts, we can ensure the overall monetary benefit of the policy benefits the poor disproportionately in both absolute and relative terms. Recent examples would include the one-off RM500 payment to households earning below RM3000. Of course, if these benefits are intended to be continued annually, they should not be removed lump-sum at a boundary like this because it can create incentive problems, e.g. for people earning just above RM3000, there is an incentive to work less in order to go below the RM3000 boundary and obtain the extra RM500.
A better way is likely to have the benefits slowly taper off as someone earns more, which reduces the distortionary effect of people suddenly losing their benefits. Nevertheless, spending money in this way is far more equitable (it is targeted specifically at the poor) than a blanket subsidy that benefits everyone in society.
WHERE DO WE GO FROM HERE?
Given the above arguments, there appears little in defence of subsidies of what economists call private goods such as food and fuel. If we truly want to help the poor, there are far more efficient and equitable ways of doing this. Therefore, in my opinion, the debate should not revolve around whether or not we want subsidies. Rather, it should revolve around what we should do with the money if we remove the subsidies. Should it go towards improving the welfare of the rakyat through direct transfers to the poor, should it go towards financing large-scale projects that should also benefit the rakyat or should it go towards paying down our national debt? To me, there is clear justification for the removal of subsidies, what is subsequently done with the money saved is the far more important issue we should be talking about.
*For those more interested in the technical aspects of subsidies, such as what might happen if producers also get some of the incidence of the subsidy, most intermediate level microeconomics textbooks will give you a comprehensive discussion of the deadweight loss and how to quantify it in a market with several consumers.