What Is Implicit Subsidy?
An implicit subsidy is an economic benefit or advantage that is not directly paid out but arises from an underlying policy, regulation, or market perception, often resulting in lower costs or increased revenue for the recipient. Unlike an explicit subsidy, which involves direct payments or grants, an implicit subsidy represents a foregone cost or a hidden transfer of value. It is a key concept in public finance and economic analysis, as it can significantly influence resource allocation, market behavior, and the competitive landscape. These subsidies often stem from government actions, such as tax provisions, regulatory frameworks, or the perception of government backing for certain financial institutions.
History and Origin
The concept of implicit subsidy has long been recognized in economic thought, particularly in discussions surrounding government intervention and market distortions. One prominent area where implicit subsidies gained significant attention was in the aftermath of the 2008 global financial crisis, specifically concerning the "too big to fail" (TBTF) problem. This refers to the notion that certain large financial institutions are so systemically important that their failure could trigger widespread economic collapse, compelling governments to provide extraordinary support. This perception leads to an implicit subsidy, as these institutions benefit from lower borrowing costs because creditors assume they will be bailed out in a crisis. The International Monetary Fund (IMF) estimated in 2009 that large financial institutions benefited from an implicit government subsidy due to their systemic importance.8 Arthur E. Wilmarth, Jr. further elaborated on how publicly-funded bailouts of TBTF institutions provide "indisputable proof" of large explicit and implicit public subsidies.7 Separately, the concept of "tax expenditures" emerged in the U.S. in the 1960s, coined by a Treasury Department official, to refer to tax preferences that act as subsidies by foregoing government revenue.6
Key Takeaways
- An implicit subsidy is an indirect economic advantage or benefit, not a direct payment.
- It often arises from government policies, regulations, or market perceptions of support.
- Common forms include tax preferences (tax expenditures) and the "too big to fail" advantage for large institutions.
- Implicit subsidies can distort market discipline and lead to moral hazard by encouraging excessive risk-taking.
- Quantifying implicit subsidies can be complex, as they represent foregone revenue or avoided costs rather than direct outlays.
Interpreting the Implicit Subsidy
Interpreting an implicit subsidy involves understanding its economic impact, which often goes beyond direct budgetary costs. Unlike direct government spending, an implicit subsidy may not appear as an expenditure in traditional budget documents, making its true cost less transparent. For instance, the implicit subsidy conferred by the "too big to fail" status allows large banks to borrow at lower interest rates than smaller competitors, effectively giving them a competitive advantage. This reduced cost of capital allows them to take on more leverage or invest in riskier assets, knowing that the government might intervene to prevent their collapse. Similarly, tax expenditures, while reducing tax revenue, are intended to incentivize certain behaviors, but their effectiveness and distributional impact require careful analysis.
Hypothetical Example
Consider a hypothetical scenario involving "GreenTech Innovations Inc.," a startup developing renewable energy solutions. The government, keen to promote green technology, offers a special provision in the tax code allowing companies in this sector to immediately expense 100% of their research and development (R&D) costs, rather than depreciating them over several years.
Normally, R&D expenses might be amortized, meaning the tax benefit is spread out. However, under this special provision, GreenTech Innovations Inc. can deduct all $10 million of its R&D expenses in the current tax year. This immediate deduction significantly reduces its taxable income and, consequently, its tax liability for the year. This reduction in current tax payments acts as an implicit subsidy. While the government doesn't write a check to GreenTech, it foregoes tax revenue it would have otherwise collected, effectively providing financial support that boosts the company's cash flow and ability to reinvest.
Practical Applications
Implicit subsidies appear across various sectors and regulatory environments. In banking, the "too big to fail" doctrine creates an implicit subsidy for systemically important financial institutions, lowering their funding costs. The IMF noted that large banks might receive an implicit government subsidy equivalent to a significant portion of their market capitalization due to the expectation of government support.5 This impacts market competition and can encourage larger institutions to take on more leverage.
Another pervasive form of implicit subsidy is found in the U.S. tax system through what are known as "tax expenditures." These include special tax deductions, exclusions, and credits that deviate from the normal tax structure to encourage specific activities or benefit certain groups. For example, the deduction for mortgage interest or the exclusion of employer-provided health insurance from taxable income are tax expenditures.4 In 2018, these tax expenditures cost the U.S. government over $1.3 trillion in foregone revenue.3 These provisions effectively subsidize activities like homeownership or employer-sponsored healthcare without direct government payouts.
Limitations and Criticisms
Despite their potential to achieve policy objectives, implicit subsidies face several limitations and criticisms. A primary concern is their lack of transparency compared to direct spending programs. Because they are not direct budgetary outlays, their true cost to the public and their economic impact can be harder to quantify and scrutinize. This opaqueness can lead to less public accountability for these policy choices.
Another significant criticism is the potential for market distortions and the creation of moral hazard. When entities receive an implicit subsidy, especially due to perceived government backing (e.g., "too big to fail" institutions), they may be incentivized to engage in excessive risk-taking because they expect to be rescued if problems arise. This can lead to inefficient allocation of resources and exacerbate systemic risks. Critics, including those from the IMF, have highlighted that the "too big to fail" problem, stemming from implicit subsidies, remains a significant source of systemic risk in the financial system.2 Furthermore, many tax expenditures are criticized for being "upside-down" subsidies, disproportionately benefiting higher-income households who are more likely to utilize certain deductions or exclusions, thereby increasing economic inequality.1 Calls for tax reform often include reevaluating or eliminating many such implicit subsidies to broaden the tax base and improve fairness.
Implicit Subsidy vs. Tax Expenditure
While often used interchangeably, "implicit subsidy" is a broader term, and "tax expenditure" is a specific type of implicit subsidy. An implicit subsidy encompasses any indirect economic benefit that arises from government policy, regulation, or market perception, leading to an uncompensated advantage for the recipient. This could be the lower borrowing costs for "too big to fail" banks due to perceived government guarantees, or the benefit received by a utility company operating in a regulated monopoly without direct competitors.
A tax expenditure, on the other hand, refers exclusively to provisions within the tax law that reduce tax liability for specific activities or groups, thereby representing foregone government revenue. Examples include tax deductions for home mortgage interest, credits for certain investments, or exclusions of specific types of income. All tax expenditures are implicit subsidies because they provide an indirect financial benefit by reducing tax burdens rather than through direct payments. However, not all implicit subsidies are tax expenditures; the "too big to fail" advantage, for example, is an implicit subsidy but not a tax expenditure.
FAQs
What is the main difference between an implicit and explicit subsidy?
The main difference lies in their form: an implicit subsidy is an indirect benefit, such as a reduced cost or foregone revenue for the government, while an explicit subsidy is a direct financial payment or grant from the government to an individual or entity.
How does "too big to fail" relate to implicit subsidies?
The "too big to fail" concept means that certain large financial institutions are perceived as so critical to the economy that the government would intervene to prevent their collapse. This perception leads to an implicit subsidy because these institutions can borrow money at lower lending rates than their smaller counterparts, as creditors assume less risk due to the implicit government guarantee.
Are tax breaks considered implicit subsidies?
Yes, many tax breaks, often referred to as tax expenditures, are considered implicit subsidies. They reduce a taxpayer's liability for engaging in certain activities, effectively providing a financial benefit without a direct cash outlay from the government.
Why are implicit subsidies often criticized?
Implicit subsidies are often criticized for their lack of transparency, as their true cost and impact are not always clear in government budgets. They can also create market distortions, lead to inefficiency, and encourage moral hazard, where beneficiaries take on excessive risk due to the expectation of indirect government support.