Subsidies can be regarded as a form of protectionism or trade barrier by making domestic goods and services artificially competitive against imports. Subsidies may distort markets, and can impose large economic costs.
Financial assistance in the form of a subsidy may come from one's government, but the term subsidy may also refer to assistance granted by others, such as individuals or non-governmental institutions, although these would be more commonly described as charity.
The recipient of the subsidy may need to be distinguished from the beneficiary of the subsidy, and this analysis will depend on elasticity of supply and demand as well as other factors. For example, a subsidy for consumption of milk by consumers may appear to benefit consumers (or some subset of consumers, such as low-income households); but if supply of milk is constrained and results in higher demand and higher prices, the milk producer may benefit and the consumer may derive no net gain, as the higher prices for milk offset the subsidy. The net effect and identification of winners and losers is rarely straightforward, but subsidies generally result in a transfer of wealth from one group to another (or transfer between sub-groups).
Subsidy may also be used to refer to government actions which limit competition or raise the prices at which producers could sell their products, for example, by means of tariff protection. Although economics generally holds that subsidies may distort the market and produce inefficiencies, there are a number of recognized cases where subsidies may be the most efficient solution.
In many instances, economics may (somewhat counter-intuitively) suggest that direct subsidies are preferable to other forms of support, such as hidden subsidies or trade barriers; although subsidies may be inefficient, they are often less inefficient than other policy tools used to benefit certain groups. Direct subsidies may also be more transparent, which may allow the political process more opportunity to eliminate wasteful hidden subsidies. This problem - that hidden subsidies are more inefficient, but often favored precisely because they are non-transparent - is central to the political-economy of subsidies.
In economics, the term subsidy may or may not have a negative connotation: that is, the use of the term may not be prescriptive but descriptive. In economics, a subsidy may nonetheless be characterized as inefficient relative to no subsidies; inefficient relative to other means of producing the same results; "second-best", implying an inefficient but feasible solution (contrasted with an efficient but not feasible ideal), among other possible terminology. In other cases, a subsidy may be an efficient means of correcting a market failure.
For example, economic analysis may suggest that direct subsidies (cash benefits) would be more efficient than indirect subsidies (such as trade barriers); this does not necessarily imply that direct subsidies are good, but that they may be more efficient or effective than other mechanisms to achieve the same (or better) results.
Insofar as they are inefficient, however, subsidies would generally be considered by economists to be bad, as economics is the study of efficient use of limited resources. Ultimately, however, the choice to enact a subsidy is a political choice. Note that subsidies are linked to the concept of economic transfers from one group to another.
Economics has also explicitly identified a number of areas where subsidies are entirely justified by economics, particularly in the area of provision of public goods.
A labor subsidy is any form of subsidy where the recipients receive subsidies to pay for labor costs. Examples may include labor subsidies and tax deductions for workers in industries, such as the film and/or television industries. (see: Runaway production)
In some cases, the "subsidy" may refer to favoring one type of production or consumption over another, effectively reducing the competitiveness or retarding the development of potential substitutes. For example, it has been argued that the use of petroleum, and particularly gasoline, has been "subsidized" or favored by U.S. defense policy, reducing the use of alternative energy sources and delaying their commercial development.
In other cases, the government may need to improve the public transport to ensure pareto improvement is attanied and sustained.This can therefore be done by subsidising those transit agencies that provide the public services so that the services can be affordable for everyone.This is the best way of helping different groups of disabled and low income families in the society .
The provision of true public goods through consumption subsidies is an example of a type of subsidy that economics may recognize as efficient. In other cases, such subsidies may be reasonable second-best solutions; for example, while it may be theoretically efficient to charge for all use of public roads, in practice, the cost of implementing a system to charge for such use may be unworkable or unjustified.
In other cases, consumption subsidies may be targeted at a specific group of users, such as large utilities, residential home-owners, and others.
As previously stated, a common form of subsidy is via a tax break. This is a reduction in the normal rate of a particular class of taxes targeted towards an individual or group of companies. Often this is described as "corporate welfare", although that term is also used as a blanket term for all other forms of subsidies. Larger companies who are planning to open a new factory, for example, shop around for a location which will provide them with the biggest tax breaks in a process called a race to the bottom. Locations provide these tax breaks because they often feel that the benefits of job creation will more than offset the decline in tax revenues. Governments of all levels may do this to encourage employment in under-developed areas. Subsidies are given as protection to smaller producers to help them compete with larger companies, to help correct international trade imbalances, to aid industry deemed critical to national security, and to help industry compete with other countries - due to subsidies being common practice throughout the world.
To some, another way that the government subsidizes industry is by failing to regulate externalities. For example, when a company pollutes, it generates savings for itself at public expense, in the form of environmental degradation and public health costs. Thus a cost of production is absorbed by the public. Some individuals argue that this is a form of subsidy of producers (since producers are not paying the full social cost of production). Even where such externalities exist, it is unclear what the most effective way of compensating for the problem is: traditional economic theory suggests that "internalizing" the costs (to the extent possible) is most efficient. It is unclear, however, whether not compensating for externalities (by internalizing costs, regulations, Pigouvian taxes or other means) amounts to a subsidy or not.
A view, held by Austrian economists and other free-marketers, is that subsidies do, in general, more harm than good by distorting economic signals.
Sometimes people believe profitable companies to be 'bullying' governments for subsidies and rescue packages, an example of rent-seeking behaviour. For example, in the case with Australian rail operator Pacific National, the company threatened the Tasmanian Government with a pull-out of rail services unless a subsidization was made.