How Subsidies Always Punish Success and Reward Failure

Is there a more sorry sight than a Federal Budget?

Well, it appears there is. It’s a state budget. Or in this case, two state budgets – Queensland and New South Wales.

We won’t waste your time by ripping either of them apart as we’re going to look at a classic example of the impact of subsidies. But you can see the desperation in these budgets as they work how the best way to spend and tax that will ensure they get re-elected.

Today’s Australian Financial Review has an “At A Glance” look at the two budgets. Here’s the pick of the crop:

Queensland – $37 billion revenue, $39 billion spending. $18 billion for capital works, $7 billion for roadworks, $9 billion for health, $7.8 billion for education. 350 new teachers, 203 extra police. Extra money for pensioners.

NSW – $52.9 billion revenue, $53.9 billion expenses. $15 billion for health, $14 billion education, $7 billion transport. Government net debt to rise from $8 billion to $15 billion by 2013. Non first home buyers to get $11,245 stamp duty saving.

The last part about the home buyers is the latest in the property prop-up stakes. It’s further evidence that government policy is designed not to make housing more affordable, but to keep it expensive and then use taxpayers money to keep it that way.

Because rather than admitting the first home buyer grant is a distortion in the market, the NSW government is now going to subsidize every other home purchase by dropping stamp duty charges by half until the end of the year.

But isn’t it a tax cut? Isn’t it good that people aren’t paying so much stamp duty?

If it was a genuine cut then we’d be happy. But it isn’t, because overall government spending will not drop. All it does is cut a tax for one set of individuals and necessarily increase the tax-take somewhere else.

It’s just fiscal musical chairs.

And of course it won’t make housing any cheaper. It will make it more expensive as buyers can bid the price up by an extra $11k. The bubble is being expanded even further. But on the plus side, it makes us happier for tipping a REIT in Australian Small Cap Investigator a few months back.

The rationale being that as the property bubble gets nearer to popping the greater the policy panic will become, the bigger the bubble will grow, and the more confidence everyone will have that it won’t pop…

Which is exactly when it will pop. We’re only up by 12% on it since the end of March, but a 40-50% rapid-fire gain in the next few months will be enough before I tell subscribers to pull the pin and get out.

But enough about subsidies, more about subsidies. As we were booking the flights for a short family holiday down to Tasmania in July it occurred to your editor that perhaps one of the most visible examples of the folly of subsidies was the Ansett Ticket Levy.

It is a perfect example how every subsidy in existence rewards failure and punishes success. As we think about it, we cannot come up with one single example where a subsidy rewards success.

But even if a government subsidy did reward success it would not be desirable. Because then you have an external force interfering with competitive markets with the potential for that company to become a state sponsored monopoly.

Now, we won’t go into a specific line by line forensic examination of the Ansett/Air New Zealand balance sheet. But let’s just use a broad generalization to say that the airline failed because it could not compete on the same cost and revenue basis as Qantas and the then newly arrived Virgin Blue.

We’ll also make another broad generalization to say that over the years most travelers chose Qantas rather than Ansett. Our vague recollection is Ansett had about a 30% market share.

Therefore travelers made a conscious decision to choose Qantas. Maybe some fares were cheaper, maybe they preferred the service or the frequent flyer programme.

They paid their fare and that was that.

But then Ansett collapsed. It didn’t have enough cash to pay out creditors, including worker termination benefits and so in its ‘wisdom’ the federal government stumped up the cash.

The result was that for the next three years, every passenger on every flight in Australia was forced to pay for Ansett’s mismanagement. They were forced to pay for Ansett’s inability to compete. Passengers were forced to pay the ‘entitlements’ for pilots, cabin crew, and ground staff of an airline that they may never have used.

An airline which they may have made a conscious decision not to use because they didn’t like the service.

In other words, the market had spoken and it had decreed that Ansett was rubbish and should die. Maybe that’s a bit harsh, but clearly for whatever reason, the business wasn’t sustainable. Despite that, travelers were compelled to pay for Ansett’s failure for another two years.

The Ansett Levy is unusual in that most other subsidies are not directly visible to the public. They are usually back-room deals where the subsidy is drawn from general government revenue rather than a direct tax on the public.

But any subsidy by its nature means that you are paying for someone else’s enjoyment or use of something. Think about grants to the arts, or government funding of a new sports stadium, or public transport support, or government road building.

Not only do subsidies distort markets but they also succeed in driving up costs. This is simply because a subsidized industry can maintain its previously uncompetitive pricing structure in the full knowledge it is getting money from the government.

And that’s how it will work in New South Wales now the state government has decided it will give preferential treatment to products made in Australia over those made in China.

In another perfect example of how governments are incapable of running a business, they have let the market know exactly what terms of the subsidy will be. They have stated that any proposal from an Australian company will automatically have a theoretical 20% discount applied to make it more competitive with the overseas products.

Hey presto! The Australian company, knowing that, could in practice raise its price if it knows its products are only 10% more expensive thus once the discount is applied its products will still be cheaper.

Surely the first rule of negotiation is not to reveal your cards. Imagine if everyone turned up to a house auction and told the vendor the highest amount they would be prepared to bid. Of course, he’d set the price at the highest bid.

It’s the same here. Far from this policy saving jobs, it is more likely to actually cost jobs as distortions in one part of the market always have a knock-on effect elsewhere.

A levy, a surcharge or a subsidy is just a tax by another name.

Money Morning Mailbag

We’ve received several responses to the question we asked yesterday. Most of the responses are strangely familiar. I won’t go into detail today, but here’s the question again that I posed yesterday:

“There is the idea that you pay off your big house, live in it for twenty or thirty years, sell it for a packet and then downsize to something much cheaper and ‘voila!’ you get to live the life of riley on the rest of the cash.

Does it really work that way? Maybe if you’ve just done that you can send an email to the Money Morning Mailbag – moneymorning@moneymorning.com.au. Only, our initial thought (that we’ve just thought in the last two minutes of typing this) is that by the time your ‘old’ house has depreciated it is now worth not much more than the land or redevelopment value, yet typically even if you downsize you will be moving into a much newer home that is fully valued.

How much of a premium is there for an older 4 bedroom house compared to say, a brand new 2 bedroom townhouse?”

We’ll follow up on this later in the week or early next week.

Other Stuff on the Markets

The S&P/ASX200 fell by 1.72% yesterday, while there was more bad news overnight on Wall Street with the Dow Jones Industrial Average dropping 107 points. But in Europe the FTSE100 gained just 0.06%.

The price of gold in Australian dollars is trading at $1,178.69, while in US Dollars it trading at $934.35.

The Aussie dollar lost ground versus the US dollar and Japanese Yen, trading at USD$0.7928, and JPY76.44.

Crude oil lost a bit of ground overnight, closing at USD$70.19.

For the biggest movers on the market yesterday click here…

And today on the economic calendar we have the Westpac Leading Index, while in the US they have the CPI numbers.

Cheers.
Kris.

Tagged as: subsidies