The Heritage Foundation

Backgrounder #388 on Agriculture

October 22, 1984

October 22, 1984 | Backgrounder on Agriculture

The High Cost of Farm Subsidies

(Archived document, may contain errors)

I TH'E HIGH 'COST OF FA.RM SUBSIDIES INTRODUCTION Bumper crops often are regarded as the hallmark of American agriculture. So are bumper subsidies. They seem to be shooting up faster than August corn. Government outlays for farm price stabilization programs alone increased from $4 billion in 1981 to about $20 billion in 19

83. Many date back to the New Deal era.

Whether or not such programs were appropriate in the 1930s today they are inconsistent with economic conditions in agricul ture. Price support programs that raise domestic prices above world market levels are not compatible with the objectives of increasing agricultural exports and achieving a more open and Urosperous domestic economy p2ograms are largely capitalized into higher prices for factors qf'production (es p ecially land And the regressive effect of these programs on income distribution within the agricultural dector is indicated by the fact that only 15 percent of farms receive about half of direct government payments that, although the programs ostensibly w e re instituted to support the incomes of low-income farmers, it is owners of large farms, with incomes quite high relative to nonfarmers, who receive mdst of the,benefits. Consumers and taxpayers, meanwhile, bear the cost of farm programs through increased taxes and higher food prices. To make matters worse, these costly programs rarely achieve their goals. The record of the past 50 years suggests that federal intervention fails as much in agriculture as it does in other economic sectors. Government attempt s to stabilize agricultural markets through "fine tuning1! of current programs seldom succeed. As' the 19.85 deadline approaches for a new farm bill, U.S. agriculture'policy stands at a crossroads with a choice of two b&3c ways to go The short-run benefits of farm The result is 1) the nation can continue and expand existing 2 programs, in which fanp income is heavily dependent on government through direct income transfers and government-sanctioned restric tions on'competition; or (2) it can rely on the mark e tplace to bring about appropriate adjustments in production and resource allocation. The evidence is very clear on this choice. Govern ment would make'its greatest contribution by doing less aimed at creating general economic conditions of low inflation a n d a more' open *economy would. be .much more helpful to farmers than the host of programs now in place Policies THE ORIGINS OF CURRENT AGRICULTURAL PROGRAMS Prior to the New Deal era, government programs in agriculture were small and seldom directly affec ted the individual farmer.

From 1862 to 1933, the United States Department of Agriculture USDA) was mainly a scientific and statistical agency limited to research and its applications to the process of farming and some policing activities s uch as food safety. Federal intervention did not begin on a massive scale until the Great Depression, when President Franklin D. Roosevelt launched a host of New Deal action programs for agriculture.1 The conventional wisdom was that the Great Depression h ad been caused by a failure of the market process and that government intervention was necessary to regulate and stabilize agriculture and other sectors of the economy. Within the agricultural sector it was held that farmers were at a disadvantage in term s of bargaining power, both in buying the raw materials for weir businesses and in selling farm products. Instead of attempting to increase competition in the allegedly monopolistic agribusiness firms handling the supplies and products of the nation's farm e rs however, there was a deliberate government policy of restricting competition in agricultural product markets. Government-organized tobacco, milk, peanuts, and other products above the competitive market-clearing level the form of high tariffs, high tax e s, high wages, and restrictive monetary policies actually caused or greatly exacerbated the economic chaos. The Smoot-Hawley Tariff Act enacted in 1930, for example, raised tariffs to the highest levels in the 20th century 52.8 percent on the assessed val u e of goods. It was in large part because of this that U.S. farm exports fell by two-thirds from 1929 to 1933 c producer cartels were formed to raise the prices of cotton What actually happened is that government intervention in It is true that the basic v i ews underpinning the New Deal agricultural program can be traced to earlier years the beginning of the modern co-op movement), the McNary-Haugen two-price plans of the mid-l920s, and the Federal Farm Board created by President Herbert Hoover in 1929 were i mportant antecedents of the Agricultural Adjustment Act of 1933 The Capper-Volstead Act of 1922 3 The U.S. government also resisted the downward adjustment of wages and prices at a time of high unemployement. While President Herbert Hoover merely IIj awbo nedll to keep wages up, President Franklin Roosevelt enacted the National Industrial Recovery Act NRA which legally prevented wages and prices from falling.

Thus, the policy of keeping farm prices up through price supports marketing orders, and various oth er measures was consistent with the NRA and-ather.attempts by government tomaintain high prices chaos. The Hoover Administration in 1932 enacted the biggest percentage increase in taxes in peacetime history, and President Roosevelt hiked taxes in 1935 and routinely thereafter. By 1938 the corporate tax rate had gone from 11 to 19 percent and the top income tax rate from 24 to 79 percent. The Federal Reserve reduced the money supply by two-thirds from 1929 to 1933 and hiked the discount rate by 2 percent in 19

32. In summary, the government policies of high tariffs, high taxes, monetary mis management, and political manipulation of wage rates and prices could hardly have been designed better for bringing about economic stagnation or preventing economic recov ery. The protectionist trade policies were especially damaging to agriculture because of its heavy dependence on exports and the adverse effects of even a small reduction in exports on domestic prices of farm products Monetary and fiscal policies also con t ributed to the economic The major objectives of farm programs during the Depression and thereafter generally have been to increase farm income and to stabilize agricultural prices, and they have persisted regardless of agricultural conditions or of econom ic conditions in general.

Proponents contend that farm programs are necessary because Ilagriculture is different" from other economic sectors. This view argues, for example, that the higher price paid for milk by consumers is a small price in view of the s tabilizing aspect of the milk program. An opposing view points out that the dairy and other agricultural programs are merely examples of income redistri bution THE STRUCTURE OF AIWRICAN AGRICULTURAL PROGRAMS Programs to Increase Farm Product Prices Price s upport programs that reduce the quantity produced or sold affect wheat, feed grains, cotton, peanuts, tobacco, and other products. These programs vary widely. In the case of tobacco, for example, participation is mandatory, and an acreage allotment and ma r keting qu-ota is assigned to each producer. For wheat, feed grains, and cotton programs, on the other hand participation is voluntary, but participating producers must place some specified acreage of cropland in a "conservation reservef1 to receive progra m benefits.

Legally binding quality or quantity restrictions are used in marketing ordersf1 to reduce'the amount marketed by the individual 4 producer. Such marketing orders affect milk, California navel oranges, and some 50 other fruit, vegetable, and spe cialty crops.

In the federal milk marketing order, the milk price is supported by government purchases of cheese, butter, and powdered milk.

This has led to the accumulation of massive amounts of these products in government storage.

Other federal progr ams -increase.-prices of .farm products by increasing demand. Food stamps and school lunch programs are the best known of the thirteen domestic food assistance programs.2 The P.L.480 Food for Peace program donates farm commodities to poor countries, funds the purchase of U.S. crops at low interest rates, and provides emergency food relief. There has been a decline in the relative importance of P.L.480 exports since the early 1970s, when the volume of U.S. agricultural exports began to mushroom 2) Programs T hat Decrease Farm Product Prices hence, tend to reduce farm product prices. The Farm Credit System (FCS), Farmers Home Administration (FmHA), and the Commodity Credit Corporation (CCC) provide implicit or explicit interest rate subsidies to qualifying bor r owers. Subsidized irrigation drainage, and conservation measures for land and water resources also reduce production costs. Under the subsidized crop insurance program, the government pays a portion of the premiums, and these premiums are set to cover onl y the expected indemnity payments-not the full operating costs of the program. The subsidy is estimated to be almost half of the insurance cost In addition to subsidized credit and crop insurance, federal tax laws historically have extended special treatme nt to those engaged in agricultural prod~ction extension activities have contributed to the dramatic increase in the supply of agricultural products.

The demand for farm products tends to shift only slowly over time, reflecting increases in population and consumer incomes As a country becomes increasingly developed economically, however rising personal incomes have little effect on the demand for farm products, relative to such items as housing and recreation As economic progress occurs, therefore, the lar g e increases in supply relative to demand for farm products exert a downward pressure on farm prices As such, the historic U.S farm problem1I characterized by falling prices and incomes per 'acre--to a consider able extent, has resulted from economic growt h . Economic growth meanwhile has encouraged a shift of labor from the farm sector to There are a number of programs that increase supply and And federally funded agricultural research and James Bovard, "Feeding Everybody: How Federal Programs Grew and Grew Policy Review, Fall 1983, pp. 42-51 For instance, farmers.are..allowed to use the cash accounting method as opposed to the accrual method of accounting 5 other sectors of the economy, as capital substitutes for farm labor.

EFFECTS OF FARM PROGRAMS In a ma rket system, prices coordinate and transmit information to participants in. the-.marketplace and .expected profits provide incentives for decision makers to use the information conveyed by prices. Agricultural production and marketing under real world con d itions is characterized by constantly changing market condi tions, which allow alert entrepreneurs to take advantage of profit opportunities In this system, profits and losses are a measure of how accurately the decision maker has anticipated market condi t ions. When price signals in agriculture are con sciously distorted or ignored through price supports, credit subsidies, and other farm programs, however, farmers have no objective basis for setting prices or for allocating resources efficiently I Domestic Protectionism and International Trade The value of U.S. farm exports jumped from $8 billion in 1972 to about 44 billion in 1981, a dramatic rise even after adjusting for inflation.4 This increased dependence of U.S agriculture on international trade has i m portant implications for agricultural policy, since there is a fundamental incompatibility between domestic agricultural price support policies and free international trade. When domestic prices are raised above the world price, imports must be limited to prevent domestic users from buying lower priced products from abroad. As a result consumer prices of dairy, tobacco, peanut, sugar, and other products in the United States are considerably higher than they would be without import controls for example, pro t ects the target price of about 17C per pound for domestic producers; prices on the world market are only 4C to 7C per pound. This import quota system, imposed by the world's biggest sugar market, is highly detrimental to Caribbean producers and is inconsi s tent with U.S. foreign policy in the Caribbean including the ambitious Reagan economic development initiative. c I The sugar import quota system I In addition, subsidies affecting product prices, easy credit terms, or reduced interest rates are used to in crease U.S. agri cultural exports domestic production and a decrease in domestic consumption.

Regardless of the type of subsidy, sellers receiving an artificial advantage in the export market are often accused of lldumpinglf by the recipient countries. Fol lowing the decrease in agricultural An export subsidy results in an increase in A decrease in U.S. farm exports since 1981 can be attributed to the world recession and, more recently, to an increase in the price of U.S. exports because of the strong value of the dollar relative to other currencies 6 exports since 1981, pressures have intensified to increase the use of export subsidies to strengthen the market for U.S. farm products.

Winners and Losers from Farm Proqrams In 1982, more than $11 billion was s pent on price support programs for ,m&l-k, wheat, feed grains, and other products At the same time, an even larger amount was spent by the USDA for credit, conservation, research, extension, and crop insurance programs that had the effect of,increasing ou t put and decreasing prices.5 If the two ways of spending dollars to affect product prices were equally effective, expenditures on price support programs would offset an equal amount of expenditures on programs that increase production (and decrease price T his suggests that more than 20 billion may have been spent by the USDA in 1982 on activities that cancelled each other, thus having little actual net impact on food costs, farm prices, or farm incomes.

Such programs do have distributional effects,within ag ricul ture. Subsidized credit, conservation, crop insurance, and research and extension programs reduce production costs for those producers receiving the benefits. The increase in supply and the resulting decrease in price penalize producers not receivin g the program benefits. Consumers would gain from such programs that led to lower food prices, but support programs which then push up prices often negate the potential benefits from decreases in production costs. Also negating the consumer benefits, of co urse are the higher taxes needed to pay for the programs.

The major gainers from agricultural price support programs are, in fact, owners of land and various specialized factors of production. When prices are supported above the market level production becomes more profitable at the existing production costs Pri c es of specialized inputs are bid up high enough so that the expected return is similar to that for other assets of comparable risk. Consequently, although owners of land and other specialized inputs receive windfall gains when a price support program is i n itiated (or price support levels increased the benefits to later producers are largely negated by higher produc tionc*costs (such as higher land prices Price support programs Uus result in what has been called a "transitional gains trap.If6 Once a price s u pport program has been in operation, its elimina tion imposes windfall losses on owners of specialized resources regardless of whether they benefited from the initial windfall owners of land and production rights today often are not the same people who re ceived the windfalls when the programs were initiated Clifton B. Luttrell, Down on the Farm with Uncle Sam (Los Angeles, Cali fornia: International Institute for Economic Research 1983).

Gordon Tullock The Transitional Gains Trap," The Beli Journal of Econ o mics and Management Science, Autumn 1975, pp. 671-678 7 81 Government employees also gain from farm programs. The Department of Agriculture staff, for example, now numbers 125,000 five times its size in 19

29. At the same time, the number of farms in th e U.S. has dropped from 6.5 million to 2.3 million programs. Consumers face higher prices for milk, sugar, peanuts tobacco; fresh oranges; and other products Taxpayers face higher tax bills in financing the $35 billion in USDA outlays for FY 1984 Farmers w ho rent or buy land or rights to produce also face increased costs of production Consumers' and taxpayers bear the major costs of government Indirect Effects of Farm Programs Restrictions on competition,reduce the efficiency of resource use in agriculture . In the case of the wheat, cotton, an4 feed grain programs, for example, farmers are being paid by Washington not to till some of the world's most productive farmland tions on domestic competiton distort the pattern of production and resource use within t he U.S. and between the U.S. and other countries. At the same time, higher prices for bread, milk sugar, and other items produced under price supports increase the pressure and need for food assistance to lower income groups.

And restrictions on output and resulting higher product prices also adversely affect consumers in other countries Restric The interest rate subsidies of the Farm Credit System, the Farmers Home Administration, and the Commodity Credit Corporation also promote the trend toward fewer an d larger farms. By decreas ing the cost of capital relative to labor, these policies encourage the substitution of machinery and other capital inputs for labor resulting in more highly mechanized farms. In view of widespread public concerns about farm size and capital requirements in com mercial agriculture it is ironic that federally operated and sanctioned credit programs are actually contributing to the trends toward larger and more highly mechanized farms.

Effect on Income Distribution Perhaps the most controversial aspect of farm policy is the effect of farm programs on incomes within agriculture. Farm programs historically were justified to a large extent on the basis of comparisons of farm versus nonfarm incomes. The concept of "average farm income,I l however, has little meaning since income per farm operator varies widely depending on the size of the farm. On commercial farms with sales of more than $100,000 per year, for example, the average family income exceeds that of nonfarmers. On small farms, o n the other hand, most family income now is derived from nonfarm sources. From 1980 to 1982 About $6 billion were off-budget Rural Electrification Administration REA) and FmHA expenditures. a farmers with farm sales of less than $20,000 per year, on avera g e obtained all of their disposable income from, off-farm work such as in the retail sector, farm products distribution, and other businesses.8 More generally, during the same period, off-farm income accounted for over 99 percent of farm operator family in c ome for 72 percent of U.S. farmseg Although -per--capita disposable -income of farmers, on average has increased over time relative to those of nonfarmers, the policy implications of such income differences are unclear. Income is the primary means by whic h labor resources are allocated both within the farm sector and between agriculture and other sectors of the economy. As farm size increased and machinery pesticides, and other capital inputs were substituted for labor and land during the 1950s and 1960s, h igher incomes from nonfarm jobs induced a large shift of labor out of agriculture. When public policies are instituted to equalize wazes in different sectors for similar work, irrespective of underlying economic trends, however, there is little incentive for labor to adjust in response to changing economic conditions.

Farm programs have important effects on income distribution within agriculture. When prices are increased by price supports small farmers are affected relatively little since benefits vary wi th sales. lo Even though the benefits of various programs differ widely, even for farms of a given size, depending upon the crops grown, means of financing, and other factors, it'is estimated that just 13 percent of farms obtain 45 percent of direct gover n ment payments, while 71 ercent of the farms receive only 22 percent of the payments. p1 This is not some maldistribution that can be improved by tinkering with the programs defect of such bureaucratic policies. U.S. agricultural programs thus disrupt dom e stic and international agricultural markets in the name of supporting the low-income farmers--who receive little benefit from the programse12 It is an inherent 8 9 10 11 12 J. Bruce Bullock Future Directions for Agricultural Policy," American Journal of A gricultural Economics, May 1984, p. 235.


Again, it should be emphasized that it is agricultural landowners rather than producers who are the major beneficiaries of price support programs and other programs affecting land values.

William G. Lesher, at the Conference on Alternative Agricultural and Food Policies and the 1985 Farm Bill, sponsored by the GiaMini Foundation and Resources for the Future, Berkeley, California, June 11, 1984.

There is a $50,000 per farmer annual maximum payment limitation from all programs, but legal loopholes limit its effectiveness. For example, in the dairy diversion program enacted in late 1983, which pays dairy pro ducers not to produce, some individual dairy producers will receive more than $1 million ful Lesson for Industrial Policy," Heritage Foundation Backgrounder No 3

20. Januarv 1984 See also Bruce Gardner, "Agriculture's Revealing and Pain9 IMPLEMENTATION PROBLEMS The regressive effect of farm programs on income distribution is but one of a large number of impl ementation problems that inevitably arise when central direction is substituted for market signals. information problems.

Among the most important of these are incentive and Incentive Problems Difficulties arise when decisions about resource use are made through the political process, which separates power from responsibility. Policy decisions in agriculture, as in other areas, often are influenced by short-run political considerations.

Before the 1976 election, for example, decisions to raise the support price of wheat and to tri le the tariff on imported sugar were basically political ones.it1g The 1983 dairy program that pays farmers not to produce milk is another example of economic reality succumbing to political pressure. Economist Edward Tufte demo n strates that such examples are not unusual, as incumbent administrations frequently confer short-run economic benefits on politically powerful groups to improve the party's standing in upcoming elections.14 tion of funds on the basis of politics rather th an on economic factors. Soil erosion is not a national phenomenon, since erosion that matters occurs on particular farms in specific locations.

The implications are clearly drawn by Nobel Laureate T. W. Schultz IThis being the case, a nationally administered soil conservation program that is politically designed to provide funds and services to all parts of agriculture, is bound to be a model of i nefficien Conservation 'programs provide another example of the alloca cy Having outgrown the clientele they were originally designed to aid, government agriculture programs have now expanded into other areas. Subsidized credit in agriculture, for example , was originally designed for farmers and ranchers. Today, Federal Home Administration loans are available for such nonfarm activi ties as fire departments, hospitals, and recreational facilities.

The Agricultural Extension Service originally focused its e fforts on production agriculture but is now providing information to urban interests on such topics as nutrition, home and lawn care and turf management for golf courses. These services--typically l3 l4 l5 Bruce Gardner, The Governing of Agriculture (Lawr ence, Kansas The Regents Press, 1981 p. 118.

Edward A. Tufte, Political Control of the Economy (Princeton, New Jersey Princeton University Press, 1978).

T. W. Schultz The Dynamics of Soil Erosion in the United States A Critical View Agricultural Economics Paper No. 82 (Chicago: Department of Economics 1982 p 17 I provided at no cost to the user=-are overused and consequently often in short supply IMoral hazard," which means that individuals or firms are encouraged to engage in high risk activities because they are protected from its consequences, is another incentive problem that is important in federal crop insurance and credit programs.

Under high-risk-conditions, land is less likely to be farmed.

The availability of a subsidized insurance program means that lands especially subject to wind or water erosion are more likely to be farmed and eroded because the decision maker does not bear the full cost of his actions. A similar situation exists in the case of the Farmers Home Administration f'limited reso urce loans for farmers who "need a lower interest rate to have a reasonable chance of success.1' Since a lower interest rate is paid until the borrower is !'able to pay" the regular rate, the incentive to be able to pay the higher rate is reduced.

Informat ion Problems Information problems, too, arise in the collective choice process because of the separation of power and knowledge problem of determining the level of price supports, for example the concept of Itparity price" was developed during the New Dea l era as a basis for setting price support levels for wheat, cotton tobacco, and other crops. The parity price approach assumes that a bushel of wheat, for example, should have the same purchasing power as it had in a base period (originally taken to be 19 10-1914).

But if price is to perform its role in coordinating economic activity it must reflect current supply and demand conditions rather-than be set on the basis of outdated economic relation ships In the The Food and Agriculture Act of 1977 embraced co st of production as a primary guide in determining the level of price supports.

The cost of production, however, is no more defensible than parity as a guide in setting price support levels price support will increase cost of production as the increased p rice is capitalized into prices of land and other specialized resources. The higher the price is set, the higher the cost of production. Thus, if the price of wheat were set at $10 per bushel, the price of specialized resources in wheat production would b e bid up because farmers competing for the resources could count on a higher output price, and this would make the expected cost of production $

10. Cost of production and parity price are subject to the same shortcomings as the long discredited Iljust pri ce idea, in that there is no objective basis for saying what the price should be Any effective A similar information problem arises in the case of subsidized credit. In the absence of the market mechanism, there is no objective procedure for determining t he "optimal amountl1 of credit for individual borrowers or for agriculture as a whole.

Interest subsidies are income transfers, and since there is noobjective basis for income redistribution, there. is no objective procedure for determining what the amount of the interest subsidy should be.

Interest subsidies provide a good example of the importance of recognizing the Ilseen and unseen" effects of government inter vention.16 The "easy credit" is deemed to be beneficial by borrowers obtaining the credit, bu t other effects are much less obvious. Since less productive producers are kept in production nonusers of subsidized credit within agriculture are harmed because of lower product prices resulting from the increased output. Credit users in nonagricultural sectors of the economy are also disadvantaged because of the reduction in credit availabi lity.

CONCLUSION The choices confronting U.S. agriculture are either reduced government intervention and increased reliance on market forces or still further dependen ce on government attempts to bring supply and demand into balance through costly supply control: and export subsidy programs. Economic conditions in the U.S. have changed dramatically since most of these agricultural programs were initiated during the New Deal era.

There is a strong a priori case for decentralized competitive markets as the most effective means of coping with changing economic ~0nditions.l those advocating the continuation or expansion of programs that limit the scope of competition. Indeed, the abi l ity of government to stabilize individual markets is limited by the same factors that thwart government attempts to stabilize the overall level of economic activity. As its dependence on international trade increases, moreover, U.S. agriculture becomes in c reasingly beyond the reach of domestic price support policies The burden of proof thus should be on The effect of price support programs, import quotas, and other government-enforced restrictions on competition is to increase income to small groups at the expense of overall produc tivity and output. Even if it is granted that farm programs were once needed because of relatively low farm incomes, this justifi cation is no longer valid.18 Government attempts to stabilize l6 l7 l8 Frederic Bastiat, Selected E s says on Political Economy (Irvington-on-Hudson New York: The Foundation for Economic Education, 1964 F. A. Hayek, "The Use of Knowledge in Society," in Individualism and Eco nomic Order (Chicago: University of Chicago Press, 1948 pp. 77-91 Per capita disp osable income of farm operators has averaged 88% of nonfarm income over the past ten years Given the favorable tax treat ment of farmers, there is no longer any basis for arguing that farm incomes need to be supported relative to nonfarm incomes."

Bullock, "Future Directions for Agricultural Policy op. cit., p. 2

35. J. Bruce 12 the overall level of economic activity during the past 15 years suggest that government policies, as they are implemented through the political process, often introduce artificial instability into agricultural markets. That government might make its greatest contribution to economic stability by attempting to do less is an important lesson for agric~1ture.l~ Noninflationary monetary and fiscal policies plus a more open.economy woul d benefit agriculture far more inXhe'long run than the host of costly action programs now in place.

Prepared for The Heritage Foundation by E. C. Pasour, Jr l9 Paul Heyne, The Economic Way of Thinking, Fourth ed. (Chicago: Science Research Associates, Inc., 1983), p. 448 Professor of Economics and Business, North Carolina State University.

The author wishes to thank M.A. Johnson and W.N. Thurman for helpful comments.

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