Direct subsidies to companies are always a bad idea

Industrial policies only serve to enrich a small group, at the expense of taxpayers and the economy as a whole. (Photo: Justin Trudeau/Facebook)

(Version française disponible ici)

When it comes to pouring industrial subsidies, Canadian governments are running an open bar.  

In the last federal budget and in the months that followed, the federal government handed out nearly $50 billion. Carmakers Volkswagen and Stellantis were particularly well-treated. Each could potentially receive up to $16 billion in public funding. In Quebec, the Northvolt project is shaping up to be the biggest private project in the province’s history. Billions more are expected to be announced. 

Politicians always find all sorts of excuses to justify preferential treatment for certain companies: creating or maintaining “good jobs,” improving our competitiveness, encouraging innovation, helping the transition to a green economy, reducing our dependence on other countries.  

But these political arguments have little basis in economics. In reality, preferential measures such as industrial policies are often ineffective and only serve to benefit a small group of individuals.  

They also foster an unhealthy culture of lobbying and stifle competition. 

Job creation: a game of musical chairs

Contrary to a persistent myth, giving preferential treatment to a company (or a region) does not create jobs. Instead, it merely displaces economic activity (and the jobs that come with it). This is even more true in the context of a labour shortage, where the company receiving preferential treatment can only significantly increase the number of workers it employs by drawing them away from jobs they already have at other companies. From this perspective, subsidies create unfair competition for companies that are not subsidized, and may be hamper their growth. 

Despite political rhetoric, there is also no evidence that jobs at subsidized companies offer employees better conditions. In the end, if there are impacts on the composition of the workforce, they are unclear and uncertain. Subsidies don’t suddenly give low skill workers the ability or inclination to go back to school.  

Innovation: taxpayers always get the short end of the stick

It’s true that companies tend to invest too little in technology, and that major innovations (the Internet, for example) have largely been supported through public funding. The government must ensure that it is supporting the right projects and that taxpayers benefit in the end.  

Unfortunately, the government is not always well-placed to pick specific technologies most likely to succeed. That role should be left to independent experts who could direct funding to broad strategic areas selected by the government. 

The government must also ensure that taxpayers do not take on all the risk without getting their piece of the pie. This is the problem with subsidies: Taxpayers lose if an innovation receiving support is a flop; meanwhile, if the investment is a success, company executives reap the reward after public money was spent. In short, taxpayers always lose out.  

And what about the idea of launching “innovation missions,” an idea popularized by economist Mariana Mazzucato? In exceptional cases, such as searching for vaccines during a pandemic or developing new weapons in the event of war, choosing the mission is relatively easy. But in normal circumstances, it’s not so clear the government is well placed to choose these missions, as most socialist economies have shown. Likewise, choosing to go to the moon at any cost is not a decision that we necessarily want or can be replicated across the rest of the economy. 

Safety: self-sufficiency has never been ideal

What about the popular idea among our neighbours to the south of ‘friendshoring’ to reduce our dependence on adversarial countries? Studies show that the best way to protect against the risks of supply chain disruption is to have a flexible economy that can adapt and turn quickly to alternative sources, which may be abroad.  

For example, during the pandemic, Canada fared very well in terms of vaccine supply because it secured deals with different suppliers in different countries. Had Canada relied solely on domestic production the consequences would have been catastrophic. 

Of course, public infrastructure and appropriate regulation are needed to allow this flexibility, which does not necessarily provide protection from some rare systemic risks. Identifying these risks and the appropriate regulatory solutions is challenging and probably requires independent institutions, such as those that make up our macroprudential framework (which aims to reduce systemic risks such as those that led to the financial crisis of 2007 and 2008).  

But giving taxpayers’ money so companies will set up shop in Canada – while displacing others that may prove more strategically advantageous in the future – is not the best approach. 

Tinkering with the industrial structure can have unforeseen consequences

Some people believe that industrial subsidies are necessary if we don’t want to end up as water carriers. That being said, the number of jobs would not change in the absence of subsidies. We would simply be producing different things (or the same things with different companies). And, we would keep $50 billion in our collective pockets.  

But would these alternate products have added as much value? Market forces would have dictated that those products were in demand in the first place, and that we would have developed a relative degree of expertise. The products that are most in demand today are not the ones that will be tomorrow, and research shows that even if governments were omniscient, the potential gains from playing with the industrial structure are minimal.  

Politicians forget (or turn a blind eye to the fact) that the economy is not a zero-sum game, but a complex adaptive system just like natural ecosystems. Trying to change the makeup of industry is a bit like trying to give preferences to certain animal or plant species. The result is a new equilibrium created artificially, with costly ramifications that are not always well understood ahead of time. 

Putting national champions on steroids is a bad idea

Since other countries resort to artificially enhancing their industrial sectors, shouldn’t we follow suit if we want national champions who put us on the map and make us proud? We could also be asking ourselves whether protecting certain industries, which can be unfair to other industries or local businesses and infringes on rules of international trade is something of which we should really be proud. 

Another way to look at it: would Sweden sink into obscurity and starve for investment if IKEA didn’t exist? Would Europeans be less proud without Airbus? Historically, national champions created by public funding have not had stellar performance. Protecting a particular company only prevents more competitive firms from entering the market. Natural monopolies (such as public utilities) may be an exception, but we’re talking about regulating or nationalizing them, not subsidising them. 

The Asian Tiger model does not apply to Canada

In the 1960s, strong growth in the Russian economy was held up as an example to justify the use of industrial policy. More recently, Japan, China and South Korea have been held up as examples. Each case demonstrates it is possible to accelerate a country’s development by copying the more advanced economies they are trying to catch, but there are limits. We saw this with Russia, then Japan and now China. Ultimately, this option is not applicable to countries with economies that are already advanced, such as Canada. 

Objectives and outcomes that are mainly political 

Industrial preferential treatment is popular because it concentrates benefits in a certain region to the delight of the people who live there, as well as the politicians who get to make splashy announcements, cut ribbons and take credit. In many countries, including the United States, the practice enables political parties to seek donations from companies that lobby for government subsidies. On the other hand, these policies are generally harmful and unfair for to the average taxpayer and the overall economy. 

Opposing industrial subsidies does not necessarily mean being an advocate of laissez-faire. You can be both against industrial subsidies and believe that government has an important role to play in keeping the economy moving in the right direction. This includes ensuring healthy competition in markets, protecting the environment and workers’ rights, supporting displaced workers and vulnerable people, and providing essential public goods and services. Redirecting billions toward these goals and away from industrial subsidies would be the better idea. 

This article first appeared on Policy Options and is republished here under a Creative Commons license.