SUBSIDIES FINANCED WITH DISTORTING TAXES

Subsidizing the production of particular goods or services is frequently justified on the basis of positive externalities, but the conventional analysis neglects the welfare cost of the taxes that finance the subsidy. This paper shows how the familiar partial equilibrium analysis of a subsidy can be extended to take account of the marginal welfare cost of raising the necessary tax revenue. The focus is on identifying the marginal social cost (MSC) of using the subsidy to expand output which, in conjunction with the marginal social benefit (MSB) of the output, determines the (second-best) optimal subsidy. Three types of subsidies are analyzed and compared: excise subsidy, marginal excise subsidy, and in-kind transfer.