Government failure

When intervention makes things worse: subsidies or taxes set wrongly, distorted price signals, unintended consequences and administrative costs. Through Northern Ireland’s Renewable Heat Incentive.

Cash for ash.

In 2012 Northern Ireland launched the Renewable Heat Incentive to encourage businesses to switch from oil to cleaner wood-pellet boilers. The subsidy for each unit of heat was set higher than the cost of the pellets, with no limit on how much could be claimed. There were claims that some users heated empty buildings to earn more. The scheme was projected to overspend by hundreds of millions of pounds, the scandal helped bring down the Northern Ireland Executive in January 2017, and a public inquiry reported in 2020.

The aim was good: cut carbon emissions. What went wrong?

Sources: Northern Ireland Audit Office (2016); Report of the Independent Public Inquiry into the Non-Domestic RHI Scheme (2020).

What is government failure?

Government failure is when government intervention leads to a misallocation of resources: a worse outcome than before, or a new welfare loss.

Main causes:

1. Information gaps: the government does not know the true external cost or benefit, so sets the tax or subsidy wrongly.
2. Distortion of price signals: taxes, subsidies and price controls change incentives in ways no one planned.
3. Unintended consequences: high taxes on cigarettes encourage smuggling; maximum rents can cut the supply of homes.
4. Administrative costs: running and policing the scheme can cost more than it saves.
5. Political pressures: short-term or popular decisions instead of efficient ones.

Think first

A government pays people £1.60 for every £1 of fuel they burn in a green boiler.

The aim is to replace oil heating with something cleaner.

What are many users likely to do?

If the subsidy is worth more than the fuel costs, every extra hour of heating makes money. Users have an incentive to burn more than they need, wasting fuel and public money. This happened in Northern Ireland with the Renewable Heat Incentive.

Step by step

1. A good with a positive externality, like cleaner heating. The market provides Q1; the social optimum is Q*.

2. A subsidy equal to the external benefit shifts supply down just enough for consumption to reach Q*. That is market failure corrected.

   Check: A subsidy equal to the external benefit is paid. Where does consumption end up?

   A subsidy equal to the external benefit closes the gap exactly: MSB = MSC at Q*.

3. Now the government sets the subsidy far too high, as with the RHI. Consumption rises past Q*, to Q2. For every unit between Q* and Q2, the cost to society, MSC, is greater than the social benefit, MSB. A new welfare loss: government failure.

4. The RHI combined several causes: poor information about costs, a price signal that rewarded waste, weak monitoring (administrative failure), and warnings that were not acted on.

   Check: Which cause of government failure best explains the RHI?

   Setting the tariff above the fuel cost, with no cap, gave users an incentive to burn fuel for profit: a distorted price signal from poor information and design.

5. Government failure is not limited to subsidies.

   Check: A government guarantees farmers a minimum price for milk, set above equilibrium. What is the most likely unintended result?

   At a price above equilibrium, farmers supply more and buyers demand less, so there is a surplus. Buying and storing it costs taxpayers money.

6. Other examples you can use: high cigarette taxes encouraging smuggling and illegal sales; rent controls that reduce the supply of rented homes; agricultural price support that creates surpluses; and regulations that cost more to enforce than they save.

A common mistake

A bigger subsidy is not always better. Beyond the social optimum, extra units cost more than their social benefit, so welfare falls. The right subsidy equals the external benefit.

Exam question

Explain, using an example, how government intervention to correct a market failure can lead to government failure.

Model answer

Government failure occurs when government intervention leads to a misallocation of resources, making the outcome worse rather than better.

A common cause is an information gap. To correct a positive externality, a subsidy should equal the external benefit, but the government does not know its true size. Northern Ireland’s Renewable Heat Incentive aimed to cut carbon emissions by subsidising wood-pellet boilers, but the subsidy per unit of heat was set above the cost of the fuel and was not capped. This distorted the price signal: users could make a profit by burning more fuel than they needed.

[Diagram: MPC = MSC, MPB, MSB. A subsidy far larger than the external benefit pushes consumption beyond Q* to Q2, creating a new welfare loss between MSC and MSB from Q* to Q2.]

Consumption therefore rose beyond the social optimum. On those extra units the cost to society was greater than the social benefit, so there was a new welfare loss, and large sums of public money were wasted: a clear case of government failure.