U.S. Cotton Subsidies: Drawing a Fine Line on the Degree of Decoupling

Journal of Agricultural and Applied Economics, Apr 2007 by Schmitz, Andrew, Rossi, Frederick, Schmitz, Troy G

Price-Based Subsidy Instruments and Crop Insurance

The cotton industry in the United States has a long history of governmental support. Following World War I, cotton farmers attempted self-imposed production controls in order to increase prices and incomes. The inevitable coordination failure of such efforts resulted in calls for legislation that would aid the farm economy, ultimately leading to passage of the Agricultural Marketing Act of 1929 (USDA 1996). In the years that immediately followed, the main policy instrument used to support domestic prices and farm incomes were production quotas, which reduced production rather than creating incentives to produce. Marketing loans for cotton farmers were then introduced in the late 1930s and opened the door to the price-support subsidy regime that, although often modified over the years, has subsequently persisted to the present (USDA 1996). The following provides a brief description of the different types of price-based subsidies that currently benefit U.S. cotton producers: direct payments, marketing loans, counter-cyclical payments, and Step 2 payments. Westcott, Young, and Price provide the basis for the following summary of direct payments, marketing loans, and counter-cyclical payments.

Beach et al. and Sumner provide information on Step 2 payments.

Direct payments (DPs) under the 2002 Farm Security and Rural Investment (FSRI) Act are made to eligible producers each year, and are based on historical acreage and historical yields. DPs are similar to the production flexibility payments (PFCs) of the 1996 Federal Agriculture Improvement and Reform (FAIR) Act, but differ in that the per-unit payment rate is fixed for the five-year life of the Act (i.e., 2002-2007). Previously, PFCs operated under a fixed total expenditure per year, with the annual per-unit payment rate based on commodity-specific parameters.

The marketing assistance loan (MAL) program of the 2002 FSRI Act continues a long tradition of government loans to producers covering a multiplicity of agricultural commodities. By pledging their crop as collateral, MALs allow producers to secure significant amounts of government benefits, while at the same time giving them several favorable options to repay the loan. These options include repaying the loan at the loan rate plus interest; repaying the loan at a lower rate (if applicable); or forfeiture of the crop, if desired, to the government at the time of the loan maturity. MALs are calculated as the difference between the loan rate and the world price, multiplied by the output quantity. Thus, they are widely considered to be a coupled subsidy as they are directly tied to production levels (Sumner).

Counter-cyclical payments (CCPs) were introduced under the 2002 FSRI Act, and rely upon a "target price" (P^sub t^). The CCP is activated whenever the market price is below this predetermined level. CCPs are based on historical acreage and historical yields and, as such, are generally regarded as decoupled (e.g., Gardner), although there is considerable debate over this issue (Anton and Le Mouel; Lin and Dismukes). This aspect of U.S. cotton policy has no official antecedent in the 1996 FAIR Act, but replaces the impromptu subsidy payments (known as "Market Loss Assistance" payments) that were made to farmers during the years 1998-2001, when several commodity prices crashed. Calculation of the CCP rate is dependent upon the DP rate (P^sub d^), and the world price (P^sub w^.) in relation to the loan rate (P^sub l^). If P^sub w^ > P^sub l^, then the CCP rate equals P^sub t^ - P^sub d^ - P^sub w^. On the other hand, if P^sub w^

CCP = (CCP payment rate) � (CCP payment yield) � [0.85 � (Base Acres)].

Although the United States terminated Step 2 program payments as of August 1, 2006, in response to Brazil's successful WTO cotton challenge, they were an important component of U.S. cotton policy. While DP, MLA, and CCP subsidies provide direct benefits to producers, the Step 2 program differed in that it was a demand subsidy that indirectly benefited producers. Sumner explains how the effects of Step 2 benefits received by U.S. mills and exporters are transmitted through the supply-demand system to subsequently depress world cotton prices. The Step 2 program was based upon an ongoing review of two separate price differentials to determine if payments were to be made (separately) to domestic mills (consumers), domestic marketers, and exporters. If the U.S. price of cotton exceeded the A Index (world price) by 1.25 cents per pound for four consecutive weeks, and if the adjusted world price (AWP) did not exceed 134% of the loan rate, then Step 2 payments were made to the eligible recipients defined above. The payment rate was equivalent to the difference between the U.S. price and the A Index, minus 1.25 cents per pound (Beach et al.).