Summer 2005, Vol. 11 No. 3
In this issue...
Safety Net Design for the New Farm Bill
Bruce A. Babcock
Chad E. Hart
Farm bill discussions are beginning in earnest, as groups prepare for congressional hearings and possible legislative action in 2006. A common outcome of organized discussions is an expressed need for a better federal safety net for farmers. This outcome is somewhat surprising in light of the existing safety net for producers of currently supported field crops. As was demonstrated in a previous Iowa Ag Review ("Risk Free Farming," Winter 2004), producers of program crops who farm their own land and successfully get their crop into the ground face almost no risk that their returns over variable costs of production will fall below the average returns without government support, as shown in Figure 1. While the situation depicted in Figure 1 is not directly applicable elsewhere, the majority of land-owning producers of corn, soybeans, and wheat face practically no risk that they will not cover their cash production costs. So what motivates the widely held perception that farmers need an improved safety net?
Risk-Free for Whom?
The finding that the current price support and crop insurance programs greatly reduce financial risk only holds for producers who do not have annual cash land expenses. A recent survey by Iowa State University economist Mike Duffy ("Recent Trends in Farmland Ownership") shows that 74 percent of Iowa farmland in 2002 was held debt free, so cash outlays for debt service do not alone significantly increase risk. However, the same survey also showed that 60 percent of farmland in Iowa is leased. And in 2002, 70 percent of leased land was cash rented. It seems likely that both proportions have increased since then.
A farmer who cash rents land is in a much riskier position than a farmer who farms owned land debt free. For the renter, land rent is a cash-variable expense just as real as cash outlays for fertilizer, seed, and fuel. The land-owning farmer in Figure 1 faces an opportunity cost of land--after all, the landowner could always lease the farm rather than farm it--but no cash costs. This allows the land-owning farmer to more easily survive a revenue shortfall in any given year. Figure 2 depicts the risk situation for the Figure 1 farmer if he cash rented land as opposed to owning the land. The level of cash rent today with government programs is approximately $160/acre for productive Iowa farmland. The expected value of government payments is approximately $90/acre. Thus, if all this value were reflected in land rents, then cash rents would fall to $70/acre with the removal of government support. As shown, the effects of the current safety net are quite limited for the land renter. It is only the land owner who truly faces a "risk-free" condition.
That 60 percent of farmers face the risk shown in Figure 2 and 40 percent face the risk-free situation shown in Figure 1 may explain at least some of the perception that a better farm safety net is needed. After all, if non-farming landowners capture most of the benefit of farm programs, what is left for farm operators?
What About Crop Insurance?
Prevalent farmer dissatisfaction with the current crop insurance program may be another reason why so many people believe we need a better safety net. The program would seem to run in a manner that is highly favorable to farmer interests. Taxpayers pay for the overhead of the program, agent commissions, loss adjustment costs, company profits, and the costs of developing new products. And premium subsidies mean that farmer-paid premiums do not cover even half of the insurance indemnities that are paid out.
But dissatisfaction with the program is widespread. There is a litany of complaints: premiums are too high for the amount of protection provided; yield guarantees lag the amount at risk because they do not reflect current technology; farmers who suffer through one or more years of poor growing conditions face dramatically lower protection levels and higher premium rates even though the inherent risk they face remains unchanged; and finally, honest farmers suffer excessive premium rates because program rules are taken advantage of by unscrupulous agents and farmers. Perhaps no program can satisfy all farmers, but the level of dissatisfaction with the current crop insurance program suggests that there may indeed be something fundamentally wrong.
Why the Focus on Price?
The last complaint about the current federal safety net is that because federal farm bill programs focus exclusively on price, payments often arrive when farmers do not need financial help and may not arrive in years when farm income is low. Consider the circumstances of Illinois corn farmers this year. Many of them will not harvest much of a crop because of dry weather. The decline in this year's crop prospects has driven the price of corn higher, which suggests that farm bill payments for the 2005 crop may be limited to only direct payments. This is in contrast to the 2004 bin-busting crop, which drove the market price down and farm bill payments up, even though market income for most corn farmers was quite adequate.
In the Spring 2005 issue of Iowa Ag Review, we argued that the current farm bill is "mistargeted" because low prices, rather than low revenue, triggers payments. We offered an alternative revenue-targeted program based on the Group Risk Income Protection (GRIP) insurance plan that would hit a revenue target much better than does the current program. This result is no surprise: if Congress wants to make sure that revenue achieves a given level, then payments should be triggered whenever revenue falls below that level. The question is, why does Congress target price in the first place? It seems to make more sense to target revenue rather than price.
One answer to this puzzle could be that it is easier to pass farm legislation that pays out when prices are low because low prices affect all farmers of a crop. If legislation targeted low revenue at the county, crop-reporting district, or state level, then those producers who farm in high-risk areas would receive payments more frequently than would farmers in low-risk areas because low yields would drive down revenue more frequently in the high-risk areas. This explanation would seem to be supported by the frequent complaints from Corn Belt farmers that their low loss experience in the crop insurance program is somehow subsidizing the premiums of farmers who live in states with frequently high loss ratios. If this explanation is correct, then Congress might be unable to move to a program that targets revenue unless the revenue targeted is national revenue, in which case if any farmer of a crop received a payment, then all farmers would receive one. Representative Charles Stenholm's Supplemental Income Payments for Farmers proposal of 1999 (H.R. 2792) set a precedent for this type of target.
An alternative explanation for why Congress targets price is based on history. Taking a step back and looking at all aspects of the farm safety net, one could surmise that Congress is indeed attempting to hit a revenue target. But instead of using one efficient policy to achieve that targeting, it is using three. Commodity programs support price. Crop insurance supports yields. And when disaster strikes, ad hoc disaster programs provide additional yield support. Because revenue is the product of price and yield, supporting price and yield separately does indeed support revenue.
Throughout the 1980s and 1990s, Congress repeatedly tried to induce farmers to buy more crop insurance. Congress knew that higher participation rates meant that the farm sector would be supported whenever low yields or low prices occurred. But high participation only came about with the dramatically increased premium subsidies. Congress found that it could only achieve its goal of an effective safety net that guards against both low prices and low yields by turning the crop insurance program into an entitlement program that provides benefits with relatively little in co-payments.
Taking Stock Today
Has Congress largely achieved effective revenue safety by supporting prices with the farm bill and supporting yields with the crop insurance program? The answer is a qualified yes. One of the qualifications is the long list of farmer complaints about the crop insurance program previously discussed. The other qualification is that the safety net is not cost-effective. Why support price in low-price years without accounting for above-average yields? And why support yields in low-yield years without accounting for the benefits of high prices? Targeting revenue explicitly would be much more cost-effective.
Another redundancy is that most farmers now purchase revenue insurance, not yield insurance. In 2004, Revenue Assurance and Crop Revenue Coverage, the two most popular forms of revenue insurance, covered 126 million acres of cropland, nearly 60 percent of all cropland in the crop insurance program. This implies that farmers can receive both an insurance indemnity and a commodity payment to compensate for a drop in price. For example, many corn farmers received an insurance indemnity for their 2004 crop because of low prices. In addition, they received a loan deficiency payment and a countercyclical payment. Given that taxpayers fund both programs, why should farmers receive double compensation for the same drop in price?
Innovations in farm programs come about slowly and rarely. When the 2002 farm bill was passed, revenue insurance was still relatively new and most farmers still purchased yield insurance. So 2002 farm bill programs to support price could largely still be thought of as a critical part of a total safety net that supported revenue. But with most farmers now insuring revenue directly, perhaps Congress will rethink its overall approach to supporting farm sector income.
We have previously discussed an alternative commodity program that would make payments when county average yield times season average price is less than the product of expected county income and a national target price. This type of program would provide efficient protection against both low prices and low yields while saving money on ad hoc disaster payments and the crop insurance program. To provide more insight into the cost of such a program at the national level, let's look at cost estimates of such a program for corn and soybeans at the national level.
Figure 3 and Figure 4 compare the expected costs of a modified GRIP program with the current program for corn and soybeans, respectively. Cost estimates are assumed to be made before a crop is planted, so both yields and prices are unknown. The revenue program is set up with a national target price of $2.46 per bushel for corn and $5.40 per bushel for soybeans. These prices are equivalent to the amount of protection provided by the 2002 farm bill programs. Farmers in a county would receive a payment if their county yield times the season average price (the same price used to calculate current countercyclical payments) fell below their expected county yield (the county trend yield) times these target prices. As shown in Figure 3 and Figure 4, the expected cost of such a revenue program for a crop year would depend on the expected season average price. If prices are expected to be strong, then expected costs will be low. Weak expected prices lead to high expected costs. This pattern between expected price and expected costs holds true for the current farm programs as shown.
We estimate that a revenue program that provides the same level of per bushel support as does the current program to all planted acres would cost about the same for soybeans and would cost perhaps $1 billion less for corn. Thus, Congress could likely save money by targeting revenue directly. In addition to the likely cost savings, additional savings would come about from the crop insurance program. Assuming that 75 percent of the risk in the crop insurance program would be rendered redundant by a farm bill program that targeted revenue, we calculate that annual savings of approximately $1.4 billion would accrue to the eight major program crops. Such savings and the resulting transformation of the crop insurance program that would result might satisfy even the strongest critics of the current program.
Advocates of a strong safety net for agriculture face the challenge of explicitly identifying why agriculture needs such a safety net, who should benefit from a safety net, and what tool or tools should be used to develop a cost-effective safety net. In selecting the tools to be used, guidance might be taken from the fact that most farmers are choosing to insure their crops with revenue insurance. After all, it is with revenue that farmers pay their production costs. ♦