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Proposed Budget Shouldn't Kill Big Ag's Profits

Proposed reductions need to be sized against total farm income.

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As part of President Barack Obama's promise to "review the budget line-by-line for waste," the administration's budget proposal calls for a reduction in agricultural subsidies. The blueprint phases out direct payments to farmers with annual sales revenue of more than $500,000, and sets a $250,000 commodity program payment limit. In addition, the plan would reduce crop insurance premium subsidies, eliminate cotton storage credits, and reform the Market Access Program.

If enacted, how might these changes affect the agriculture sector? Let's start by outlining current farm policies.

Current Farm Policies
The most significant components of federal farm support are commodity programs, conservation programs, and crop insurance programs. Commodity programs--which cost approximately $8.3 billion per year according to Congressional Budget Office estimates--encompass direct payments, countercyclical payments, and marketing loan programs (including loan deficiency payments). Under the crop insurance program, the government pays a portion of farms' premiums and a portion of private insurance companies' administrative expenses. We'll focus on commodity programs--the focus of the proposed changes--which have been used to support farm incomes and reduce volatility by shifting some risks to the federal government.

Commodity Programs
Direct payments are fixed annual payments to farmers based on historical production--they don't vary with market prices or output. In recent years, direct payments amounted to $5 billion per year, according to the Congressional Research Service.

The countercyclical program makes an automatic payment to a farmer when market prices fall below a specific target price, while the marketing loan program essentially establishes a floor for crop prices. These programs become less important when crop prices are high, and therefore have tended to constitute a smaller portion of total commodity program outlays in recent years. Similar to direct payments, countercyclical payments are proportional to base acres, whereas one actually needs to produce the crop to participate in the loan deficiency program.

Under the 2008 Farm Bill, farmers are subject to certain limits on commodity program payments. For example, if a farmer's three-year average farm adjusted gross income exceeds $750,000, then no direct payments are allowed. However, these farmers are still eligible for countercyclical and marketing loan benefits. There is an effective limit of $210,000 on the total amount of direct and countercyclical payments a farm may receive. However, there is no limit on marketing loan payments.

Proposed Changes

Commodity Programs
As we mentioned earlier, the administration's proposed budget would phase out direct payments to farmers with annual sales revenue of more than $500,000, and limit commodity program payments to $250,000. If enacted, these items could save the federal government about $1.2 billion per year by 2013. For context, recall that existing commodity programs amount to roughly $8.3 billion in annual spending.

How could these potential reductions in commodity payments impact farmers? Let's take a look at some data from the USDA's 2007 Census of Agriculture. The average net cash farm income for all farms with more than $1 million in sales was nearly $800,000. For farms with $500,000 to $1 million in sales, the average net cash farm income was just over $225,000. Since under current policies farms with more than $750,000 in net farm income are ineligible for direct payments, we know that some farms in the $500,000-plus-in-annual-sales category already don't receive direct payments. The census data speak to this point--of the nearly 120,000 farms with annual sales greater than $500,000, just less than 80,000 received government payments.

The census data also show us that of the $500,000-plus crowd receiving government payments, the average amount per farm was just shy of $40,000. These farms earn $380,000 per year, on average.

Other Changes
The proposed budget would also reduce crop insurance premium subsidies and underwriting gains, which could save the federal government about $600 million per year by 2013. For comparison, the government now spends about $4.4 billion per year on this program, according to Congressional Budget Office estimates. The administration's blueprint includes some user fees (for example, inspection fees), which could cost the agricultural sector approximately $108 million per year by 2013. Next, the elimination of cotton storage credits could save the federal government about $56 million per year by 2013. Finally, a reform of the Market Access Program is expected to save $40 million per year.

Ethanol
We point out that the budget proposal contains no mention of a modification to the Renewable Fuels Standard (RFS), which indirectly supports corn growers. RFS calls for 12 billion gallons of first-generation biofuel use in 2010--escalating to 15 billion gallons per year by 2015--a requirement satisfied primarily by corn-based ethanol. In 2008, the U.S. produced 9.2 billion gallons of ethanol, consuming roughly 30% of the U.S. corn crop. Thanks to RFS, U.S. ethanol production is set to grow, creating additional demand for corn (all else equal). Ethanol production supports corn economics not only by creating a new source of demand for corn, but also by increasing corn prices when oil prices are extremely high. As we saw last summer when oil prices reached their peaks, corn prices were driven higher because the usefulness of corn increased due to its ability to be converted into a substitute for oil products.

Conclusions
If enacted, it's possible that the proposed changes could hurt farmers' profits, reducing their ability to purchase equipment, crop protection chemicals, fertilizers, or even seeds. However, we stress that the proposed reductions need to be sized against total farm income. The total net amount of subsidy reductions is anticipated to be approximately $2 billion, compared with 2007 total farm revenues of nearly $300 billion and net income of roughly $75 billion. In other words, the proposed reduction in subsidies amounts to less than 1% of the sector's 2007 revenues and less than 3% of 2007 net income. Further, for the farms that could be most impacted by the proposed changes--the $500,000-plus crowd--a complete elimination of all government payments would reduce net income by just over 10%, from about $380,000 to $340,000. However, this extreme outcome seems unlikely, as some of these farmers may still be eligible for countercyclical payments, marketing loan programs, crop insurance subsidies, and conservation programs. We merely calculate the 10% figure in an attempt to gauge an upper bound on the possible impact on the $500,000-plus crowd. In sum, we believe the effects of the proposed budget on the agriculture sector could be fairly minor, and one of the chief risks to the domestic farm industry would be a reversal of ethanol policies, which aren't touched by the budget proposal.

Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.