2.2.3 The effectiveness of State aid

State aid that is intended to correct market failure may seem like a sound policy instrument. However, there are a number of drawbacks which limit the effectiveness of State aid.

The existence of a market failure is a necessary but not a sufficient condition for granting aid. State aid is only an appropriate instrument to address market failure if there are no better options available. This is why State aid has been called a “second-best option”.1 The first-best solution would be to address market failure directly. The most typical alternatives are regulation and taxation. In the case of externalities, there are two approaches: internalisation or subsidisation. For instance, in the case of a negative externality such as air pollution, the government may impose a tax on emissions. The tax would internalise the externality, because the tax entails that the undertaking has to bear the cost of pollution.2 However, this may put undertakings at a disadvantage compared to undertakings in other countries with a less strict environmental policy.3

The Commission has recognised that there are alternatives to State aid. In many of its Communications, the Commission stresses that aid should be an ‘appropriate policy instrument’.4

It is difficult to measure the exact size of the market failure. As a result, it is difficult to determine the right amount of State aid. For instance, in the case of positive externalities, the social benefits are greater than the private benefits. As a result, the undertaking produces less than is optimal from a social welfare perspective. The government may induce the undertaking to produce at the optimal scale by granting subsidies. Optimally, the amount of the subsidy should equal the difference between the social and private benefits. This, however, may be difficult to determine.

Government intervention may have benefits. But there is also a cost-side. State aid should only be granted if the benefits outweigh the costs. State aid is costly and has to be financed. In the end, taxpayers bear the cost.5 Furthermore, state resources are limited. Funds that are used to finance State aid cannot be used to finance other domains of government. This is called the opportunity cost of State aid.6

It is perhaps ironic that a government intervention which is intended to correct a market failure, may be subject to a “government failure”. This is the case when the intervention is misdesigned or misimplemented. Politicians do not always take the “right” decisions. There are several reasons for this. Firstly, there may be information asymmetry. Governments do not have perfect information. Secondly, politicians may be susceptible to lobbying. State aid policy may have been captured by special interest groups. Thirdly, politicians wish to be re-elected and sometimes, they pursue their private goals.7 State aid may make politicians popular, especially when the benefits are more easily perceived than the costs. These three reasons (information asymmetry, lobbying and self-interest) may be interrelated. If politicians do not possess enough information, then they may be more susceptible to lobbying.8 Also, politicians may decide to grant State aid according to the wishes of certain interest groups, because this may have favourable electoral consequences.