2.2.2 Motives for granting State aid

As explained in the previous subsection, State aid may give rise to competition distortions. This raises the question why governments grant State aid. There may be several motives for governments to grant State aid; motives which can be of an economic or non-economic nature. The economic motives are reflected in the efficiency objective of aid, whereas the non-economic motives are reflected in the equity objective of State aid.

Market failures may provide a justification for government intervention. Market failure means that the market fails to deliver the optimal outcome.1 A market failure occurs when the market does not provide a good or service even though the economic benefits are greater than the economic costs.2 There are several types of market failure. In this section, the two most prominent ones will be discussed: i) externalities, and ii) information asymmetry.3

The existence of externalities may provide a justification for granting State aid. “Externalities” is an economic concept and essentially means that economic actors (such as undertakings) cannot fully internalise the costs or benefits of their actions. There are positive externalities and negative externalities. Negative externalities (or external costs) are costs that result from a certain activity, but those costs are incurred by society and not by the undertaking conducting the activity. The classic example of a negative externality is pollution. Assume that an undertaking produces certain products and that the production process causesair pollution. The undertaking itself is not affected by it, but the activity obviously has negative effects on society. In such a situation, the social costs are higher than the private costs.

Positive externalities (or external benefits) occur when a certain activity entails benefits for society which are not appropriated by the undertaking itself. A classic example is R&D. Some R&D-projects are not invested in by undertakings; this occurs when the rate of return on these projects is not attractive from the perspective of the undertaking. This is the case when the undertaking cannot fully appropriate the benefits of the R&D-project; for instance when patents do not provide full protection.4 However, these projects may still be beneficial for society as a whole, since R&D may create knowledge spillovers or opportunities for other undertakings to develop complementary products and services.5 In such a situation, the social benefits are higher than the private benefits.

Externalities are a form of market failure, in the sense that the market fails to deliver an efficient outcome.6 This is because undertakings only take into account the private costs or benefits (and not the social costs or benefits). As a result, in the case of a negative externality, more products are produced than is desirable from a social welfare perspective. In the case of positive externalities, the activity is performed at a smaller scale than would be optimal for society. Giving subsidies (i.e. State aid) to the undertakings concerned may remedy this market failure, because these subsidies induce the undertaking to produce at the optimal scale.

Information asymmetry means that one side of the market has more information than the other side. A good example is the capital market/credit market. On the demand side, there are undertakings that want to obtain funding for their activities. On the supply side there are banks and investors. The undertakings know more about the prospects and profitability of their activities than banks and investors. Also, the default risk is often unknown to potential suppliers of credit. In other words: there is information asymmetry. As a result, it is difficult for potential investors to distinguish between good and bad investments.7 Risk- averse investors may be reluctant to provide capital to such undertakings. In economic terms: there is an imperfect matching of supply and demand. This means that some projects will not be financed, even though they are worth financing.

Especially young undertakings and SME’s find it difficult to obtain funding.8 This is because there is less information about them. Information asymmetries may provide a justification for State aid that provides incentives to the financial sector to increase (SME) investments.

The equity objective concerns redistribution of wealth and resources. As Friederiszick, Röller & Verouden put it: the efficiency objective is about “making the cake bigger”, the equity objective is about “dividing the cake better”.9 State aid is one of the instruments governments can use to redistribute income. In the absence of market failures, the market will deliver efficient results. This does not mean, however, that the market outcome is equitable/socially desirable. This might provide a reason for the government to intervene. This is the case for regional aid, social aid and aid to promote culture.

Regional aid is a typical example of a redistribution of income. Public funds are used to support the poorer regions of a Member State. Regional aid has an equity objective, because “it is morally, socially and therefore politically unacceptable for a country to allow great differences in the standard of living of its regions”.10

An example of social aid is aid for the employment of disadvantaged and disabled workers. Employers might be reluctant to hire disadvantaged and disabled workers. As a result, these workers might have difficulties entering (or staying in) the labour market. This is an outcome that is not socially desirable.

In order to encourage undertakings to hire more disadvantaged and disabled workers, Member States may choose to subsidise the wage costs of these workers.11

Aid to promote culture is another example of the equity objective. If too few cultural goods are produced, then State aid may be justified in order to increase (or sustain) the production of cultural goods. In that regard, it should be noted that the TFEU explicitly recognises the utmost importance of promoting culture.12