Objectives for granting subsidies — and for agreements on subsidy limitations
With respect to a government’s objective for granting subsidies, two constellations matter in particular. On the one hand, the government (of a democratic country) might grant subsidies to specific firms or industries if political decision makers expect a positive return in terms of voter’s support. Assume, for example, that an unprofitable airline is ‘saved’ from bankruptcy by granting a subsidy. The political decision makers presumably hope that in the future the employees of this airline (plus their families, friends and neighbours) might vote for those politicians who supported the decision. In general, political economic theory suggests that the likelihood of selective advantages in favour of a specific group increases with the homogeneity of that group and the relative importance of the advantage within the overall income of the group members.
On the other hand, if policymakers aim at welfare maximisation, subsidies should be granted if they help to overcome market failures. The textbook example, which is rather uncommon in the transport sector, is an external benefit justifying a ‘Pigouvian’ subsidy. Moreover, in a natural monopoly market characterised by increasing returns to scale (e.g. an airport), marginal cost pricing - which is usually considered to be the prerequisite for allocative efficiency - leads to losses (since average revenues are below average costs) that might be covered by a subsidy. However, since in reality the generation of tax revenues also causes allocative distortions, the overall welfare effect of such a subsidy might as well be negative (Joskow, 2007).
Many subsidies favouring the air transport industry are linked to regional policy objectives (see Fageda et al., 2018). According to Article 174 of the Treaty on the Functioning of the European Union (TFEU) the EU ‘shall aim at reducing disparities between the levels of development of the various regions and the backwardness of the least favoured regions’. Also, many EU member states highly prioritise regional policy objectives in their respective territories. Although some arguments in favour of a dedicated economic policy against regional disparities might be put forward on the basis of efficiency considerations (e.g. negative externalities of agglomeration), there might also be a trade-off between the reduction of differences in average income (distribution objective) and overall economic efficiency.
The theoretical analysis of tax competition suggests that jurisdictions might engage in a race to the bottom1 (with respect to tax rates) if they aim to support their ‘domestic’ firms when competing with firms located in other jurisdictions. Quite similarly, a race to the top2 might occur when states or regions use subsidies to strengthen the market position of a domestic industry. To avoid such developments, which might be seen as a prisoner’s dilemma, states could agree on common rules for taxation or subsidies. In particular, parallel to the deregulation of the European air transport market, the general rules on the limitation of state aid were also applied to the airline sector. Regarding airports, it took the EU much longer to introduce rules that aim to prevent competitive distortions caused by state aid. Both regulatory frameworks are further discussed in the forthcoming sections.
