The purpose of this section is to offer a taxonomy of financial inducement as a preparation for the economic analysis which follows. Four methods of classification of these inducements are considered according to (a) the type of financial instruments; (b) their economic coverage; (c) whether they are designed to influence outputs or inputs; and (d) whether they are direct or indirect.
There are two types of financial instrument identified:
This is a payment from government to a company which appears as a current expenditure item in the government accounts and as a revenue item in the company's accounts. Such a definition would also embrace the purchase of goods and services by government from a company, so we must add the restriction to the definition that the government does not receive any goods or services in exchange, though its own production activities may benefit from any spin-off effects. A common term for such an ‘unrequited’ payment is a subsidy.
EC countries have a long history in the use of subsidies to promote employment and start-up of Small Business Enterprises (SMEs), combining the two objectives in some cases by grants to unemployed persons starting SMEs. A latter-day variant has been to introduce a regional aid dimension by offering venture capital to small business in regions of high unemployment who would have difficulty in raising equity funding. All such schemes are liable to take time to launch because the EU Commission frequently questions whether or not they conform to EU Competition Policy.
This is a payment from government to a company which may be made in the form of tax concessions, tax rebates, and loan interest and repayment terms at below market rates. Unless the firm has to make a special claim for such payments, these payments do not appear as such in the company's or in the government's accounts. Company payments or tax or loan charges will be less than they would otherwise be, as will government tax or interest receipts and loan repayments, all things being equal. A general term sometimes used for such implicit payments is a tax-expenditure which signifies that the government finances companies through a lowering of its ‘tax-take’. The term invites the objection that it seems to assume that the government has the right to take what it likes in taxation, but foregoes these rights through tax concessions!
Instead of paying a grant towards the investment in some particular project, the government, as an alternative, may offer tax concessions such as ‘generous’ depreciation allowances designed to encourage the project. Such a system, which is commonly used in industrial countries, assumes that firms are making enough profits to induce them to claim such allowances.
An attempt has been made by the EC to produce a breakdown of aid according to the type of payment, as illustrated in Table 6.3. There is obviously considerable variation between EC countries but it is noteworthy that in all countries explicit payments in the form of grants are of major importance.
| Country | Grant | Tax exemptions | Equity participation | ‘Soft loan’ | Tax deferred | Loan guarantee |
| Belgium | 60 | 28 | 4 | 4 | 1 | 3 |
| Denmark | 63 | 31 | 0 | 6 | 0 | 1 |
| France | 28 | 47 | 13 | 9 | 1 | 3 |
| Germany | 58 | 12 | 0 | 23 | 1 | 5 |
| Greece | 97 | 0 | 0 | 3 | 0 | 0 |
| Ireland | 60 | 29 | 7 | 0 | 0 | 4 |
| Italy | 55 | 37 | 4 | 1 | 0 | 2 |
| Luxembourg | 93 | 6 | 0 | 2 | 0 | 0 |
| Netherlands | 66 | 19 | 0 | 5 | 8 | 2 |
| UK | 94 | 1 | 0 | 2 | 1 | 1 |
Note: These figures are approximate only. Some variation may be due to rounding up.
Source: As for Table 6.1.
The second classification of subsidies of relevance concentrates attention on their economic coverage. Prest (see Whiting, 1976) offers the useful distinction between ‘broad-base’ ‘intermediate-base’ and ‘narrow-base’ subsidies.
These are designed to achieve the policy aims discussed in section6.2 by their influence on macroeconomic variables, such as the total wage bill, total profits, total consumption, total investment and total exports, as these items are defined in the National Accounts. Many theoretical schemes have been put forward by economists which are founded on the provision of general subsidies using macroeconomic variables as a base, either alone or in combination with other fiscal measures. One proposal designed to promote the growth of the economy would have the government subsidise firms according to the increase in their value added per year.
In practice, there are administrative problems attached to applying any principle of ‘generality’ which mainly arise in defining the limits of the particular base used. Broadly speaking, industrial countries have concentrated broad-base subsidization on capital investment but operating through tax reliefs related to the life of capital assets rather than through capital grants. Of course, this does not preclude other forms of financial inducement offered to investors in fixed capital.
In many industrial countries generous provision is made for writing off the cost of capital in arriving at the tax base for a company. While tax theorists might argue that depreciation of capital should be based on the cost of the asset and its length of useful life, governments rarely pay more than lip-service to this principle. Before the tax reform of 1986, capital costs in the US in the 1980s were covered over a shorter period than the life of the asset. Even though this general provision was modified in 1986, so that more real depreciation rates were introduced, the US Congress was induced to accept that oil and gas exploration represented special cases. Deductions allowed for costs of exploration, discovery and development of a mine or oilfield often exceed the cost of the mine or oilfield.
These are subsidies which apply some principle of selection by which certain companies in defined categories are favoured and others are not. In terms of the policy aims identified in Section 6.2, this is a very important category. For example, equalising of employment opportunities in different areas of a country often leads governments to select companies in particular regions. Growth policies are often based on the proposition that there is a close correlation between economic growth and the encouragement of entry of new, small firms into manufacturing business, thus leading governments to give selective assistance to such firms through special subsidies and/or tax reliefs. Similarly, if growth depends on exploitation of economies of scale, it is claimed that this makes a case for preferential treatment for manufacturing industry.
In 1972 the UK introduced Regional Development Grants (RDGs) which applied two criteria of selection. The first was based on region – the so-called Assisted Areas where unemployment was relatively high – and the second was based on activity – the RDGs being payable only to manufacturing, mining and construction. Between November 1984 and March 1990, RDGs totalling £540m. were paid out, supporting £2730m. of capital investment.
These subsidies are directed at a single company or a relatively small region, e.g. a particular town. Leaving aside government's interest in preventing a particular firm from going bankrupt, i.e. ‘rescue cases’ there is no clear link, discerned by economists at least, between economic policy aims and narrow-base subsidies. For example, the employment aims would have to specify a guarantee to employees that they were entitled to a permanent job in a particular firm and this aim would clearly conflict with the need to preserve economic incentives and to encourage companies to use labour efficiently, both of which are fundamental to the promotion of economic growth. Nevertheless, governments claim that subsidies to promote R and D have to be narrow-based. The reason given is that the determination of the government contribution and the conditions of award of assistance must rest on detailed predictions of the prospects of the individual company, and sometimes even on reorganization of the company's structure.
The UK Government became worried in the late 1960s about the development of computer technology and computer marketing. Government assistance was concentrated on one firm, International Computers Ltd (ICL), but it was a condition of assistance that two firms were merged and that the government took a 10 per cent equity in the new company. An initial government grant of £13.5m. was provided for the company's R and D programme.
Many of the examples given above have been of subsidies to inputs. These subsidies directly encourage firms to employ more labour or invest in more capital equipment. Other policy instruments are designed to encourage domestic output. Examples of output subsidies can be found in the energy sector of the economy. After the privatisation of the electricity industry, long-term contracts with generators committed them to purchasing coal at prices above world levels from British mines. This was a form of ‘hidden’ or ‘implicit’ output subsidy to coal since the cost would appear in higher electricity prices for consumers and not in the government's accounts. These contracts have now expired. Similar encouragement is given to the output of ‘renewable’ forms of electricity generation. The Non-Fossil Fuel Obligation (NFFO) allows premium prices to be paid for electricity from renewable sources. Since February 2000, there has been a ‘new Renewables Obligation on all electricity suppliers to supply a specific proportion of electricity from renewables’. Thus, suppliers of electricity to consumers are forced to take a proportion of their electricity at higher pries than they would otherwise pay – a hidden or implicit subsidy to the output of electricity from renewable or non-fossil fuel. Support for coal is now more explicit. Under the UK Coal Operating Aid Scheme, the level of subsidy is determined as follows: ‘Subsidy will be paid in respect of loss making sales, to make up the difference between the cost of producing coal and the revenue associated with that coal. The level of subsidy paid must not cause the delivered price to undercut third country coal of an equivalent quality sold on equivalent terms’. This scheme is similar to the situation analysed in more detail below in Section 6.4.
The forms of financial inducement discussed so far are traceable in the accounts of the individual company and in the government accounts, or could be quantified, as in the case of tax rebates or ‘cheap’ loans, as benefits to the companies that they are meant to support. Such inducements are direct. However, governments may offer financial support indirectly through fiscal measures which influence the activities of third parties and do not normally involve direct negotiations between the government and the companies which it wishes to benefit. Thus while a broad-base subsidy to capital investment might take the form of cheap loans provided directly by the government to firms, an alternative would be a general subsidy to lending by private banks. An intermediate-base subsidy might take the form of subsidising particular groups of consumers so that they would buy the products of particular kinds of companies, as in the favourable tax treatment afforded to house purchasers in the UK, which will influence capital investment in housing construction. It might also take the form of taxing goods bought by particular consumer groups in order to divert their purchases to the products of particular companies, as in the use of import duties designed to redirect domestic purchases towards home goods. (This last example illustrates vividly the problem of defining the term ‘subsidy’ for it implies that almost any fiscal measure was designed with that intention in mind.)
