Literature review on business subsidies

The literature on business subsidy programs is plenty and diverse. Studies can be classified depending on the type of subsidy examined (i.e. R & D, Investment Tax Credit - ITC⁸ -, fixed investment, etc), on the impact level (micro, macro), on the time perspective (ex ante, ex nunc, ex post), on the method of analysis (qualitative, quantitative), etc⁹.

Indicative scientific¹⁰ studies reviewed here, including some which survey the literature, are by Chirinko (2000, 1993), Gravelle (1994), Gale (1990), Barkman and Fölster (1995), Roper and Hewitt-Dundas (1998), Venetoklis (2000a, 2000b).

Chirinko (2000) surveyed the US Investment Tax Credit impact studies which among others measured the marginal cost of funds and the additional investment per dollar of tax loss. He argued that the elimination of ITC in the US back in 1986 was welfare enhancing (p.13). Earlier, the same author (Chirinko, 1993) surveyed studies on ITC which applied a wide range of econometric models. The results again suggested limited impacts.

5 For more on industrial and regional policy within the EU, see chapters 8 and 10 in McDonald and Dearden (eds.) (1994, pp.

116-135 and pp.157-186).

6 The new law on the implementation of business subsidies (aid to business Act 150/1999) came into force in 2000.

7 If we include the projects partly financed through EU Structural Funds, the percentage of business subsidies distributed by the KTM is even higher than the aforementioned 55%. We shall return to this in the last chapter.

8 Direct transfers of subsidies to firms can occur in different formats. For example, one could be through transfer of funds literally from a government bank account to a firm bank account. Another way is through tax exemptions. In literature these are referred to as Investment Tax Credits ( ITC). ITC are nothing more than a reduction in a firm’s tax liabilities as a percentage of the price of a purchased asset. In other words the firm pays less than it would have done for the asset without the ITC. Under this context, we are reviewing studies on ITC since they may influence the behaviour of the recipient firm the same way as if the firm had received directly a grant. In both cases the firm first itself makes the initial outlay of funds and then reports the expenditure the relevant authorities (ministry or taxation office). The only difference is in the time of reimbursement. The ITC may be realised in the following financial year after the firm outlay, where as the direct grant is paid as soon as the firm submits the invoices showing the expenditure. ITC is a very popular government intervention tool in the US. In the study’s empirical section (chapter 4) we examine only the former type of direct business subsidies, namely direct transfers of money from a government institution to a firm.

9 See Venetoklis (2000b) for a detailed classification.

10 Scientific studies are emphasised here for their results which are pessimistic and indicate poor impacts. However as has been noted by some authors (e.g. Barkman and Fölster (1995), Venetoklis (2000b)) usually this may not be the case if the commissioner is an organisation (ministry) which itself distributing subsidies. Then the results are much more encouraging. We shall refer to this oxymoron in chapter 4 where we discuss the phenomenon of information asymmetry within business subsidy programs, in connection to bureaucratic behaviour.

Gravelle (1994) also surveyed the literature on types of investment subsidies and their economic efficiency. She concluded among others that investment subsidies are not very successful as short-term counter cyclical devices; at best they are risky choices. If a firm faces credit rationing and financial constraints, having it subsidised, probably leads to inefficient allocation of its resources (p.121).

Gale (1990) examined whether a government intervention through the use of business subsidies increases efficiency. He reported that subsidies or guarantees, specifically aimed at credit rationed firms, may in fact worsen efficiency.

Roper and Hewitt-Dundas (1998) looked at the effect of grant support on small business performance during the period 1991 to 1995 in firms located in N. Ireland and in Ireland. The results indicated that grant aid had no effect on either the turnover growth or profitability of small businesses in either area.

On the other hand subsidies did boost employment. The writers commented that although the employment growth is a positive outcome for job creation, it has potential worrying implications for the firms’ longer-term competitive position through its (negative) effect on productivity.

Venetoklis (2000a) examined the impact of direct grants on the Value Added growth by using a large data set consisting of 36 000 firms around Finland 35%, of which had received subsidies. The results suggested that the impact, although positive, was much less in monetary terms than the subsidy funds distributed; and that, in turn, implied that the net welfare effect was negative.

The consensus of the evidence presented in these studies is that business subsidies - especially in the form of direct transfers (grants) - do not seem to achieve their predefined goals in terms of firm productivity growth, increased competitiveness, sustainable job creation, increased firm R&D investment, etc. As Clements et al. (1995, pp.18-23) put it

“Concerns for the duration of any particular subsidy program arises because economic agents (firms) alter their behaviour in order to capture the benefits of subsidy programs.

Beneficiaries may also resist exclusions from subsidy programs when their circumstances change. It is this behaviour that, over time, renders many subsidy programs ineffective and excessively costly“.

Nevertheless, we see a perpetuation of these business programs, both in Finland and at EU level. In addition, we also show below that a great portion of business subsidies is distributed to the same firms which - as has been argued above - is ineffective and excessively costly. Hence, a question that rises is this: If the business subsidy policies have proved unfruitful why are they still adopted? This will be the subject of the following chapter.