Recently we published a new discussion paper I was working on for quite some time. My coauthor and me study the effectiveness of subsidies for research and development (R&D) at the European level. Subsidies to support R&D activities by private firms are an essential part of science and technology policy in all OECD countries. Economic theory tells us that (especially small and young) firms invest too little in innovation, either because they’re financially constrained or because their ideas get imitated. Therefore governments should step in to boost R&D and enhance the competitiveness of the economy.
In recent years there have been substantial efforts to harmonize R&D policies of individual European countries and to establish joint programs across national borders. This is desirable because firms could benefit from R&D cooperations with international partners, which possibly facilitate their access to export markets and stimulate technology transfer. Thus, allocating subsidies at the European level might be more effective than what can be achieved at the national level alone.
But how do you organize a pan-European subsidy scheme? At the national level the process is usually quite simple. First you issue a call for proposals and firms apply with their project ideas. Then, you pick the best proposals out of the pool of applications and fund as many as your program budget allows. At the supra-national level, however, the program budget is provided by all the participating countries. If you pooled these contributions to a single budget this would imply cross-subsidization between countries when, let’s say, a German firm is funded by taxpayers’ money from Spain.
Such cross-national money flows are difficult to explain to voters at home. In general, transfer payments within the EU are a highly sensitive topic politically. For this reason—and also because the legal frameworks for R&D policies are not yet harmonized across European states—policy makers invented the so-called Virtual Common Pot (VCP). The system works as follows. Firms need to form international project consortia with at least two partners from different countries (because we want to promote R&D cooperations and knowledge transfer across Europe). With their joint proposal they then apply to a central agency—which is responsible for all participating countries—and the applications get evaluated according to common evaluation criteria. So far so good. But now comes the crucial point. Every individual country only pays subsidies to their own respective applicants. An application can thus only get granted when there is still enough money available in all the countries involved.
Take a simple example from our paper: Suppose there are four countries participating in the program, A, B, C, and D. And each country provides a budget to fund exactly two firms, so that there is a total budget of eight. A fictitious quality ranking of applications could look like the following:
|1||A, B, B||✔||✔|
|2||B, B, C||✔|
|4||A, B, C, D|
|5||C, D, D||✔|
|6||A, C, D|
A consortium of three firms, one from country A and two from country B, submitted the best project proposal. Another consortium of firms, from country B and C, had the second-best application, and so forth. In the normal process, what is also called a Real Common Pot (RCP), the three best proposals in this ranking would be funded. After that, eight firms received a grant and the common budget would be exhausted. Under the Virtual Common Pot, however, the individual national budget constraints need to be respected. The first proposal receives funding as before. But then, country B’s budget of two is already used up. The second-ranked proposal cannot receive money anymore because the granting decision is always for the project as a whole. For the third project there are again sufficient resources available.
Note how the VCP leaves gaps in the quality ranking of projects that would otherwise get granted under the Real Common Pot. You can imagine that such a system creates some inefficiencies as not all of the best ranked projects necessarily get funded. In the paper we study a European subsidy program for R&D-performing small and medium-sized enterprises, called Eurostars, that was organized as a Virtual Common Pot. We estimate the effect of Eurostars grants on job creation.* And indeed we find that an additional job would have cost 27% less if the RCP allocation rule had been applied. Consequently, we could expect a substantial efficiency gain from removing the restriction on cross-subsidization and moving to a single European budget for R&D policy (as for example in the framework programmes). Whether that’s politically feasible, however, is an entirely different question.
* For my technically skilled readers: the VCP also provides us with a very nice and clean identification strategy, details can be found in the paper.