Industrial policy works for smaller firms

John Van Reenen 17 February 2012

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The Great Recession has brought industrial policy back into fashion. Huge subsidies have been granted by governments around the world to private firms, most dramatically in financial services, but also in other sectors like automobiles (see for instance Evenett 2011). Despite the ubiquity and cost of such schemes, rigorous evaluations of the causal effect of these policies are rare.

The basic evaluation problem in working out the impact of these schemes is that such programmes might simply finance activities that firms would have undertaken anyway. If this is the case, large amounts of taxpayer money are simply wasted, even before taking into account the distortion arising from higher taxation and other unintended consequences. The consensual view among economists is that industrial policy is a failure, but the empirical basis for this conclusion is hardly overwhelming. As Rodrik (2007) emphasises, many of these policies are targeting firms and industries that would be in difficulties in the absence of government support, so that simply looking at what happens to recipients compared to non-recipients could substantially underestimate the impact of receiving government support.

More jobs and investment from the policy

In recent work (Criscuolo et al. 2012), my co-authors and I try to address these problems and identify the causal impact of an industrial policy called ‘Regional Selective Assistance’. This has been the main business support scheme in the UK over the last 40 years and similar policies exist all over the world. This programme offers investment subsidies to firms in depressed areas on condition they “create or safeguard employment” in these areas – a condition that one might suspect is hard to enforce, especially for larger firms. Figure 1 illustrates the areas of the UK where firms were eligible to apply for government grants. We exploit changes in these “maps of assistance” to figure out the effects of the policy.

Figure 1. Areas of Great Britain eligible to receive investment subsidies in 2000

Notes: This shows all the different levels of NGE (Net Grant Equivalent, the maximum investment subsidy) by area. Tier 1 areas had 35% NGE and Tier 2 areas ranged between 10% and 30%.
Source: Department of Business

 

We find that the scheme was successful at boosting investment and increased employment by around 100,000 a year at a cost of around $6,300 per job, which is relatively cheap. Manufacturing employment rose and these jobs seemed to come from lower unemployment rather than being “stolen” from unaffected regions and firms.
Government grants to smaller firms (eg those with fewer than 150 workers) were effective in increasing investment and employment, but money given to larger firms had effectively zero effect. The reason why there is no effect for large firms is probably because they are able to “game” the system and take the subsidy without changing their investment and employment levels. Another explanation is that grants help remove the financial constraints faced by smaller firms, whereas larger firms have deeper pockets.
Another possible downside of the scheme was lower aggregate productivity as the grants tended to go to less productive firms and had no impact on improving their productivity.

Experimental variation caused by the European Commission’s changes to state aid laws

Our research analyses the impact of expenditure on the Regional Selective Assistance programme over a 20-year period. We have access to every grant and examine every manufacturing plant in England, Wales, and Scotland – over 2.3 million observations – before and after receiving government support. The main factor holding back credible evaluations of industrial policies is the absence of a way to figure out what would have happened in the absence of policy. However, because EU law governing state aid changed twice over our sample period, some parts of Britain became eligible for subsidies and others saw their grants disappear. These EU-wide rule changes induce a quasi-random element to programme eligibility. For example, the level of an area’s GDP per capita relative to the EU average GDP capita was one criterion determining whether firms in a region can obtain grants. When richer countries joined the EU this made some UK regions relatively poorer and therefore eligible for subsidies even though nothing in the UK region had changed. This enabled us to work out the impact of investment subsidies on firm performance by comparing similar firms that only differ in terms of their changing eligibility for treatment.

We found that a 10% investment subsidy causes about a 7% increase in employment, with about half of this arising from growth in existing plants and half from higher net entry. We also show that these effects have been underestimated as previous work did not take into account the fact that the participants are firms and areas that would otherwise have performed badly.

Policy conclusions

Does this mean the government should be providing much more support to smaller firms in disadvantaged areas? Not necessarily. Regional Selective Assistance was targeted at firms that served national or international markets, so this could be a reason why we do not detect much displacement (where jobs at supported firms just replace jobs at nearby unsupported firms). However, many smaller firms, particularly in the service sector, serve local markets and so one might reasonably expect support to those firms to generate more displacement (see Elias and Overman 2012 for more discussion).

In short, as usual, careful empirical evaluation cannot necessarily answer all the questions about a policy. But one central message does emerge: If the government is to have this type of investment subsidies, targeting smaller firms would be much more cost-effective than supporting larger firms. The European Commission is currently considering how to re-write the regional guidelines for state aid; we would urge them to take these results into account when deciding how to do this.

References

Criscuolo, Chiara, Ralf Martin, Henry G Overman, and John Van Reenen (2012), “The causal effects of an industrial policy”, CEPR Discussion Paper No. 8818
Einio, Elias and Henry G Overman (2012), “The Effects of Spatially Targeted Enterprise Initiatives: Evidence from UK LEGI”, LSE mimeo.
Evenett, Simon J (ed.), Trade Tensions Mount: The 10th GTA Report, globaltradealert.org and CEPR.
Rodrik, Dani (2007), One Economics, Many Recipes, Princeton University Press.
 

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Topics:  EU policies Industrial organisation International trade

Tags:  subsidies, protectionism, small business

Professor of Applied Economics, MIT

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