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The positive analysis of the economic constitution of the Community

provided in chapter 3, forms an important basis for any economic study

of European integration. The present chapter builds on this by asking

the following normative question: which public economic functions

should be assigned to the EU level and which ones should remain at the

Member States' level? The economic analysis of multi-tier government

may help us to identify criteria to justify, on economic grounds, the

assignment of public economic functions to the highest (that is, EU)

level of government. The functional application of these criteria is

constrained, however, by the degree of political willingness to accept

fully fledged liberalisation of markets (which reduces domestic

autonomy) and to transfer regulatory and other public functions to the

EC level. As noted in chapter 1, a minimum commitment in these

respects is required before the economic analysis of multi-tier govern-ment can be fruitfully applied.

It is therefore not surprising that, once the EC-1992 programme and

the Single Act had been agreed, the Commission asked for a study of

the systemic implications for the EC of completing the internal market.

The resulting Padoa-Schioppa report (1987) gave prominence for policy

makers to the economic analysis of multi-tier government via the prin-

ciple of subsidiarity. Section 4.1 will provide the basic economics of

subsidiarity, followed by the application to the public economic functions

as they pertain to the European Community. A subsidiarity test will be

developed in 4.2 and applied in a case study about environmental policy

(case study 4.1). For a more general application of subsidiarity to the

EUs economic functions, it is useful to remember that the equity func-

tion is very weakly developed (see chapter 15), whereas the

macro-economic stabilisation function will (largely) shift to the EU level

due to EMU (see chapters 16 and 17). Therefore, in 4.3 we shall

Topics covered

4.1 The economics

of subsidiarity

4.2 A subsidiarity test

for the Union

4.3 Subsidiarity and EU

regulatory strategy

4.4 Subsidiarity and non-

regulatory EU functions

4.5 Summary

CHAPT ER 4 Subsidiarity and Economic Functions of

the Union

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concentrate on the application of subsidiarity to the

most pervasive role of the EU: regulation. Section4.4 briefly discusses the application of subsidiarity

to five non-regulatory economic functions of the

Union.

4.1 The economics of subsidiarity

4.1.1 Assignment criteria

An economic approach to subsidiarity can be found

in the economic theory of federalism or, moreprecisely, of multi-tier government.

The starting point is as simple as it is crucial.1 Itwould be a serious mistake to presume that the

process of economic integration must ultimately

lead to the complete centralisation of all publiceconomic functions at the EC tier of government.

All-out centralisation is bound to be suboptimal interms of economic welfare. If all voters, localitiesand regions had congruent preference sets, knownat the central level, this fundamental problem need

not arise. But regions or EC countries typically

differ or only partly overlap in their preferences.Could a central government not pursue a set of

policies which would be differentiated regionally insuch a way that it replicates what regions would

otherwise have done anyway? And if regional poli-

cies conflict or trade-offs between regions wouldarise, couldnt the central government outperformany total decentralisation by resolving theseconflicts? In actual practice the central government

cannot do this because it is far less accountablethan regional governments. For this reason it is

less able to extract all the relevant information from

mistrusting regions. It should also be expected tobe less responsive to regional needs than the

regional governments, and this without muchregional power to correct or prevent central deci-

sions. In short, central governments have a morelimited ability and willingness to implement idealreplicas of decentralised solutions. Therefore they

are inefficient, unless special reasons reduce oreliminate the relative advantages of assigning

public economic functions to the regional (orMember States) level. The subsidiarity principle

says that close correspondence of public policy

with voters preferences will often require the

assignment of policy competences to local govern-ment. Assigning public economic functions to

higher tiers of government should only be donewhenever, and to the extent that, one or more ofthe relevant criteria for policy efficiency and effec-

tiveness are fulfilled. The subsidiarity test is aboutthe appropriate application of the criteria for

possible assignment of functions to the EU level.

The criteria are listed in Table 4.1.The economic approach to subsidiarity takes a

willingness to integrate (centralise) public

economic functions for granted, once one or more

criteria are fulfilled; the criteria then point to

welfare gains from centralisation. It differs from

the political approach, where the economic gains of

centralisation are weighed against the political

costs of centralisation itself. The economic

approach provides the analytical basis for a

rational application of subsidiarity, but, in actual

practice, an ultimate political judgement remains

decisive.

The reasoning behind Table 4.1 amounts to asearch of the benefits of centralisation and runs as

follows. First, establish whether a criterion is rele-

vant (for example, positive externalities across

intra-EU borders). Second, verify what economic

policy or regulation gives rise to this observation

(see examples). Third, efficiency (the lowest cost

for achieving the objective of policy or regulation)

48 Foundation

1The following also draws from Pelkmans (1990), Forte (1977) and CEPR (1993).

Criterion Nature Examples

1 positive reduces regional an expenditureexternalities effectiveness impulse by a

veryopen economy,unilaterally (givenexchange rates)

2 negative beggar-thy- water or air externalities neighbour pollution

policies, inimical trade protectionto adjacenteconomies

3 economies high fixed costs defenceof scale of supply, or developing a

indivisibil it ies modern jetfighter

particles


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and/or effectiveness (actually accomplishing the

objective) may then require a degree of coopera-tion, joint action or fully fledged centralisation. Not

included in the table, and subsequent to the appli-

cation of the criteria, is the consideration of the

economic cost of this centralisation: these costs

ought to be minimised.

By far the most powerful case for centralisation

in economic integration is related to the internal

market. By and large, it would refer to the criteria of

negative externalities: any hindrance of intra-EU

movement of goods, services or factors, or any

country-specific distortions would in principle

qualify. However, the resulting centralisation need

not consist of positive integration: negative integra-

tion might suffice. The centralisation in case of

negative integration would merely consist in the

required common regulation prohibiting Member

States (and economic agents) to pursue certain

actions or measures in other words, common

regulation only for the purpose of intra-EU free

movement. Since centralisation may well mean

negative integration only, or many mixtures of

negative and positive integration, the term centrali-

sation in a subsidiarity test is considered in a

purely functional way. The reader is warned that, in

the actual political debate in the EU, centralisation

often refers to its most extreme variant: the full

transfer of certain powers to the EU level, if not tothe Commission and the EP only. Such a politi-

cised perspective is dysfunctional and may lead to

serious misunderstandings it may cause flawed

assignments and hence welfare costs. Other than

prohibitions, centralisation also refers to many

intermediate variants with different benefitcost

ratios.

The three criteria (negative and positive exter-

nalities across intra-EU borders; scale, beyond the

national level) are by far the most important ones to

consider. However, a number of other criteria may

play a role in the EU: they may be subsumed under

the three principal criteria (for benefits), or, they are

specific criteria for reducing the economic costs of

centralisation. Thus, one could favour centralisation

on the basis of criteria such as

uniformity of Community law, including case law

(a special case of scale);

insurance against macro-economic shocks

which are country-specific, by pooling part

of unemployment payments among

Member States (a special case of scale);

differentiation of central policies according to

national preferences or circumstances(reducing the costs of centralisation, by

responsiveness to differences in preferences).

Special mention is due to (common) bargaining

power in, say, trade negotiations or negotiations

about fishing rights. It amounts to a combination of

(a threat of negative) externalities and scale, so it

is not an independent criterion. Moreover, the

presumption is that the gains in welfare may well

be at the expense of others. Finally, one cannot a

priori exclude the possibility that political homo-

geneity increases over time in the EU, although

one should not push this idea too far. An example

is solidarity, having been introduced into the aimsof the Maastricht Treaty. The Union is still very far

removed from the degree of homogeneity similar to

that expressed in the idea of nationhood. Thus,

there is a big gap between avowed and actual soli-

darity. The higher actual solidarity, the stronger the

argument for transfers via the centre.

The criteria of Table 4.1 suggest ways to ratio-

nalise why the assignment of a particular regulatory

or policy or tax competence should move beyond

the regional/ country level. They do not, in and by

themselves, suffice to justify centralisation. Since

subsidiarity stresses the inherent costs of centrali-

sation, the optimal approach is to maximise thebenefits by moving beyond the regional/country

level (once a criterion is fulfilled), while seeking

degrees and forms of centralisation which minimise

its costs. Thus, it may well be possible as indeed

has happened in some of the examples in Table 4.1

to establish voluntary (ad hoc) cooperation or

coordination with a sufficient degree of binding and

sufficient additional gains for all to satisfy

subsidiarity. Such a solution pre-empts full centrali-

sation. The nuclear particles accelerator CERN in

Geneva is a form of ad hoc cooperation beyond the

EU. Fighter jets are sometimes produced by ad hoc

consortia. Some aspects of pollution may only befought at world level, inevitably with a moderate

degree of binding.

In other words, the criteria in Table 4.1. do not

necessarily lead to the conclusion:

1 that a grouping such as the EU is assigned to

tackle the problem; the relevant grouping may

be smaller (for example the Rhine convention)

or bigger (for instance, the International Atomic

Energy Agency, checking nuclear safety); so,

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the level of centralisation may be variable;

2 that centralisation with strict binding is superior(less costly) than cooperation or coordination or

innovative ways to blend centralisation with

differentiation; so, the degree of stringency of

centralisation may also be variable.

4.1.2 Subsidiarity applied to federations

The application of these analytical notions to the

public economic functions of federations provides

interesting lessons for European integration. At a

highly general level three such functions are distin-

guished: allocative ones (related to the functioningof markets, or to alternative instruments for arriving

at factor allocation for particular economic objec-

tives), redistribution (via tax-ation and social

transfers) and macro economic stabilisation (the

combination of the lowest possible inflation with the

lowest possible unemployment, without throttling

economic growth).

The allocative functions in a federation will typi-

cally be assigned to both (federal and state) levels,

although with the broad presumption of internal free

trade in goods and services and free factor move-

ments. This presumption severely constrains

regulatory and policy autonomy at the state level

but that is constitutionally accepted. Given such a

constitutional underpinning of an internal market, a

functional application of subsidiarity suggests the

outlawing of all (remaining) beggar-thy-neighbour

policies at the state level. Where regulation or other

allocative interventions are justified by market fail-

ures or widely shared political objectives, the

optimal degree of common regulation or interven-

tion will have to be found so as to combine

liberalisation and the proper functioning of the

internal market. As shown in chapter 3, the ECs

constitutional underpinning for the internal market

has become much firmer in the Single Act. This was

preceded by judicial review (starting with theDassonville ruling in 1974) outlawing or limiting

numerous attempts by Member States to maintain

beggar-thy-neighbour policies in a rather frag-

mented common market. Emphasising subsidiarity

may be viewed as the other side of the single

market coin: what regulatory or policy autonomy

can be kept by Member States without being incon-

sistent with the single market?

Once the internal market is given, it will severely

circumscribe the scope for redistribution at sub-

federal levels. Suppose, factor mobility in theinternal market is costless. In such a hypothetical

case, there would be no scope whatsoever for a

single state to impose redistributive levies used for

transfers to poor, unemployed or disabled people.

Any unilateral differential with adjacent jurisdictions

would cause all (employed) factors to leave. In

actual practice, however, there is considerable

discretion because labour mobility is costly (though

more in the short than in the long term) and

company plants will have incurred sunk costs. Yet,

factor mobility at the margin may quickly discipline a

state. Moreover, the equilibrium among all the

states is likely to be unstable if strategic behaviour

cannot be ruled out. Suppose parallel behaviour of

states A to H keeps the redistributive differential to a

minimum. Although there is no assignment of redis-

tributive functions to the federal level or other

explicit cooperation, the disciplinary potential of

factor mobility is well understood and keeps the

equilibrium stable. Suppose now that state D

suddenly initiates a strategy of attracting mobile

factors it is interested in: for example, new industrial

plants and high-skilled workers. To improve the

investment and immigration climate, D sharply

reduces corporate taxes and high-income taxation.

This move would destabilise the redistributive equi-

librium. The other states are eventually forced toreact and a race to the bottom begins. In the

extreme case, the redistributive functions at state

level are pre-empted and if social objectives are

not given up, strict coordination at, or assignment

to the federal level will be required in order to

achieve them.

A somewhat similar problem arises for macro-

economic stabilisation. For the internal market to

function properly, price signals should be informative

and confusion or uncertainty should be avoided. If all

states maintain their own currencies, this condition

translates into a high degree of exchange rate

stability and well-functioning forward markets to

hedge against short-term currency volatility at low

costs. The two elements are not entirely independent

because, with a high degree of currency instability,

that is, gyrating exchange rates, forward markets

would impose high risk premiums. The incentive to

realise stability is a positive function of the ratio of

intra- to extra-federal economic intercourse.

However, reliable exchange rate stability requires

coordination; in other words, macro-economic func-

tions are partly governed by assignment to a

50 Foundation


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common decision-making mechanism. The political

sensitivity of tying states hands is likely to be higher,the higher the initial level of inflation, the higher the

average outstanding public debt (since an agree-

ment on price stability will rule out an inflation tax on

holders of public bonds) and the greater the initial

unemployment. Other elements might come into play

as well. So, coordination may be difficult to achieve

and the short-term political incentive for free riding is

strong. A learning process of costly breakdowns of

coordination may eventually convince the states that

credible coordination, yielding reliable exchange rate

stability, must effectively rule out free riding. In effect

this would mean that core macro-economic functions

would have to be assigned to the federal level,

together with the necessary instruments (for

example, one currency and monetary policy). This

eventual shift of position of the states is likely to be

facilitated by the long-term, as opposed to the short-

term, impotence of state exchange rate policy to

influence real economic activity (see also chapter

16). With respect to the short run, in terms of the

subsidiarity principle, one could argue that competi-

tive depreciation is a beggar-thy-neighbour policy

which imposes undue costs on other states

economies for mere short-term domestic employ-

ment gains.

4.1.3 Caveats for the European Union

The economic theory of multi-tier government with

the subsidiarity principle as the centrepiece

provides an interesting framework of analysis for

the higher stages of economic integration. But

there are four difficulties when applying this frame-

work to European integration. That is why the term

economic theory of multitier government is prefer-

able to economic federalism. The difficulties also

constitute a warning that underlying assumptions

about the constitutional and economic environment

should be made explicit before the economics of

subsidiarity can be meaningfully applied.

The first problem has already been mentioned insection 1.7. The political logic of ever more ambi-tious economic integration among otherwiseindependent countries is radically different from thelogic of (economic) decentralisation in a maturefederation. Thus, even if subsidiarity could provide

an economic case for monetary union, short-

termism in domestic politics or the politicalsymbolism of keeping ones national currency maystand in the way of a functional assignment. Similararguments may rear their head with respect to theassignment of redistributive functions. The politicalcosts of centralisation weigh heavily in integrationprocesses.

The second problem is the constitutional provi-

sion of a single market. The provision may be

incomplete to such a degree that it affects the

assignment following from subsidiarity. Thus,Canada (see, for example, Courchene, 1986;

Pelkmans & Vanheukelen, 1988) has long suffered

from important instances of fragmentation of its

internal market and the Canadian Supreme Courtcould not rely on sweeping jurisprudence (as in the

US and the EC) to overcome many of these inter-

provincial barriers because some powers of theprovinces were constitutionally protected. In the

EU there have long been problems with Art. 295,

formerly Art. 222, EC (stating that matters of

ownership are assigned to the Member States).

This is exemplified by the problems in creating a

common EC patent or rules on other intellectual

property rights or by a long-held policy viewregarding state-owned enterprises. However, as

chapters 9 and 15 will show, still greater problems

reside in the internal market for labour. The fear

that redistributive functions, kept at Member States

level in the EU, would be disciplined by cross-

border labour mobility has made it next to

impossible to apply the subsidiarity principle in an

economic fashion. For socio-political reasons theredistributive assignment to the national level has

been sacrosanct, which has led to the sacrifice of

the completion of the internal labour market. In

Europe, this was relatively easy since the natural

barriers to cross-border intra-EC labour mobility

(languages, and distinct social and cultural habits)

are high and not quickly overcome except by highlyskilled workers.

A third diff icul ty is that the EU has not (yet)assumed a number of properties which are taken

for granted in federations. For instance, the EU has

only had a common currency since 1999 and this

euroland still (in 2001) does not include all 15

Member States three retain their national curren-cies. In addition, the EU level has no right to tax

even the common customs code and common


2See the (anonymous) exercise for applying the criteria to some 75 economic functions in a slightly different way

in a background study to the MacDougall report (MacDougall et al, 1977, Volume II). See also CEPR, 1993.


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external tariffs are implemented by national

customs services. Also, the Union has a weaklydeveloped common foreign policy and, only since

Amsterdam has it begun carefully and on a coop-

erative basis between those Member States whichare interested to build a common defence. The

economics of federalism provide economic justifi-

cations (such as scale, externalities, solidarity) for

the assignment of all such powers to the federal

level. If, in this respect, the accordance between

economic theory and actual federations such as

Canada, the USA, Germany, Switzerland,Australia, or even Belgium, Spain or Austr ia is

anything to go by, the EU is simply pre-federal.

Finally, and of course not unrelated to the

previous difficulty, the Union has no federal govern-ment. Again this sets it apart from the federations

mentioned above. The discrepancy between

todays governance of the European Union and atrue government, directly accountable to the

European Parliament and the European voters, has

come to be termed the democratic deficit. It has

not been overcome in Amsterdam. The Community

does make use of a supreme Court that, with

respect to the internal market and related economic

policies, has proved to be integrationist.Nevertheless, given the limited scope of EC law

and the avoidance of a government of judges, this

cannot and should not compensate for the weak-

ness of other Union institutions in this respect. As a

consequence, issues such as political legitimacy of

federal authority, the political programme for a

Commission period, and the enforcement of the

(federal) law of the land remain incomparablebetween the current EU and existing federations. It

goes without saying that this contrast is not without

consequences for the application of subsidiarity.

4.2 A subsidiarity test for the Union

The analytical framework discussed above can be

elaborated and applied to every public economic

function in European integration.2 In the present

chapter and in the remainder of this book refer-

ences to it abound. In principle, it is possible to

arrive at a comprehensive assessment of the

economic constitution of the Union and its short-comings or inconsistencies. However, such a

normative economic analysis should not be mixed

up with the more limited meaning of subsidiarity in

the Maastricht Treaty. As noted in section 3.3, an

unrestricted application of subsidiarity to the acquis

communautaire might be inconsistent with the

equally prominent stability requirement in the

Maastricht Treaty that the acquis cannot be

affected. No less important, any finding that inte-

gration deficits at the EU level would have to be

filled with additional competences, would by-pass

the constitutional process of decision making.3As

this would undermine the political legit-imacy of

integration it would be pointless.

For these reasons the Amsterdam Treatyrestricts the application of subsidiarity to public

economic functions where competences are

concurrent (that is, shared between) at the Member

States and the EU levels. Article 5, EC (formerly

Art. 3B) prescribes:

In areas which do not fall within its exclusive compe-

tence, the Community shall take action, in accordance

with the principle of subsidiarity, only if and in so far

as the objectives of the proposed actions cannot

be sufficiently achieved by the Member States and

can therefore, by reason of the scale or effects of the

proposed action, be better achieved by theCommunity.

Any action by the Community shall not go beyond

what is necessary to achieve the objectives of the

Treaty.

Therefore, any action taken by the Communitymust fulfil two conditions. First, in areas of shared

competence, the Community must demonstrate a

need to act, as given by the existence of either

economies of scale or cross-border externalities. If

either of these conditions hold, non-cooperative

policy making would be less efficient, or even detri-

mental, compared to cooperative policy making.

This is broadly in line with the basic economics of

subsidiarity. Second, any action must be propor-tional to the desired objective. Again, this is a

logical corollary to the primacy of lower-tier govern-ment, where possible and efficient: no more than

that which is necessary to attain the objective

52 Foundation

3It would require an intergovernmental conference, followed by ratification by the Member States (Art. 48, EU).4This interpretation is close to that actually proposed by the European Commission. See SEC (29) 1990, The

principle of subsidiarity, 27 Oct 1992. A concise instruction to the various EU institutions, broadly reflecting those

considerations, is found in the Protocol on the Application of the Principle of Subsidiarity and Proportionality attached


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should be done at the central level. Thus, when

deciding whether to enact binding or non-bindingmeasures, the EU level must justify the need for

non-discrimination and legal certainty (both being

indivisible in nature) before

considering uniformity in measures. Even then, the

EU should demonstrate the costs of differentiation

before opting for a high degree of uniformity. The

degree of binding could also increase, commensu-rate with the degree of complexity. If these

justifications fail, EU regulations or directives would

be disproportionate and only coordination, recom-

mendations or consultation should be pursued.

When binding measures (that is, legislation) are


CASE STUDY 4.1 Subsidiarity andenvironment

The question when applying subsidiarity to the

environment is whether the Union level should

be assigned powers to pursue environmental

policy. To argue for exclusive rather than sharedpowers (step 1) would surely be inappropriate

knowing that EU countries have different nationalendowments with different environmental

absorption capacities, as well as different prefer-

ences. Since at least some environmentalproblems are local, regional or national in nature,

these differences can best be taken into account

at those levels of governments.5 But it is also

well-known that many negative cross-border

externalities are to be found in the area of envi-

ronment. This fulfils one criterion in step 2 of the

subsidiarity test.

When setting objectives, three levels of exter-

nalities should be distinguished: bi or trilateral,

Community-wide and worldwide. Cooperation

(step 3) might be possible in bi/trilateral frame-

works but will become ever more difficult when

the number of countries increases. Moreover,

cooperation might even fail in the bilateral case

because the full costs of the polluter pays prin-

ciple may be resisted. This would satisfy step 4.

However, it does not follow that all bilateral prob-

lems should be addressed at Union level:

cooperation may, and does, succeed (perhaps

also because it would otherwise be tackled at

EU level). For Community-wide issues, internali-

sation of the externalities is best done at EUlevel. For global issues, a common EU policy

stance both reduces the number of countries for

worldwide cooperation and might (but need not)

provide leadership to arrive at agreement. For

the Union countries, jointness would also

increase negotiating power.

At the level of instruments the problems get

much more complicated. To begin with, anobjective such as a minimum ambient quality at

intra-EC borders may be easier to apply to

rivers than to air pollution. This is partly

because some sources of air pollution are

extremely mobile (cars, sprays containing

CFCs, etc.). It is probably less difficult to come

to a consensus about precise instruments which

are easy to monitor than it is to set objectives

for Member States, in the presence of mobile,

polluting sources. Hence, the EC often uses

product standards. Once product standards are

chosen for mobile goods, the single market will

severely limit the national ability to employ this

instrument effectively. Thus, in the single

market, either the national product standard

will effectively be undermined as imports

complying with other standards come in

anyway, or steps 3 and/or 4 of the test will

apply. Because cooperation is voluntary (hence,

every country has a veto), it will not easily

succeed since adjustment costs and competi-

tiveness create incentives for avoiding

regulation. If step 4 were to imply approximation

of technical regulations (Art. 95, EC, formerly,

Art. 100A) it would be subject to qualif ied

majority voting, an incentive for more efficient

bargaining. Such common mandatory (product)rules will combine the protection of the environ-

ment (internalising externalities) and internal

free trade. Steps 4 and 5 suggest, however, that

Member States are free to impose higher

5The treaty criteria (need to act) do not apply. However, some people argue that the Unions citizenship

(established by the Maastricht Treaty) could be seen as consisting inter alia of a set of citizen rights

including minimum ambient quality (in turn including minimum public health). If so, the political homogeneity

criterion would be satisfied. For the moment the point is a rather speculative one.


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needed, framework directives should first be

considered as they leave greater discretion to

national and regional governments; if they would beinappropriate, directives may still be preferable to

EC regulations which are directly binding for all

economic agents in the market. Where possible and

efficient, Member States should play the primary

role in policy implementation.4

One important criterion to decide upon the

degree of centralisation, once the need-to-act test is

passed, is credibility. If all Member States would

voluntarily cooperate on a given policy issue, there

would seem to be no need for centralisation. As

game theory teaches, simple and repetitive cooper-

ative games lead to learning and may eventuallyresult in efficient bargaining. But non- repetitive

cooperation is often difficult to agree upon, for

instance when the number of interested parties is

large, the range of policy alternatives is wide, the

problem is complex, and when (relative) gains and

losses of players would be unevenly distributed.

What really matters for economic agents in the

market, however, is whether cooperation is cred-

ible, hence sustainable. Credibility of cooperation is

54 Foundation

national standards, as long as they do not inter-

fere with free movement. What this means is

that the perceived local benefit of ad-ditional

environmental protection will incur costs which

primarily fall on local economic agents.

However, in a more elaborate application of

subsidiarity to environmental policy instruments,

the nature and efficiency impact of various

instruments need to be considered. Thus,

ambient quality and diffusion objectives might

be achieved more efficiently (that is, with lowerwelfare costs), with fiscal and economic instru-

ments rather than with regulatory ones (except

when risks are intolerably high, such as

hazardous waste). Again, such national subsi-

dies, taxes, tradeable pollution permits and tax

credits may distort competition in the single

market and will therefore be limited, conditioned

or outlawed in a Community framework. Special

ecotaxes impose costs on local sales but

cannot prevent users and consumers from

switching to untaxed imports from other

Member States.6 This would argue for common

minimum eco-taxes, but the difference

between steps 3 and 4 is not great, as taxationdirectives are subject to unanimity.7 In the

special case of a proposed eco-tax on fuels

and some other energy products, the externali-

ties affecting competitiveness go beyond the

EC, so that step 4 (an EC minimum tax) might

well be made dependent on prior cooperation

with key OECD countries (step 4, but in a wider

context).

Some instruments apply to stationary

sources (for example, power plants). Although

the free movement of goods is not at issue

here, national regulatory discretion may still be

circumscribed by effects on competitiveness:differences in national environmental require-

ments may lead to different prices for energy

inputs, which will especially affect the competi-

tiveness of energy-intensive companies (for

example, chemicals, aluminium, paper).

Finally, any application of subsidiarity must

carefully reflect on step 5. The usual breakdown

of public functions here is into problem diag-

nosis; policy formulation and (if applicable)

legislation; implementation, monitoring and

control; and enforcement. Diagnosis should be

at EU level in all cases where a prima facie

expectation for spill-overs or scale exists; other-

wise, the principle of subsidiarity cannot bemeaningfully applied. Policy formulation should

be at EU level when step 4 of the test is

6As long as the destination principle applies. Once the origin principle was introduced in the EU (see

section 5.4.3), it would also negatively affect the export position of producers in the origin country, if the tax is

not VAT (VAT is paid back producers).7There is a difference in credibility, since EC directives cannot easily be undone.

CASE STUDY 4.1 continued


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reached. However, in the past, the EU has pursued

policies which do not pass steps 2 or 3 (forexample, the cleaning of the Mediterranean sea).

Perhaps the EU should only be a partner in a step-

3-type regional cooperation, as currently is the

case for the Rhine agreement. Implementation is

traditionally assigned to the Member States, except

for certain worldwide or continental negotiations.

Monitoring and control should be supervised by the

EU level (precisely so as to obtain the credibility

that cooperation may lack), but can be executed by

national agencies. This is also true for enforcement

where ultimate resort to (for example) the EC Court

should be possible.



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56 Foundation

low if information is highly imperfect or asymmetri-

cally distributed, especially in complex policy areas,because this renders it impossible to monitor

compliance. Credibility is also low when the incen-

tives to cheat are strong and the ability or

willingness to impose collective sanctions is

perceived as minimal. If cooperation cannot

come about, or it would not be credible, there is a

case for centralisation.

The subsidiarity test can then derive assign-

ments to the Union level as follows, in five steps:

1 Identify whether a measure falls within the area

of shared competences (if exclusive to the EC,

the treaty test does not apply);

2 Apply the criteria (scale and externalities, Art. 5,

EC, and possibly other criteria) this is the need

to act test;

3 Verify whether credible cooperation is feasible;4 If 1 and 2 are confirmed, and 3 denied, then the

assignment is to the Union level;

5 Define to what extent (proportionality) implemen-

tation, monitoring and enforcement should also

be assigned to the EC level, or, indeed, can be

assigned to the Member States, perhaps in a

common framework.

The test would become fully general that is, not

bound by the treatys text if the first step is

ignored and all possible criteria are considered in

the second step. Note also that step 3 may lead to

cooperation at levels lower than the Union level, at

EU level, or at continental or world level.

The following merely sketches the highlights of the

state of the art in economic regulation theory.9

Market powermay, but need not, depend on the

observation of an apparently high concentration of

firms and/or a low elasticity of demand. If there is

contestability (a credible threat of potential competi-

tion), such market characteristics yield no power. Once

barriers to entry keep such potential competition at bay,

incumbents may enjoy market power. A barrier to entry

into a market is a cost of production for a new entrant

that is not incurred by incumbent firms. Sunk costs

(non-recoverable, market-specific costs) are the only

private entry barrier which may justify regulation of a

kind. Neither scale nor product differentiation do, in and

by themselves. If scale costs can be recuperated upon

exit (for example, in second-hand markets), entry is not

costly. Once these costs are sunk, entry becomes risky

and a barrier exists. Similarly with product differentia-tion: if incumbents try to prevent entry by what is called

brand proliferation, this would only act as a barrier if,

and only if, the establishment of new brands by the

entrant would imply sunk production and marketing

costs. However, sunk costs create risks of exposure as

well: excessive entry could be destabilising and entail

welfare costs. Long-term contracts are a typical private

response to this. The risk-sharing involved may permit

an increase in irreversible capital. However, there are

many problems with such contracts (for exampleenforcement in the presence of contingencies; negotia-

tion strategies; market power vis--vis consumers),

such that regulation may be justified. For utilities, with

natural monopolies and extremely high sunk costs,

regulation may at the same time protect a firms right to

serve (allowing investment in capital and networks with

a long life-span) and the consumers right to be served.

In cases of less extreme sunk costs, they may lead to

collusion or monopolistic behaviour which can be miti-

gated or prevented by competition policy.

Externalities are costs or benefits transmitted

between agents, in the absence of any related

economic transaction between those agents. By defi-

nition, therefore, there is a missing market and thenegative or positive benefit remains uncompensated.

Examples of negative externalities include pollution,

ADDITIONAL READING

8The efficiency of such regulation remains an economic issue, of course. Thus, as chapter 11 will show, assuring

European farmers a fair income, is better accomplished by non-market transfers than by regulating market variables.

9Authoritative sources in the literature include Spulber (1989) and Laffont & Tirole (1993). A good blend of

economics and law is found in Ogus (1994) and Baldwin & Cave (1999).


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the harm a pedestrian may incur in an accident with a

car, or the discomfort of congestion. The concept can

be extended to depletable externalities such as

common fishing grounds and mineral resources.

Positive externalities include a bee-keeper benefiting

from an adjacent orchard or so-called agglomeration

effects (local/ regional clusters of complementary

and competitive skills and services leading to

extremely fine specialisation, with higher value-added

or growth or innovation as a positive externality for all,

hence tending to attract still more of the most

productive factors to the agglomeration) like Silicon

Valley or the London City.

It is often said that creating the missing market

by defining the property rights completely and

exhaustively, internalises the problem and will

remove the market failure.10 However, defining prop-

erty rights accordingly in the case of the environment

is a formidable and costly enterprise, as Spulber

(1989) calls it, and might still require regulation.

Moreover, internalisation is not a perfect recipe

either, as the third type of market failure (see below)

will show. Hence, in the case of externalities, regula-

tion is often employed to impose internalisation by

equating private and social costs. To do this properly

is very difficult and will invariably introduce some

regulatory costs. In the environment, regulation may

rely on economic instruments (such as subsidies,

penalties, tax credit or tradeable pollution permits) or

by prohibition and mandatory technical requirements

the command and control approach. Products with

health and safety risks may also cause negative

externalities (for example, contamination and acci-

dents) for other persons or to society as a whole (for

example, in the case of state health insurance).

Internalities refer to costs and benefits of a trans-

action that the parties to the transaction have not

accounted for in the terms of exchange.11 Unlike themarket failures of market power (imperfect competi-

tion) or externalities (a missing market), internalitiesoften exist in competitive markets. Harm to a

consumer due to product failure, not foreseen or

covered in the contract terms, is a negative inter-

nality. A breach of contract, with the consequences

not reflected in the contract, is another negative inter-

nality. A positive internality is the case of

on-the-job-training of an employee which does not

follow from the labour contract. As will become clear

in this book, regulation addressing internalities is

important to the EU internal market of goods and

services.

Internalities are due to special transaction costs

or incomplete information. More precisely, sources of

internalities are:

The costs of writing contingent contracts in the

presence of risks (the most important case is

that of long-term contracts for utilities and so on

mentioned above);

When behaviour is imperfectly observable, the costs

of observation and monitoring may be high;

When parties possess private information, there

may be high costs of information gathering and

disclosure.

This book will deal mainly with EU regulation based

on the latter two sources of internalities. Imperfectly

observable behaviour gives rise to moral hazard, anincentive problem for the design of market contracts.

Thus, there may be imperfect incentives for

employers to prevent accidents, once they have

insured their workers, or consumers may use prod-

ucts carelessly once they enjoy warranties from the

supplier. Liability reduces but does not eliminate

moral hazard. Regulatory alternatives (for example,

product standards, workplace safety standards,

inspection) may assist in establishing more correct

observances, but they entail costs and inefficiencies

too.

Private information gives rise to strategic behav-

iour in markets due to the asymmetry between the

parties in this respect. If parties do not reveal infor-mation, the presence of asymmetric information

ADDITIONAL READINGcontinued

10Thus, in the case of pollution, the assignment of property rights to create such a missing market requires:

identification of the least-cost way to abate or avoid the pollution (often a public task due to scale economies of

centralisation, due to collection of information and high skills, rather than repetitive court cases), definition of the

rights to pollute and definition of rights to clean water or air. See Spulber, (1989, pp. 512) and his chapter 12.11See Spulber, 1989, p. 54 for a similar definition.


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4.3 Subsidiarity and EU regulatorystrategy

As this book will stress time and again, economic

integration in Europe is overwhelmingly about

regulation, not about budgetary spending. And a lot

of this regulation is actually for the purpose of liber-

58 Foundation

implies that markets may fail even if transactions are

made however, they might also not be made at all.

A major problem is adverse selection. Insurance

markets may fail or even fail to exist if individuals

cannot be induced (for example, via ex-post penal-

ties) to reveal all information for the proper

assessment of risk. Clearly, individuals with the

greatest health risk have the least incentive to

provide such information, whereas healthy individuals

though perhaps willing to provide it have lower

incentives to buy insurance. The market would thus

lead the insurance companies to suffer from adverseselection of policyholders, causing unsustainable

losses.

In many product markets, adverse selection is a

potential problem for which private and regulatory

remedies have emerged. The used-car market may

turn into a market for lemons (lemons being bad

cars) due to adverse selection, but guarantees by

reputable dealers and reliable private testing and

certification (say, based on public safety regulation)

can overcome this problem. In the absence of safety

regulation, asymmetric information in the labour

market may cause workplace safety to be lower than

workers expect, whereas in product markets buyers

may get products which are less safe than they

expect. In professional services, buyers generally

have no way of assessing the providers service until

after the service is consumed and frequently not

even then. In such cases, minimum entry conditions

(for example diplomas) and publicly acknowledged

self- regulation may overcome the market

failure. In banking and insurance there is, moreover,

the impossibility of knowing for sure whether the insti-

tutions holding their deposits, securities or premiums

are financially sound, which justifies strict and

permanent prudential control.

Public goods such as national (that is, external)

and domestic security, and a legal system providingand enforcing basic market rules for every economic

agent in the jurisdiction are typically produced by

governments. They are characterised by non-appropri-

ability (of adequate revenues) and non-excludability

(of consumption) once again, a matter of ill-defined

property rights so that they cannot be profitable. As

a consequence, in private markets they would either

be undersupplied, or their supply would break down

or appropriability would be restored by imposing

exclusivity, thereby sacrificing their public nature.

Taxation can overcome non-appropriability, while non-

excludability is usually declared a citizens right as a

counterpart. Therefore, it is a major political questionof legitimacy and authority to supply public goods and

be granted the right to levy taxes.

If goods have weak appropriability and weak

excludability, collective action in a limited group of

producers may internalise the market failure to such

an extent that free riding, or avoidance of controls,

no longer undermines supply. An example of such an

impure public good is a voluntary technical standard

which improves the technical efficiency of all

suppliers, and thereby the functioning of the

market.12 Another example concerns knowledge,

which has strong public goods characteristics. Basic

research is typically subsidised by government. Themore applied, hence specific, the knowledge is, the

higher the probability that it can be patented for

appropriability and/or that it can be embodied in

products which have excludability. However, R & D

consortia between firms may, at times, internalise the

market failure, too.

ADDITIONAL READINGcontinued

12A simple example is the market for beds. By agreeing to limit the number of standard bed sizes to very few,

economies of scale can be achieved for the mass market of beds and mattresses, while also enabling the

unbundling of the bedmattress combination, which enhances competition. Since the standard is volunary, non-

standard beds are still produced but at a premium; likewise for the compatible mattress.


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alisation, that is, free movement in the internal

market. As a consequence, subsidiarity will mainlybe applied to a vast range of regulatory issues in

the European economy. The three core questions

to ask in this respect are: why regulate?

regulate at what level of government?

how to regulate?

Throughout the book these questions will be applied to

specific regulatory problems of the Union. But to some

degree, a general economic approach is possible,

which can be used as a tool for specific applications in

almost any field. In addition, EC-1992 has prompted a

new regulatory strategy for economic integration which,

on the whole, is far superior to the old approach toeconomic regulation (say, before 1985). This nexus

between subsidiarity and the Communitys regulatory

strategy will be explained step by step.

4.3.1 Why regulate?

There are economic and non-economic justifica-

tions of regulation of market variables or behaviour.

Non-economic justifications may include security-

of-supply considerations (energy; agriculture) and

equity objectives (fair distribution of income).8

Here, our concern will be the proper economicjust ification, which tra-di tionally consists of over-

coming market failures. To put it more precisely, the

benefits of regulation can only consist of over-

coming market failures where the latter dont

exist, markets are superior to regulation as an

allocative and cost-minimising device. At the same

time, however, the costs of regulation ought to be

kept to a minimum, otherwise regulatory failure

would take the place of market failure.

There are four types of market failure:

market power;

externalities;

internalities; public goods.

Whether, and under what conditions, public regu-

lation, other interventions or public ownership is

economically justified, is the subject of a separate

specialisation in economics. In principle, the

insights from the economics of regulation apply

just as wel l to European integration, al though thespecial institutional and political context needs to

be taken into account. The rule of thumb, crucial

for the reader of this book, is that regulation is

justified:

1 if market failures are overcome;

2 the least-cost form of regulation is opted for;

and

3 the net benefit is positive.

These justifications form the core of the norma-

tive economic theory of regulation. Commission,

EP and Council can rely on the normative theory

when applying the rule of thumb. Such a normative

approach is operational and ensures net benefits inthe European public interest. However, there is

also a positive theory of regulation. The question

asked here is not whether economic regulation is

justified on the grounds of market failure but rather

how actual regulation can be explained by the real

behaviour of all the relevant players involved. The

normative theory treats the government as a black

box, by definition pursuing the public interest. The

positive theory disaggregates the government into

lawmakers, bureaucrats (and their ministers) and

(appointed) regulators. All these players have their

own objectives and pursue them, subject to

constraints of accountability and legal obligations.

The regulated industries, including sectoral trade

unions, may be capable of influencing nominations,

policy or even the rules themselves, thereby

creating and entrenching vested interests. This is

called capture of regulators. This may extend to

suppliers as well.13 The crux of the positive

approach is that regulatory failure may occur due

to regulation being designed to serve various

vested interests of players closely involved, behind

a facade of laudable public interest objectives. As a

result regulation is not in the public interest or too

costly.

In the EU context this implies that the economic

justification of an existing market failure is a neces-sary, but not a sufficient condition for agreeing to

regulation. The combination of the how and the

what level questions should be addressed in such

a way that regulatory failure is prevented (both at

the EU and the Member States level). Better still,

the regulatory strategy should lead (ceteris


13The positive theory can be derived from public choice and the Chicago approach to regulation. See e.g. Stigler

(1971), Peltzman (1976; 1989).


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paribus) to the best possible framework for the

internal market so that it can function at the highestpossible level of technical efficiency. It is to this

problem that we now turn.

4.3.2 Regulate at what level?

The EU has a multi-tier regulatory system. The EC-

tier has rules shaping the internal market or

substantiating policy. The principle of free move-

ment is critical as a necessary condition for the

internal market to be established. Its mere exis-

tence severely constrains the regulatory autonomy

of the Member States. As their regulations ought

not to infringe the free movement principle, national

regulation may be prohibited by EU rules to that

effect. Not infrequently, existing national regulation

boils down to EC directives transposed into

national legislation. Some policies with a strong

regulatory content (for example trade policy) have

been assigned exclusively to the EU level (step 1

of test). In competition policy, there is nevertheless

a subsidiarity issue in that the exclusive assign-

ment to the EU level is restricted (in the treaty) to

competition issues having actual or potential

effects on intra-EC exchange (the cross-border

spillover criterion of step 2). This leaves scope for

national competition policies. Chapter 12 willaddress this point.

In general, there are three instances where

Member States can still regulate. First, Member

States may regulate domestic economic activities

which do not actually or potentially affect the cross-

border exchange of goods, services or factors.

Clearly, this is in tune with subsidiarity. Thus,

national rules for opening hours of shops, the speed

limit on secondary roads or the liability for old

hazardous waste in local soil are consistent

with subsidiarity. Second, Member States may regu-

late beyond the EC rules as long as free movement

is not affected. This may seem puzzling.

Suppose, a technical EC directive for good X

ensures minimum safety requirements, but the

national regulation makes the

requirement stricter. Would this not fragment the

internal product market? Before, say, 1985, the

answer to this question was yes. A product would

have to be adapted or produced in another produc-

tion run which would add costs; not doing so,

would imply an import ban. But since this was so,

the EU attempted to harmonise the national rules

in such a way that Member States would feel they

could indeed forego additional requirements. As a

consequence, EU harmonisation was pushed up to

strict, if not the strictest requirements irrespective

of whether this was justified by the underlying

market failure and became very detailed, so as to

satisfy as many existing specifications as possible.

Member States could exercise leverage in Council

because harmonisation was subject to unanimity.

The upshot was always inefficient: either, harmoni-

sation processes became deadlocked because

national requirements were inconsistent or too

different, with some Member States refusing to

change, so that free movement was not actually

realised; or total harmonisation led to a full substi-

tution of national by EC regulation, with incredible

detail. This double regulatory failure deadlock or

overregulation was effectively overcome in the

new regulatory strategy which emerged from EC-

1992. The crux of the matter is the notion of mutual

recognition: national regulation beyond EC rules is

allowed but does not apply to intra-EC imports (see

4.3.3).Third, Member States may regulate where dero-

gations from free movement are commonly agreed.

This political agreement in the Union does not

necessarily reflect an economic justification,

however. Following EC-1992 these instances have

been relatively few: in product markets, an example

60 Foundation

14The EU Court uses a rule of reason on Art. 28, EC. This led to a legal basis for derogations with respect to

environment and consumer protection, areas not mentioned as derogations in Art. 30, EC.

Political Judicial Regulatory

core qualified majority judicial free

movement

voting mutual no internal

recognition frontiers

(given equivalent subsidiarity

objectuves or if minimum

Art. 36 does

approximation/

not apply) harmonisation

regulatory

mutual

recognition


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is that of Sweden and Finland for alcoholic bever-

ages (a temporary derogation); in services, somefinancial cross-border retail services are under

derogation via the so-called general good(see

chapter 7); and in factor markets it is mainly labour.

The two-tier regulatory structure can be

assessed with the help of the subsidiarity test (see

section 4.2.). In effect, this test combines the what

level with the how questions and should, thereby,

prevent regulatory failure. The new regulatory

strategy of the Community brings this out.

4.3.3 EUs new regulatory strategy

Via a tortuous process of learning-by-doing, a new

EU regulatory strategy has emerged. It took two

alterations of the EC treaty and years of experi-

menting in the framework of EC-1992 with respect to

goods and services markets. In the following this

strategy is set out against the backdrop of the

subsidiarity test. The crux of the strategy is the

primacy of free movement in goods and services

under political, judicial and regulatory conditions.

The strategy consists of a political, a judicial and

a regulatory panel (see Table 4.2.). The regulatory

panel, in turn, is made up of a quintet; taking due

account of the other two panels, this regulatory

quintet is central to the establishment and properfunctioning of the single market, the economic hard

core of the Community.

The Single Act removed the veto obstacle (see

political panel). For most internal market matters

qualified majority voting (QMV) was de jure and de

facto introduced. This altered the conduct of

Member States representatives in Council. No

longer could every detail and every deviation with

other Member States be imposed on the

Community: compromises were either needed to

obtain some concessions from others or they were

indispensable to form a blocking minority. QMV

thereby reduced the costs of how the EC regu-lated, while significantly lowering the probability of

deadlock, so that the internal market could be built

much faster.

The judicial panel has its roots in the 1970s,

albeit only for product markets. In the Dassonville

ruling in 1974, the EC Court gave an economic

definition of regulatory barriers in the internal

market. These barriers are called measures with

an equivalent effect to quantitative restrictions inArt. 28, formerly Art. 30, one of the most important

provisions of the treaty. The Court defined such

measures as all trading rules enacted by Member

States which are capable of hindering, directly or

indirectly, actually or potentially, intra-Community

trade. The reader will notice the analogy between

this definition of market access barriers with that

of barriers to entry (see section 4.3.1). Thus, if

such mea-sures make intra-EC imports more diffi-

cult or costly than the sales of domestic products,

they are forbidden by Art. 28 (except for the dero-

gation under Art. 30, formerly Art. 36, mainly

health, safety, environment and consumer protec-tion). This economic approach formed the basis of

an extensive case law removing hundreds of regu-

latory barriers. A second important step came with

the Cassis de Dijon ruling of 1979 and many

similar cases in its wake. This case law introduced

mutual recognition even when Art. 30 (for

example, national health or consumer protection

objectives) is invoked by Member States, as long

as the national regulatory objectives sought are

equivalent. This judicial form of mutual recognition

is remarkable because, in effect, it undermines the

regulatory autonomy of a Member State with

respect to intra-EC imports.

In other words, the free movement principle is

overriding:

when the national regulatory objectives are not

based on the derogations in Art. 30; the prohibi-

tion of Art. 2814 applies, and Dassonville is the

(radical) guideline;

when Art. 30 is invoked, but the objectives

sought are equivalent; mutual recognition

applies so that intra-EC imports are still free;

whenever approximation (Arts 94 or 95,

formerly Arts 100 or 100A) is accomplished

because this pre-empts Member States

regulatory autonomy (with the sameobject); this is logical because approximation,

by definition, makes the national regulatory

objectives equivalent.

Judicial mutual recognition proved capable of

declaring inapplicable to intra-EC imports a very

large number of regulatory specifications in foodlaws, machine safety regulations, construction


15In remaining veto cases (e.g. taxation) progress is less satisfactory but not zero (see 5.4.3 and chapter 9).


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62 Foundation

products, and so on. It made superfluous a lot of

tedious approximation that was deadlocked on thetechnical specifications, not on the regulatory

objectives sought. Just as QMV did after the

Single Act, judicial mutual recognition altered the

behaviour of the Member States. First, it came to

be understood that the need to act (step 2 of the

subsidiarity test) at EU level often did not apply

where health and similar objectives were the same

or equivalent. This had the practical effect of

reducing the EU regulatory burden (that is, less

approximation) while exposing national overregula-

tion (with technical specifications) to free

movement. In one stroke, therefore, the probability

of costly regulatory failure diminished greatly at

both levels of government. Second, it led to arethink of how approximation could best be tackled

whenever there was doubt about the equivalence

of regulatory objectives. Inspired by judicial review,

the objectives sought were carefully defined in EC

directives, but the specifications were either left toEuropean standard bodies or to the Member

States. In other words, approximation was

minimised to the essential requirements of health,

safety, environmental or consumer protection.

Beyond these regulatory objectives, Member

States were free to regulate more strictly, but

mutual recognition would apply (regulatory mutual

recognition). This had the great advantage that

agreement in Council would be far easier to

achieve as, in Europe, regulatory objectives hardly

diverge in the large majority of cases. It meant that

the establishment of the internal market became

politically feasible.

The Court also introduced another principle,that of proportionality. For example, because judi-

cial mutual recognition may confuse consumers, as

they are confronted with products from different

16E.g. the national measure has to precede EC legislation, and Commission and Court should approve.

CASE STUDY 4.2 Regulatory competition

From the perspective of the economics of regu-

lation, it may be argued that an optimal

economic strategy would also incorporate regu-

latory competition between the Member States.Judicial mutual recognition will expose

national regulation to the forces of arbitrage:

consumers may choose between (products or

services produced under) domestic regulation

or that of any other Member State, by importing

the relevant products or services.

Regulatory competition is dynamic and takes

this process further. It is defined as the alter-

ation of national regulation in response to the

actual or potential impact of cross-border

mobility of goods, services or factors on national

economic activity (Sun & Pelkmans, 1995a).

Behind this alteration are complex busi-

nessgovernment interactions. Jurisdictions

with costly regulations may find business

pressing to reduce their regulatory burden,

when faced with import competition from juris-

dictions with light regimes. Alternatively, local

business and government may agree on

strategic deregulation so as to boost certain

activities in the internal market. Since this may

also be practised, or responded to, by other

Member States, iterative processes of regula-

tory competition may develop.As a rule, one would expect a process of

regulatory competition to induce a market-

driven regulatory convergence in the EC.

However, this should not be allowed where

negative externalities is the relevant market

failure as this would lead to fragmentation of the

internal market or underregulation (for example

environment, discriminatory measures); never-

theless it would be suitable if information

asymmetries or other internalities are the

problem. It could well be economically superior

to Council-driven approximation as decision

makers cannot be assumed to pursue the

general interest unconditionally, as the positive

theory of regulation teaches. Unfortunately,

regulatory competition may not be as smooth as

simple theory might stipulate, because signifi-

cant distortions can remain. It is nevertheless

useful to allow it as an option for Member

States. Had the regulatory failure of the old


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regulatory regimes, it did accept labelling require-

ments as a least restrictive measure to protect theconsumer. Thus, asymmetric information can be

overcome at very little cost and without impeding

free movement.

The regulatory panel emerged from this evolu-

tion. With the Single Acts removal of internal

frontiers and the Maastricht Treatys adoption of

subsidiarity, the quintet was complete. The EC

discovered how the quintet could be applied to

services. For instance, in banking and insurance, a

minimum approximation of prudential rules and

supervision requirements was achieved, so that

service providers could be brought under home

country control which was mutually recognised. A

home-country licence thereby became a passport

to provide cross-border services throughout the

single market (see chapter 7).

It is hard to overrate the significance of the

regulatory quintet for European economic integra-tion. The combination of free movement, no

internal frontiers and mutual recognition as well asproportionality at the Member States level is justi-

fied by the need-to-act test (step 2): negative

cross-border externalities should be removed. Butthe crucial point is that all that is needed mayoften be no more than this negative integration. Alot of EU regulation can thus be lean and merely

serve liberalisation. Should common regulatoryaction beyond step 3 be necessary, it is neverthe-

less still bound by the combination of subsidiarity

(as in the treaty, Art. 5), minimum approximationand EC-level proportionality.

The economic advantages are many. It is farless likely that the internal market may be dead-

locked.15 The propensity to overregulate for vestedinterests or bureaucratic reasons is severelyconstrained at both levels of government. QMV

and regulatory mutual recognition prompt aprocess of learning among Member States about

best-practice regulation, thereby generating abuilt-in tendency to raise the quality of regulation at

both levels.There is one important caveat. Establishing the

internal market while overcoming market failures

and minimising regulatory failures should improve

economic welfare, as a rule. But this conclusioncannot be fully generalised. Consider the case ofEU countries having very large differences in pref-

erences: health, safety or environmental objectivessupposedly diverge sharply. An inconsiderateapplication of free movement would pre-empt the

satisfaction of the strictest local preferences (insay, environmental regulation). Article 30, EC

should prevent this from happening. But approxi-mation may similarly suppress such preferences if

QMV overrules the relevant Member State(s). Thismight mean that common regulation to overcome

market failure would lower welfare in some

Member States. Assuming that the overruled pref-

erences expressed in Council are widely held bythe voters in these countries and do not merelyreflect covert protectionism, this would be a serious

drawback.

There are two possible responses to this

problem. First, in the Single Act Art. 100A (now Art.

95, but revised), an escape clause was formulated,

under strict conditions,16 allowing a Member State

to maintain stricter legislation without mutual recog-

nition. Although this clause has hardly been

invoked, the Amsterdam Treaty has elaborated it

with respect to national environmental regulation or

to the workplace, in case of new scientific

evidence. In the case of public health (Art. 95, sub.

8), a Member State can now spur the Commission

to propose amendments to existing EC directives.

The impact of these new provisions is probably

minimal, but their enactment demonstrates the

strong preferences felt particularly, in the Nordic

Member States. Second, a Member State may

maintain or enact stricter legislation, but of course

subject to mutual recognition. As noted before, in

economic terms, the effect will be that the regula-

tory costs will fall on the suppliers in the Member

State itself. If such preferences are truly wide-

spread in the country, the satisfaction of these

preferences may well offset the regulatory costs.

17Explicitly excluded here are foreign policy and security functions (e.g. peace keeping) as well as possible or actual

functions under pillar 3 (e.g. Europol).18Note that the removal of internal frontiers (in the Single Act and the EC-1992 programme) would not have been

possible on this basis. It was agreed to lift this to treaty level in the Single Act (now Art. 14).19Everything else remaining unchanged. This underlying assumption is problematic, however. For instance, the long-

term effect of getting used to EC taxes is that the overall burden of taxation of all tiers of government is harder to reduce.

In other words, to prevent this, any EC tax should substitute for a national tax, not add on to it.


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4.4 Subsidiarity and non-regulatory EUfunctions

Subsidiarity can also be applied to non-regulatory

economic functions of the Union. This is a poten-

tially very wide and heterogeneous range of

functions. In actual practice, however, several EU

policies turn out to be almost entirely regulatory. A

prominent example is the common transport

policy a separate title (now V, Arts 7080, EC

since Amsterdam) in the treaty. In fact, this policy is

largely a combination of free movement (and

establishment), approximation and a somewhat

special application of competition policy. Otherones are social policy (now Title IX, Arts 136145,

EC) and environmental policy (now Title XIX, Arts

174176, EC), although they do not carry the label

common.

The non-regulatory economic17 functions of the

Union may comprise:

taxation;

expenditure-driven policies;

efficiency-driven transfers;

equity-driven transfers;

macro-economic stabilisation.

It is not possible to present a detailed application

for all these categories in a book such as this,

though some instances will be dealt with in the

relevant chapters. Nevertheless, a few preliminary

notes in light of the subsidiarity test and the

overall economic structure of the treaties as shown

in chapter 3 may be helpful to the reader.

At first sight, it seems perverse that the EC has

no right to tax. Its system of collecting revenue,

without any tax of its own, is byzantine and has a

degree of arbitrariness that almost inevitably

causes frictions between Member States (see

chapter 15). In some specific areas the mere

option of an EC right to tax could facilitateconsensus on environmental taxes, the taxation of

capital income and savings (see chapter 9), and

possibly the definitive shift to the origin principle

(chapter 5). In a legal sense, the treatys

subsidiarity test cannot be applied, however, as

step 1 blocks the test (no shared competences,

only the Member States). So, one could pose two

questions. First, given the constraint of the EC

having no right to tax, could the subsidiarity test

help in determining whether weaker forms of

centralisation in taxation are justified? The answeris yes. There is a need to act (step 2) with regard to

cross-border trade in goods and services because

of negative externalities. Chapter 5 will show the

need to harmonise the system, base and (to some

degree) the rates of indirect taxation including

excise taxes short of incurring tremendous costs

for cross-border commerce compared to domestic

commerce. In taxation, indirect tax cooperation

between Member States would neither be credible

(step 3) nor stable.18 Difficulties arise in step 4 (EU-

level decision making is under unanimity) and step

5 (how to minimise the costs of an EU-approxi-

mated indirect regime). Unanimity creates high

hurdles to find the optimal combination of approxi-

mation and tax competition. Cost minimisation of

an indirect tax regime in a completed internal

market may require the shift to the origin principle

(rather than keeping the destination principle) but

this is perceived as a further move to centralisa-

tion, weakening national fiscal autonomy. However,

negative externalities can also be identified for

some forms of tax competition in capital markets as

well as for locational competition for subsidiaries,

the main seat of companies and/or foreign direct

investment. In these instances, step 3 might be a

possibility (for example a mutual information

system, see chapter 9). If not, steps 4 and 5 needto be taken, but, thus far, the EU has not fully

resolved the outstanding problems.

Second, are there sound reasons to query the

total absence of the ECs right to tax? Since the EU

is pre-federal, any right to tax immediately

introduces profound issues of political legitimacy

and the representativeness of the EP (no taxation

without representation). These aspects go beyond

the scope of this book but, of course, do carry

weight. Nevertheless, in the context of subsidiarity,

there are functional arguments for (modest) EC

taxes. All these arguments have one thing in

common: solutions would be made simpler by the

existence of EC taxation. This is worth investi-

gating for the shift to the origin principle and for

harmful corporate tax competition. The idea behind

this is illustrated by federations:

states/provinces/cantons all combine fiscal competi-

tion with a greater tax autonomy (that is, little or no

approximation), because of the presence of federal

taxation. For the proper functioning of the

internal market, it is not essential that the EC be

given the right to tax, but lifting the taboo might well

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reduce the costs of an approximation regime.19

Expenditure-driven policies are few in the EU.The EU budget shows that, other than transfers

(see below), the main items are agriculture (and

fisheries), and research and technology subsidies.

In agriculture the (relatively) high EU expenditure is

the result of a conscious political choice: if national

agricultural interventionism in markets were not

either abandoned or broadly balanced, the internal

market for agro-products (and possibly food prod-

ucts) would become or remain fragmented or

distorted (step 2). Realising an internal market

through cooperation in agriculture is not feasible

(step 3), so interventionism has to be centralised

(step 4). However, as chapter 11 will analyseextensively, price setting along common lines is

used to accomplish a fair standard of living for

farmers. This violates proportionality (step 5) it is

only recently that the how to centralise question in

EU agriculture has been tackled in earnest by polit-

ical decision making.

Research and technology subsidies at EU level

are typically justified by the scale argument (step

2). Scale here does not merely refer to the size of a

project. It may also refer to the exploitation, in a

competitive fashion, of an EU-wide pool of R & T

A crucial element of economic integration analysis is a

framework to answer the question: which public

economic functions should be assigned to the EU level

and which ones should remain at the Member States

level? The economics of subsidiarity suggests an optimal

approach, maximising the benefits of centralisation

only when certain criteria are fulfilled, however and

minimising the costs by varying the degrees and forms of

assignment to the EU level.

Assignment to the EU level will bring benefits if one of

three criteria are fulfilled: positive externalities (across

intra-EU borders), negative externalities, economies of

scale. Applying subsidiarity to federations, one may

generalise the results as follows. Allocative functions will

typically be assigned to both federal and state levels

however, with the broad presumption of internal free

trade in goods and services and free factor movements.

Redistributive functions will at least be partly assigned to

the federal level since an interstate race to the bottom

will largely pre-empt state autonomy in this respect. Also,

core macro-economic functions will be centralised.

Applying subsidiarity to the public economic functions

in the EU does not a priori yield similar results as in

federations. There are four differences with federations:

the political costs of centralisation weigh heavily in inte-gration processes, the internal market may remain

incomplete for constitutional reasons (especially, for

labour), the EU lacks typical federal properties (like the

right to tax) as well as lacking a federal government.

The proposed subsidiarity test for the Union goes

through five steps: identify whether a measure falls in

the area of shared competences; apply the treaty criteria

(scale, externalities) the need-to-act step; verify

whether credible cooperation is feasible; if steps 1 and

2 are confirmed and step 3 denied, go for EU assign-

ment; step 5 is then concerned with ways to minimise

the costs of centralisation. How to apply the test is illus-

trated in a case study on environmental regulation.

A more elaborate analysis of the regulatory strategy

of the Union, against the backdrop of subsidiarity, is

conducted with the help of three queries: why regulate,

at what level of government, and how? A brief survey of

four types of market failures is provided: market power,

based on sunk costs; externalities or missing markets;

internalities caused by imperfectly observable behaviour

or asymmetric information; and public goods. The rule of

thumb is that regulation is justified if market failures are

overcome, the least-cost form of regulation is opted for,

and the net benefit is positive. The positive theory of

regulation demonstrates, however, that (costly) regula-

tory failures are not so easy to avoid.

The new EU regulatory strategy is based on five regula-

tory principles: free movement, no internal frontiers,

subsidiarity, minimum approximation, and mutual recogni-

tion. It also hinges on qualified majority voting for

regulation, as well as proportionality both for national and

EU regulation. The crux of the strategy is the primacy of free

movement under political, judicial and regulatory condi-

tions. The new strategy has great economic advantagesover the old EU approach (which often led to

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