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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
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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
Subsidiarity and Economic Functions of the Union 51
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
Subsidiarity and Economic Functions of the Union 53
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.
Subsidiarity and Economic Functions of the Union 55
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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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Subsidiarity and Economic Functions of the Union 57
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
Subsidiarity and Economic Functions of the Union 59
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
Subsidiarity and Economic Functions of the Union 61
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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Subsidiarity and Economic Functions of the Union 63
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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Subsidiarity and Economic Functions of the Union 65
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