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State aid: a key tool of industrial policy in the EUThis paper assesses the effectiveness of vertical industrial policies within the EU. For the purpose of this paper, industrial policy is defined as "the set of government interventions that by way of taxes (or subsidies) and regulations on domestic products or factors of production attempt to modify the allocation of domestic resources that results from the free operation of the market" (Gual 1995, p. 9).To narrow down what otherwise is a very broad definition, we exclude measures directed to primary sectors as well as those related to non-tradable industries, such as housing services or retail trade. Policies that affect most firms in a country to a similar extent -for example, investment tax credits or subsidies for the employment of a particular kind of labour -are also excluded.State aid is part of the toolkit available for governments to implement their preferred industrial policy. This toolkit is somewhat limited for EU countries due to the agreements and legislation directed towards creating a single internal market, including a common policy with respect to trade barriers, mutual recognition of standards, and so on. European laws defining the legality of state aid constitute perhaps the most important element in the agreed framework for implementing industrial policies within Europe.The main economic justification for industrial policy, including state aid, is the quest for efficiency. Thus, government aid aims to correct market failures, such as externalities, asymmetric information, market power, coordination problems, and public goods. The most common example of (positive) externalities is the research and development (R&D) activity of private companies. Asymmetric information, in turn, is used as a justification for granting aid to small and medium-sized enterprises (SMEs). Asymmetric information between a bank and an SME about the latter's potential to repay a loan or about the riskiness of its projects may prevent even a profitable SME to access finance.Market failures such as these justify the general objectives of R&D or SME support. Additional arguments are needed, however, to justify government intervention in specific industries or firms. Optimal use of government resources suggests that intervention should focus on those industries where externalities are particularly important. In the case of R&D, general support to all sectors may be desirabl...
