SUBSTITUTION EFFECT OF PUBLIC SUPPORT PROGRAMS AT LOCAL LEVEL.

• Author: Szitasiova, Valeria

1. Introduction

   European Union member states which accessed in 2004 and 2007 have been granted large amounts of financial support through EU structural funds. They were considered as lagging behind regions of the EU. This has allowed them to obtain a strong support for regional and local development. This new international level of regional support greatly exceeded existing public expenditures at the local level. Even though EU structural funds are intended to enhance the growth of the least developed regions within the EU, high amounts of additional resources can create wrong incentives for public finance allocations.

   Local communities, including local governments, should adapt and plan their expenditures in line with EU structural funds priorities. Therefore we focus our research on the interaction between local municipalities and structural funds priorities. We specifically focus on the negative incentives EU support creates at the local level, namely the substitution effect. We measure the inefficiency level of the EU funds allocation in the public sector in Slovakia. We try to quantify the level of the substitution inefficiency based on the example of the Regional Operational Program targeted on support of school infrastructure in primary education.

   Slovak municipalities are responsible for primary education in their districts. The costs for education are paid from the state transfers based on the number of pupils in a particular school. These transfers are supposed to cover both the personnel costs as well as the investments into the infrastructure. In most of the cases the schools are deprived, paying low wages and having only little money for investments.

   The aim of this study is to focus mainly on the substitution effect in relation to the financing of the selected priorities by local municipalities. We identify the extent of the substitution effect and then characteristics of the municipalities which most likely replace their own resources by the EU funds.

   Previous research on the efficiency of this assistance focused mainly on the analysis of aid to the private sector. Considerably less attention has been paid to the relation of the public support especially at lower levels of the public sector. This article is therefore focused on exploring the substitution effect, pointing to the problems of inefficiencies that may occur in supporting the public sector at the local level.

   In the next section we offer literature review that emphasizes the theoretical foundations of the substitution effect. Then we elaborate on the data description as well as on methodology. The suggested type of methodology was until now used mainly to analyze the public support of the private sector. However, it will also help us to identify whether the funding priorities of the EU actually translate into higher volumes of support for the development priorities at the local level. Finally, we formulate some policy recommendations to EU funds design for the public sector.

2. Theoretical framework of the research

   The EU support for lagging regions comes from the effort to stimulate their growth which is expected to result in economic and social convergence of these regions. To achieve this, the proper application of this support is extremely important. Therefore, the distribution of EU funds is bind by several principles (Reg. 1083/2006) which should ensure the proper allocation of money. Two of them are important in our research. The first principle is concentration meaning that EU funds should be allocated to the areas which need it. The second of them is additionality, which should ensure that EU funds are complementary to national and local resources rather than supplementary.

   The additionality principle is defined from both macro and micro level perspectives. The macro level is defined by the European Commission that sets limits to EU expenditures which are related to the public expenditures of the government (Reg. 1260/1999, Reg. 1083/2006). At the micro (local) level, additionality principle means that the recipient should use the additional funds as the extra resources and should not substitute it with its own resources. Both, macro and micro levels are difficult to control and measure. According to Georghiou (1994) the additionality principle can be defined according to three dimensions: input additionality, output additionality and behavioral additionality. The first analyzes whether the additional funds/aid received by targeted subjects increases their expenditure on the target activity. The second aims at gauging the output which would not have been achieved without the policy intervention. Finally, behavioral additionality deals with the changes in terms of the internal allocation of funds and operative decisions of the targeted institution after the policy inception. The principle of additionality can be measured in many ways; the most common are measuring deadweight, displacement, substitution effect and leakage (BIS, 2009).

   Output additionality is very often measured by the deadweight effect. This effect represents the proportion of total outputs/outcomes that would have been secured anyway without the intervention in question (BIS, 2009). In the case of projects under the Structural Funds, these are projects that would not be implemented in whole or in part without the support from the EU. The results of studies by different authors (Wren, 2005; Lenihan and Hart, 2006; Tokila and Haapanen, 2010; Sipikal, 2010; Sipikal, Pisar and Labudova, 2013) vary considerably. The obtained values range from 20% (Wren, 2005) to 73.5% (Lenihan and Hart, 2006). This indicates a large potential for the inefficiency of support. All studies are methodically based on interviews with businesses that received support, which can significantly distort the measured value.

   Input additionality is usually measured by the substitution effect, the main interest of this paper. This effect arises as inefficiency when beneficiaries of the EU funds reduce their own resources on the given priority and replace them with the external resources, such as the EU funds. The measurement of the substitution effect examines whether the expenditures on a given priority spent by the beneficiaries have changed after receiving support from the EU funds. Substitution effect is an undesired outcome of the public support schemes. Considering the long term effects of the EU support programs, sources replacement is perceived as deteriorating the behavior of public entities. The reason is that once public entities substitute their own resources with EU money, in the long run they would have to invest even more if financial support will be ceased. Another reason is that with the substitution in public sector the EU investments schemes lose their importance and therefore end up as useless investments with no multiplicative effect in the lagging behind regions.

   As stated in Barca report:

   'The task of place-based development policies is not to compensate for the failure of some places to raise enough revenue from their own sources to finance their development. If this were the purpose, an EU-level regional equalization fund could be set up, as is common practice in many countries. Instead, the task of such policies is to trigger a change in the behavior of private actors in regions where either an efficiency or a social exclusion trap exists. The simple transfer of funds cannot get close to doing this and might even worsen problems by creating a dependency culture' (Barca, 2009, p. 39).

   The problem is that there is no standard methodology on how to evaluate the effective implementation of the principles which ensure the correct implementation of EU funds. In the case of additionality, this is also reported by Del Bo et al. (2011)--it is concluded that even though additionality as a criterion is controlled by the national authorities and the European Commission, 'there is no standard methodology and the information provided is very heterogeneous in terms of quality and usefulness' (p. 6).

   The Cohesion policy of the EU is one of the most developed systems of international support to the less developed regions. Mutual interaction between local, national and transnational forms of support should be guided by several fundamental principles (Council Regulation no. 1083/2006), including the principle of additionality. In order to ensure a genuine economic impact, contributions from Structural Funds should not replace public expenditure by Member States under the terms of this Regulation. As a general rule, the level of the expenditure of recipient shall be at least equal to the amount of average annual expenditure in real terms attained during the previous programming period (Council Regulation no. 1083/2006, p. 24).

   This is a system that ensures that substitution does not occur. In practice, it is automatically achieved by co-financing EU programs by the state budget of the supported country. However, not all member countries fulfill this principle (Reg. 1083/2006). There is no obligation for co-financing at the local level, even though local levels also contribute to the financing of the projects (in our research case co-financing is 5%). In...