Do EU transfers spur growth?

Against this backdrop, research with my colleagues, Peter H. Egger and Maximilian von Ehrlich, looks at the effectiveness of one of the EU’s primary expenditure areas, its Regional (or Cohesion) Policy. The EU spends €130 billion per year, equivalent to roughly 1 per cent of the gross national income (GNI) of its 27 member states. Expenditures on Structural Funds and the Cohesion Fund account for more than one-third of the EU budget. These funds aim to reduce regional disparities in terms of income, wealth and opportunities. Money is spent in a large number of different areas, such as infrastructure, research and development, social inclusion and regional cooperation. But is this massive expenditure successful at increasing growth rates in the poorer regions of the EU?

Are all recipient regions equally adept in turning transfers into additional economic expansion or does the impact on growth depend on regional conditions, often referred to as a region’s absorptive capacity? If they are beneficial in principle, do larger transfers lead to more growth or are there diminishing returns? Answers to these questions are important in determining whether the EU Regional Policy is successful, and whether some key adjustments are needed.

Evaluating the success of EU transfers in achieving convergence is no trivial matter. For example, poor regions that are going through a catch-up phase might grow faster than rich regions, quite independently from the receipt of transfers. Generally it is very difficult to find the ‘causal effect’

However, funding under Objective 1 (now called Convergence Objective) is particularly compelling for analysis. Objective 1 funds represent the largest part of EU Structural Funds by far, and these funds are assigned by a clearly defined rule that aids analysis. Regions in which the GDP per capita is less than 75 per cent of the EU average are eligible. Assignment of funds to regions to the left and right of the 75 per cent threshold, serve a role that, from a statistical perspective is quite like the flipping of a coin – providing a quasi-experimental situation that aids our analysis.

Our research shows that Objective 1 funds are, on average, helping recipient regions to grow faster, but the ‘multiplier’ is around 1. That is, on average, ‘you get out what you put in’, but not more than that.

Going beyond average effects of Objective 1 funds, the question is whether there are differences in the growth effects of Objective 1 funds, depending on region characteristics. In other words: Do different regions respond differently?

The answer is yes. The results vary enormously. A region’s human capital and quality of government matter – and matter a lot. The fund transfers serve as an effective accelerator for economic growth, but only in regions with a more educated work force and/or a high calibre of governance. These successful regions, representing 30 per cent of the recipient areas, are driving the positive average effect of the programme, we find.

Specifically, when the share of the work force with at least a high school diploma is one standard deviation (14 per centage points) higher than the recipient region average, this can translate into per capita GDP growth rates that are 0.63 per cent higher. By contrast, regions with a less educated work force and/or low quality of governance do grow, but not any more than would have been expected without the funds. The lack of sufficient education levels and the presence of corrupt politicians or bad administrations undermine the goal of aid transfers in some needy regions.

Our findings strongly suggest that unless a region’s absorptive capacity has reached an appropriate threshold, structural funds have had no medium-term growth effect. This kind of econometric evaluation goes well beyond the EU’s auditing of appropriate use of funds and underscores important ways in which improvements could be made to its Regional Policy.

Regions with low levels of education and poor governance fail to make good use of EU transfers, pointing to the need for a degree of conditionality when earmarking future transfers.

As for EU Structural Funds as a whole, do more funds mean more growth?

Our research shows that more funds do not necessarily mean more growth. We analyse the effect of transfer ‘intensity’ on regional growth and find that there are decreasing returns. That is, after a certain point, additional funds do not lead to additional growth.

How can the EU’s Regional Policy be improved? Our analysis points to a number of potential policy options within the existing structure of the EU’s Regional Policy. First, our work suggests that to avoid a further waste of resources, the EU could impose an upper limit on the transfer intensity. Transfers under the EU’s Regional Policy should thus be limited to the maximum desirable level, around 1.3 per cent of a recipient region’s GDP. About 18 per cent of recipient regions received transfers above the maximum desirable treatment intensity in the programming periods 1994-99 and 2000-06. A reallocation of transfers from those regions, most of them in the periphery of the EU, would therefore not be detrimental, and could well be of benefit to other regions. The overall Structural Funds budget could then be either reduced or, if the budgeted money is to be spent, given to those recipient regions that are still below the maximum desirable amount of funds.

The failure of regions with poorly educated workforces and/or with low levels of government to convert transfers into additional growth suggests some possible options in tailoring policy to achieve growth in the long term. The funds could be withheld in full or given to recipient regions with higher absorptive capacity, but this might leave poor regions in a poverty trap, and it certainly would run counter to the aim of achieving convergence. An alternative would be to tie transfers to investments in education and quality of government in order to build up additional absorptive capacity. To the extent that both the formation of human capital and institutional change of governments take time – most likely about one generation rather than merely a few years – such a policy shift would not produce any short-term or even medium-term miracles.

However, the changes might well be beneficial to the regions, and it would enable them to make better use of future transfers.