## _wp1358 - 6. Potential Justification for Subsidies

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---

### Introduction
- Context and purpose
  - Revisits the conceptual framework guiding government investments toward efficient outcomes in light of events such as the global economic slump of 2008-2012 and fiscal retrenchment in Europe and the United States.
  - Emphasizes that deviations between social returns and private returns (Pigou, 1920) can justify intervention but that intervention need not be effective even when large deviations exist.
  - Two additional reasons government provision or subsidization may fail:
    - (a) private returns may still be high enough to guarantee private provision; and
    - (b) all returns, private and social, may be too low to justify any investment.
  - Focuses on large discrete, all-or-nothing investments; applicable to national public investment policy and international aid organizations.
- Information and practice gaps
  - Useful information for investment choice includes whether genuine market failures or externalities exist, and whether/under what conditions the private sector would undertake the investment (private and social rates of return or net present values).
  - Experimental impact evaluations are increasingly used but apply to a small fraction of public sector expenditures.
  - Net present value or economic rate of return calculations are estimated for less than half of public sector investments even at institutions such as the World Bank; a major reason is failure to finance data collection.
  - References to guidance:
    - IMF (2005) recommends assessing scope for mobilizing private and public resources and prioritizing projects by economic and social rates of return (quoted: p. 17 and p.24).
    - World Bank Operational Policy 10.04: project acceptable if (a) expected present value of net benefits is not negative; and (b) expected present value of net benefits is ≥ expected net present value of mutually exclusive alternatives. The policy notes "The project is also compared with the alternative of not doing it at all" but does not explicitly analyze private-sector alternatives.

### A graph of Possible Investments (Figure framework)
- Axes and interpretation
  - Vertical axis: Private Rate of Return.
  - Horizontal axis: Social Rate of Return.
  - 45 degree line: projects with no externalities (private and social returns coincide).
  - Southeast of 45°: positive externalities (social returns > private returns).
  - Northwest of 45°: negative externalities (private returns > social returns).
  - Pure public goods: private returns = 0, social returns > 0 (points on horizontal axis).
- Investment adoption rule for private sector
  - Rational private investors adopt all investments for which the private rate of return exceeds the rate of interest (illustrated: private sector invests in projects B, C, and F in Figure 2).

### Decision Rules for State Investments
- Common decision rules and shortcomings
  - Rule: select projects with highest social return (rank by social return). Problem: may select projects (e.g., F) the private sector would already undertake, yielding zero additional impact.
  - Rule: select projects with largest social-minus-private return (gap). Problem: does not prevent choosing privately funded projects like F.
  - Rule: provide pure public goods only (points on horizontal axis). Problem: may omit projects with higher social returns (e.g., E).
- Welfare-maximizing rule (illustrated)
  - Governments should consider both private and social returns and their budget constraint.
  - Optimal policy: select only from investments that fall in the bottom-right rectangle (projects with private returns below the private-investment threshold but social returns high enough) and rank those by social return until budget is exhausted.
  - Example policy action: invest directly in D but subsidize E until privately perceived return just exceeds the rate of interest, so private sector will voluntarily invest.
- Key managerial rule stated in text
  - "It is taken as given in this paper that it is never optimal for the state to perform an investment that the private sector would do voluntarily."
- Region of maximum impact
  - Region C (Figure 3): positive-social-return projects that the private sector would not do — this is the focus area for public investments.
  - Investments in regions A and B: may appear impactful but are not additional (private sector would do them).
  - Investments in regions D and E: low-return for both sectors and would waste funds relative to Region C.

### Do Externalities Always Justify Intervention?
- Conceptual points
  - Externality exists whenever there is a wedge between private and social returns; not all externalities imply intervention should occur.
  - Historical statements (Pigou, Samuelson) are often interpreted as implying intervention whenever externalities exist, but the paper shows this is not universally correct.
- Illustrative cases
  - Region B: positive externality but private investment may still occur; social benefit above private benefit is a "free benefit" — not necessarily a market failure unless the private market produces less than socially optimal output.
  - Region A: negative externality but social return can remain positive; negative externalities alone do not automatically justify intervention.
  - Region D: social value exceeds private value but both are too low — public provision would still be inefficient.
- Conclusion
  - Presence of an externality is neither a necessary nor a sufficient condition for public-sector provision.

### How to Efficiently Support the Private Sector
- Role of public agencies (Sovereign Investment Funds, Government Agencies, World Bank groups, IFC)
  - Many such agencies co-finance or finance private sector investments in regions A, B, or F.
  - The mere existence of positive social consequences from a private investment does not imply a public agency’s involvement adds net social value.
- Mechanisms by which a Public Agency (PA) can add net social value
  - Bringing superior business expertise or experience that increases project success:
    - Moves an investment from position F to Y or Z in Figure 4.
    - If benefits accrue only to the firm, the PA’s contribution equals the horizontal distance from F to Z (social component of firm benefit).
  - Restructuring investments to increase social benefits for given private returns:
    - Moves an investment from F to X; social contribution equals horizontal distance F to X.
    - If restructuring provides private benefit too, outcome lies north of X.
  - Demonstration projects:
    - PA undertakes projects to prove commercial viability where private actors believe projects lie below the interest-rate line; demonstration can change private beliefs and induce future private investment.
- Critical determinant of PA net contribution
  - Whether another financier (bank) would have financed the investment and on what terms; if another bank would have financed on the same terms, PA contribution is zero despite social effects.
  - Need to understand specific attributes the PA brings that normal banks would not (expertise, structuring, demonstration effects).

### Final practical point in this section
- The paper emphasizes that demonstration, structuring, or expertise must be shown to be additional to justify public-sector finance; mere co-financing where private finance would have occurred on equivalent terms yields no net social contribution.

### *Source: _wp1358 - 6. Potential Justification for Subsidies (excerpts provided).*

---

### _wp1358 - 5. Suppose that in fact those investments would be commercially viable

### Contribution of demonstration projects
- Mechanism and social valuation
  - If the public authority (PA) subsidizes or offers concessionary financing to investment “A1” to induce a private partner to invest, and other private investors observe profitability and voluntarily invest in similar projects, then the PA causes additional investments that would not have occurred without intervention.
  - Social value of such demonstration-induced investments = social return of the additional investments minus the cost of the subsidy.
- Conditions increasing demonstration effectiveness
  - More additional projects involved.
  - The social return is higher relative to the private return of the group of projects.
  - The subsidy is less costly.
- Diagrammatic elements preserved from the source
  - Private Rate of Return, Social Rate of Return, 45 degree line, points labeled A1, A2, BC, D, A3, and circles indicating investment positions (Figure 5).

### Subsidies: framework and critical issues
- Two key effects of a subsidy
  - raises the rate of return as perceived by the private sector investor; and
  - incurs efficiency costs for the economy due to distortions and fiscal cost (the need to raise revenues and thereby cause further distortions).
- Diagrammatic interpretation
  - A subsidy creates a wedge between private-perceived returns and true social returns, and the fiscal cost shifts the true return leftward.
- Four points to consider with any subsidy
  - pre-subsidy private-sector return;
  - pre-subsidy social return;
  - post-subsidy private-sector return; and
  - post-subsidy social return.
- Illustrative cases from Figure 6
  - A1: before subsidy, unattractive for both private and public sectors; after subsidy private return may move to B1, but social return shifts left to C1; subsidy not socially justifiable.
  - A2: low-return investment despite positive externalities; subsidy may still not be socially justifiable.
  - A3: high social return relative to private return and private return below the rate of interest; subsidies can raise welfare and may be justified.
- Key conceptual points
  - Part of a subsidy can be a transfer from taxpayers to firm beneficiaries; if there is no net distributional benefit, this transfer nets to zero for societal returns.
  - Subsidies are best reserved for investments with very high social return relative to private returns, and private returns below the rate of interest.
  - Investments on the 45 degree line (private returns equal social returns) do not justify subsidies if private agents have accurate information and there are no externalities.

### When externalities, information, and gap-filling matter
- Limits of simple rules
  - Simple gap-filling or externality-based rules are necessary but not sufficient:
    - Investments off the 45 degree line entail externalities, but not all such investments warrant public funding.
    - Region B (in the framework): public funds wasted because private sector would perform the investments anyway.
    - Regions D and E: public funds wasted because social return is low.
  - Gap-filling principle (public sector restricts itself to investments the private sector would not perform) is insufficient by itself because it may include investments in regions D and E with low social returns.
- Role of public-good enabling investments
  - Legal and regulatory frameworks can shift private returns up for many investments; in the diagram these could be represented along the x-axis, effectively increasing the set of investments deemed profitable by the private sector.

### Policy statements from governments (examples)
- European Commission (summary)
  - Public expenditure should address genuine market failures; otherwise taxpayers’ money is wasted and markets distorted.
  - Support should target where it can make a difference for competitiveness, stimulate innovation, growth and employment.
  - Comment in framework terms: addressing externalities is necessary but not sufficient; the statement requires further elaboration to avoid justifying inefficient state provision.
- Australian draft Energy White Paper (December 2011) principle
  - Government energy policy interventions should be transparent, cost-effective, justifiable against objectives and targeted to address identified market gaps or failures.
  - Comment in framework terms: “market gaps” understood simply as investments the private sector would not do is necessary but not sufficient; it can include low-social-return investments (regions D and E) that should be excluded.

### Concluding statements and practical implications
- Combined analysis required
  - Two analyses should be combined to avoid major public investment mistakes:
    - Analysis of whether the private sector would pursue the investment in the absence of government incentives or direct provision.
    - Assessment of the social rate of return of the investment.
- Externalities are neither necessary nor sufficient
  - Externalities alone do not automatically justify public intervention because private investors may still choose to undertake investments with externalities if private returns are sufficiently high.
- Focus of the paper
  - The paper focuses on discrete, lumpy projects with no margin for quantity adjustment to highlight that the private sector might provide socially optimal quantities even in presence of externalities.
- Practical state of practice and measurement
  - Measurement imprecision is acknowledged, but feasible improvement is valuable: on a hypothetical scale of 1-10 (10 = perfect analysis), the maximum feasible analysis is assigned a 7; current practice is roughly scored as 3. Moving from 3 to 7 is worthwhile even if 7 < 10.
- Use of the graphical framework
  - The graphical framework helps clarify when government efforts to support the private sector, invest in demonstration projects, or subsidize private investments can be welfare-improving and what must be demonstrated to justify such interventions.

*Source: Extracts from the specified IMF working paper chapter titled "5. Suppose that in fact those investments would be commercially viable."*

### 1. Illustration of Private and Social Rates of Return for Investments ......................................7

### _wp1358 - 1. Illustration of Private and Social Rates of Return for Investments ......................................7

### 1. Illustration of Private and Social Rates of Return for Investments ......................................7
- Section title: "1. Illustration of Private and Social Rates of Return for Investments"
- Page reference: 7

### 2. Six Possible Investments – Which Should the Public Sector Do?........................................8
- Section title: "2. Six Possible Investments – Which Should the Public Sector Do?"
- Page reference: 8

### 3. State Investments Should Focus on Region C .....................................................................10
- Section title: "3. State Investments Should Focus on Region C"
- Page reference: 10

### 4. Possible Contribution of Government Investment in Private Sector Projects .....................14
- Section title: "4. Possible Contribution of Government Investment in Private Sector Projects"
- Page reference: 14

### 5. Possible Contribution of Demonstration Projects ................................................................15
- Section title: "5. Possible Contribution of Demonstration Projects"
- Page reference: 15

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1358.pdf*

### 6. Potential Justification for Subsidies ...............................................................................

### _wp1358 - 6. Potential Justification for Subsidies

### Introduction
- Context and purpose
  - Revisits the conceptual framework guiding government investments toward efficient outcomes in light of events such as the global economic slump of 2008-2012 and fiscal retrenchment in Europe and the United States.
  - Emphasizes that deviations between social returns and private returns (Pigou, 1920) can justify intervention but that intervention need not be effective even when large deviations exist.
  - Two additional reasons government provision or subsidization may fail: (a) private returns may still be high enough to guarantee private provision; (b) all returns, private and social, may be too low to justify any investment.
  - Focuses on large discrete, all-or-nothing investments; applicable to national public investment policy and international aid organizations.

- Information and practice gaps
  - Useful information for investment choice includes whether genuine market failures or externalities exist, and whether/under what conditions the private sector would undertake the investment (private and social rates of return or net present values).
  - Experimental impact evaluations are increasingly used but apply to a small fraction of public sector expenditures.
  - Net present value or economic rate of return calculations are estimated for less than half of public sector investments even at institutions such as the World Bank; a major reason is failure to finance data collection.
  - References to guidance:
    - IMF (2005) recommends assessing scope for mobilizing private and public resources and prioritizing projects by economic and social rates of return (quoted: p. 17 and p.24).
    - World Bank Operational Policy 10.04: project acceptable if (a) expected present value of net benefits is not negative; and (b) expected present value of net benefits is ≥ expected net present value of mutually exclusive alternatives. The policy notes "The project is also compared with the alternative of not doing it at all" but does not explicitly analyze private-sector alternatives.

### A graph of Possible Investments (Figure framework)
- Axes and interpretation
  - Vertical axis: Private Rate of Return.
  - Horizontal axis: Social Rate of Return.
  - 45 degree line: projects with no externalities (private and social returns coincide).
  - Southeast of 45°: positive externalities (social returns > private returns).
  - Northwest of 45°: negative externalities (private returns > social returns).
  - Pure public goods: private returns = 0, social returns > 0 (points on horizontal axis).
- Investment adoption rule for private sector
  - Rational private investors adopt all investments for which the private rate of return exceeds the rate of interest (illustrated: private sector invests in projects B, C, and F in Figure 2).

### Decision Rules for State Investments
- Common decision rules and shortcomings
  - Rule: select projects with highest social return (rank by social return). Problem: may select projects (e.g., F) the private sector would already undertake, yielding zero additional impact.
  - Rule: select projects with largest social-minus-private return (gap). Problem: does not prevent choosing privately funded projects like F.
  - Rule: provide pure public goods only (points on horizontal axis). Problem: may omit projects with higher social returns (e.g., E).
- Welfare-maximizing rule (illustrated)
  - Governments should consider both private and social returns and their budget constraint.
  - Optimal policy: select only from investments that fall in the bottom-right rectangle (projects with private returns below the private-investment threshold but social returns high enough) and rank those by social return until budget is exhausted.
  - Example policy action: invest directly in D but subsidize E until privately perceived return just exceeds the rate of interest, so private sector will voluntarily invest.
- Key managerial rule stated in text
  - "It is taken as given in this paper that it is never optimal for the state to perform an investment that the private sector would do voluntarily."

- Region of maximum impact
  - Region C (Figure 3): positive-social-return projects that the private sector would not do — this is the focus area for public investments.
  - Investments in regions A and B: may appear impactful but are not additional (private sector would do them).
  - Investments in regions D and E: low-return for both sectors and would waste funds relative to Region C.

### Do Externalities Always Justify Intervention?
- Conceptual points
  - Externality exists whenever there is a wedge between private and social returns; not all externalities imply intervention should occur.
  - Historical statements (Pigou, Samuelson) are often interpreted as implying intervention whenever externalities exist, but the paper shows this is not universally correct.
- Illustrative cases
  - Region B: positive externality but private investment may still occur; social benefit above private benefit is a "free benefit" — not necessarily a market failure unless the private market produces less than socially optimal output.
  - Region A: negative externality but social return can remain positive; negative externalities alone do not automatically justify intervention.
  - Region D: social value exceeds private value but both are too low — public provision would still be inefficient.
- Conclusion
  - Presence of an externality is neither a necessary nor a sufficient condition for public-sector provision.

### How to Efficiently Support the Private Sector
- Role of public agencies (Sovereign Investment Funds, Government Agencies, World Bank groups, IFC)
  - Many such agencies co-finance or finance private sector investments in regions A, B, or F.
  - The mere existence of positive social consequences from a private investment does not imply a public agency’s involvement adds net social value.
- Mechanisms by which a Public Agency (PA) can add net social value
  - Bringing superior business expertise or experience that increases project success:
    - Moves an investment from position F to Y or Z in Figure 4.
    - If benefits accrue only to the firm, the PA’s contribution equals the horizontal distance from F to Z (social component of firm benefit).
  - Restructuring investments to increase social benefits for given private returns:
    - Moves an investment from F to X; social contribution equals horizontal distance F to X.
    - If restructuring provides private benefit too, outcome lies north of X.
  - Demonstration projects:
    - PA undertakes projects to prove commercial viability where private actors believe projects lie below the interest-rate line; demonstration can change private beliefs and induce future private investment (discussion continues beyond provided excerpt).

- Critical determinant of PA net contribution
  - Whether another financier (bank) would have financed the investment and on what terms; if another bank would have financed on the same terms, PA contribution is zero despite social effects.
  - Need to understand specific attributes the PA brings that normal banks would not (expertise, structuring, demonstration effects).

*Source: _wp1358 - 6. Potential Justification for Subsidies (excerpts provided).*

### 5.  Suppose that in fact those investments would be commercially viable

### 5.  Suppose that in fact those investments would be commercially viable

### Contribution of demonstration projects
- If the public authority (PA) subsidizes or offers concessionary financing to investment “A1” to induce a private partner to invest, and other private investors observe profitability and voluntarily invest in similar projects, then the PA causes additional investments that would not have occurred without intervention.
- Social value of such demonstration-induced investments = social return of the additional investments minus the cost of the subsidy.
- Demonstration projects are more likely to have a positive impact when:
  - more additional projects are involved;
  - the social return is higher relative to the private return of the group of projects;
  - the subsidy is less costly.
- Diagrammatic elements preserved from the source:
  - Private Rate of Return, Social Rate of Return, 45 degree line, points labeled A1, A2, BC, D, A3, and circles indicating investment positions (Figure 5).

### Subsidies: framework and critical issues
- Two key effects of a subsidy:
  - raises the rate of return as perceived by the private sector investor; and
  - incurs efficiency costs for the economy due to distortions and fiscal cost (the need to raise revenues and thereby cause further distortions).
- In the diagrammatic framework, a subsidy creates a wedge between private-perceived returns and true social returns, and the fiscal cost shifts the true return leftward.
- Four points to consider: pre-subsidy private-sector return, pre-subsidy social return, post-subsidy private-sector return, post-subsidy social return.
- Illustrative cases from Figure 6:
  - A1: before subsidy, unattractive for both private and public sectors; after subsidy private return may move to B1, but social return shifts left to C1; subsidy not socially justifiable.
  - A2: low-return investment despite positive externalities; subsidy may still not be socially justifiable.
  - A3: high social return relative to private return and private return below the rate of interest; subsidies can raise welfare and may be justified.
- Key conceptual points:
  - Part of a subsidy can be a transfer from taxpayers to firm beneficiaries; if there is no net distributional benefit, this transfer nets to zero for societal returns.
  - Subsidies are best reserved for investments with very high social return relative to private returns, and private returns below the rate of interest.
  - Investments on the 45 degree line (private returns equal social returns) do not justify subsidies if private agents have accurate information and there are no externalities.

### When externalities, information, and gap-filling matter
- Simple gap-filling or externality-based rules are necessary but not sufficient:
  - Investments off the 45 degree line entail externalities, but not all such investments warrant public funding.
  - Region B (in the framework): public funds wasted because private sector would perform the investments anyway.
  - Regions D and E: public funds wasted because social return is low.
- Gap-filling principle (public sector restricts itself to investments the private sector would not perform) is insufficient by itself because it may include investments in regions D and E with low social returns.
- Public-good enabling investments (legal and regulatory frameworks) can shift private returns up for many investments; in the diagram these could be represented along the x-axis, effectively increasing the set of investments deemed profitable by the private sector.

### Policy statements from governments (examples)
- European Commission (statement summarized):
  - Public expenditure should address genuine market failures; otherwise taxpayers’ money is wasted and markets distorted.
  - Support should target where it can make a difference for competitiveness, stimulate innovation, growth and employment.
  - Comment in framework terms: addressing externalities is necessary but not sufficient; the statement requires further elaboration to avoid justifying inefficient state provision.
- Australian draft Energy White Paper (December 2011) principle:
  - Government energy policy interventions should be transparent, cost-effective, justifiable against objectives and targeted to address identified market gaps or failures.
  - Comment in framework terms: “market gaps” understood simply as investments the private sector would not do is necessary but not sufficient; it can include low-social-return investments (regions D and E) that should be excluded.

### Concluding statements and practical implications
- Two analyses should be combined to avoid major public investment mistakes:
  - Analysis of whether the private sector would pursue the investment in the absence of government incentives or direct provision.
  - Assessment of the social rate of return of the investment.
- Externalities alone do not automatically justify public intervention because private investors may still choose to undertake investments with externalities if private returns are sufficiently high.
- The paper focuses on discrete, lumpy projects with no margin for quantity adjustment to highlight that the private sector might provide socially optimal quantities even in presence of externalities.
- Practical state of practice and measurement:
  - Measurement imprecision is acknowledged, but feasible improvement is valuable: on a hypothetical scale of 1-10 (10 = perfect analysis), the maximum feasible analysis is assigned a 7; current practice is roughly scored as 3. Moving from 3 to 7 is worthwhile even if 7 < 10.
- The graphical framework helps clarify when government efforts to support the private sector, invest in demonstration projects, or subsidize private investments can be welfare-improving and what must be demonstrated to justify such interventions.

*Source: Extract from the specified IMF working paper chapter titled "5.  Suppose that in fact those investments would be commercially viable."*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1358.pdf_