Should State Aid that Is Passed on to Consumers Not be Recovered?

Should the amount of recoverable aid be similarly reduced by the amount that is allegedly passed on to consumers? I will argue the case against it.

 

Introduction

On 5 February 2015, the General Court, in cases T-473/12, Aer Lingus v Commission[1] and T-500/12, Ryanair v Commission[2], annulled Article 4 of Commission Decision 2013/199. In that decision the Commission found that a lower tax on air travel in Ireland that applied to flights that were essentially domestic was State aid. The Commission concluded that the aid was incompatible with the internal market and had to be recovered. The amount that had to be recovered was the difference between the lower and the standard rate of tax on all other flights from Ireland [which was EUR 8 per passenger] multiplied by the number of passengers who bought tickets taxed at the lower rate.

The two airlines argued that the Commission was wrong to demand recovery of the full amount of the tax difference because they had passed it on to passengers in the form of cheaper tickets. Surprisingly, the Court agreed with that point of view. It censured the Commission because “116 […] inasmuch as the economic advantage resulting from the application of that reduced rate could have been, even only partially, passed on to the passengers, the Commission was not entitled to consider that the advantage enjoyed by the airlines amounted automatically, in all cases, to EUR 8 per passenger.”

At the time the judgment was rendered, I wrote an article on this blog criticising it for misinterpreting the concept of advantage and for misunderstanding how airlines could exploit the reduced tax even if they passed it on to passengers.[3] The claim that the aid was passed on raised an important question that was not considered by the General Court. If the two airlines passed all aid to passengers why did they bother to receive it in the first place? Surely they were not acting selflessly.

Now one of the most reputable economic consultancies in Europe argues in favour of recovery only of aid that is not passed on to consumers. It believes that “there does not appear to be any strong economic reason why the quantification of pass-on would be different in the case of an ‘undercharge’ caused by alleged State aid compared to an overcharge caused by an upstream cartel.”[4]

In the context of anti-trust rules, and in particular Directive 2014/14 on actions for damages, competitors or users of a cartelised product are entitled to compensation for damage they have suffered as a result of paying the price fixed by the cartel. However, the amount of compensation is reduced in proportion to the price increase that they can pass on to the users or consumers of their own products. This is because if they can raise the prices of their own products, they suffer a small damage as a result of the price increase effected by the cartel.

Should the amount of recoverable aid be similarly reduced by the amount that is allegedly passed on to consumers? I will argue the case against it.

Why it is not a good idea to reduce the amount of recoverable aid

The suggestion to reduce the amount of aid to be recovered by the amount that is eventually passed on to consumers in the form of lower prices is at first glance reasonable. If the firm that has received the aid has passed it on, why should it have to repay it? It also appears to be a reasonable policy practice to apply the principle of calculating damage in the anti-trust field to similar cases in the State aid field.

Indeed, the Commission has on occasion considered that aid is passed on to third parties when it is channelled through an intermediary who retains no advantage. This is typically the case with funds which are established for the sole purpose of channelling aid from a public authority to final beneficiaries. Typically the intermediary’s activities are limited to the holding and disbursement of funds. It is also not allowed to engage in any other economic activity.

Despite its apparent attractiveness, it is not a good idea to limit the amount of aid that should be recovered for the following three reasons. First, in the field of anti-trust, it is the victims of a cartel that can claim damages. Here it makes a lot of sense to calculate the true extent of damage and to take into account whether they could avoid harm by raising their own prices. In State aid, it is the aid recipient who has to repay the incompatible aid. The aid recipient has not suffered any damage. On the contrary, it has received an unfair advantage that the recovery of the aid seeks to neutralise. If it does not have to pay back the aid, then it suffers no penalty. It should be recalled that it is the obligation of any firm not to accept State aid that has not been granted legally. By definition, incompatible aid is aid that has not been granted legally. If the firm simply passes all aid to final consumers and does not have to pay it back, it avoids bearing any penalty for engaging in an illegal activity. By contrast, in the field of anti-trust, the cartel members are penalised at any rate by administrative fines imposed by competition authorities, regardless of whether they eventually pay damages to the users of their products. Any policy has to be effectively enforced. If the recipients of incompatible aid do not have to repay aid they pass on, then they will not have any incentive to ensure that they do not accept illegal aid.

Second, the judgments in the Irish tax cases have not yet established firm principles in the case law. I think they constitute an aberration and the Court of Justice is unlikely to confirm them. In fact, the Court of Justice in case C-156/98, Germany v Commission, dealing with a tax incentive for investors in the new Laender, explained that “27 the fact that investors then take independent decisions does not mean that the connection between the tax concession and the advantage given to the undertakings in question has been eliminated since, in economic terms, the alteration of the market conditions which gives rise to the advantage is the consequence of the public authorities’ loss of tax revenue.” The Court of Justice here correctly refers to the advantage derived from “alteration of market conditions”. Correspondingly, the fact that the Irish airlines decided to pass on the aid to passengers does not mean that they obtained no advantage. The reduced tax changed market conditions.

Third, and more importantly, even by passing on all aid to passengers the airlines could still derive a number of advantages. The rest of this article shows how the airlines may have enjoyed several advantages. But first, I explain who bears a tax.

Who pays a tax?

Perhaps it seems obvious and unnecessary of any comment that a tax is paid by the buyer of the taxed product. However, this is in almost all cases the wrong conclusion. A tax is in fact shared between the buyer and the seller of a product. A tax raises the price of the taxed product. This depresses demand. The seller compensates for the reduction in demand by absorbing part of the tax. How the tax is shared between buyers and sellers depends on the elasticities of demand and supply. Buyers absorb more of the tax when the demand is steep and the supply is flat. By contrast, sellers absorb more of the tax when the supply is steep and the demand is flat.

A tax on air travel in Ireland would have been shared between airlines and passengers. Although the exact proportion is not known, it follows that if the tax is removed, prices would adjust too to their pre-tax levels, ceteris paribus, and passengers would enjoy a reduction in prices that was equal to the portion of the tax that they had absorbed! This is the natural functioning of demand and supply and had nothing to do with the intentions or corporate strategy of the two airlines.

It is worth stressing this point. Any tax relief or tax reduction will result in consumers paying lower prices. But this has nothing to do with the sellers wanting to pass on the benefits of the tax reduction to consumers. This happens even when a company enjoys monopoly powers and can charge whatever price it wants. It will still charge the price that maximises its profit and in the process it will charge a lower price. The annex provides a mathematical proof of this point.

Advantages from passing on all aid to consumers

i) Full recovery does not necessarily eliminate all advantages

Recovery of incompatible aid means paying back the full amount of aid plus interest. The rate of the recovery interest that is charged is very low. It is the base rate of the Member State concerned plus one percentage point [100 basis points]. Normally, when a firm obtains a loan it pays the opportunity cost of the money, which is assumed to be the base rate, plus a risk margin plus administrative costs. Hence, first of all, it has to be understood that even if a firm pays back all aid plus recovery interest, it still retains a small advantage which is the difference between the recovery rate and the rate that it would have to pay according to its credit profile. When a firm accepts illegal aid that is later declared as incompatible by the Commission and has to pay it back, it is as if it is given a low-interest loan. The longer that the Commission is not aware of the aid, the larger the advantage for the firm because the longer the duration of a loan, the larger the risk for the lender and the higher the interest rate that would be changed by the market. Below, two other kinds of advantage are outlined.

ii) Extra profit can be made even if all aid is passed on

Assume that an airline incurs a fixed cost, F, of 700 and constant variable cost, V, of 3 per passenger. Further assume that this airline, due to competition, cannot charge a price, P, which is more than 10 per passenger. At that price, the number of passengers, N, who buy tickets is 100. Its revenue, R, is R = 10×100 = 1000, and its total cost, TC, is TC = 700 + 3×100 = 1000. In other words, it merely breaks even, as R – TC = 0.

Now, assume that, it does not have to pay an air travel tax of 1. This is a form of State aid. It decides to pass on 100% of the aid to passengers. It lowers its price to 9 which is equivalent to 10% price reduction. Since air travel is an activity with elastic demand, it is reasonable to assume that a 10% reduction in price will raise the number of passengers by more than 10%. Let’s say, N = 120. Now, R = 9×120 = 1080 and TC = 700 + 3×120 = 1060. The firm makes profit which is R – TC = 20.

This result is not unusual. It is the outcome of the fact that the firm has a large fixed cost [the cost of the airplane] which generates economies of scale. The larger its output, the smaller its cost per passenger.

Admittedly, the numbers are contrived, but they do demonstrate that under certain conditions a firm can make profit even if it passes on all of the tax reduction to its customers.

iii) Publicity, loyalty and irreversible effects

The company can advertise the cheaper fares. It does not have to explain that the lower fares are the result of lower taxes. Advertising presumably has a positive effect that remains even when prices are raised in case the tax is re-imposed.

Indeed, in the Irish air tax case, the normal tax would have to be re-imposed. When the Commission discovers instances of incompatible aid it instructs the Member State concerned to recover the aid. If the aid is in the form of a tax reduction, in addition, that Member State has to levy the normal rate of tax. Therefore, Ryanair and Air Lingus have to incorporate in their fares the normal rate of tax, regardless of whether they pay back any aid. Let’s consider an example of what may happen when aid enables a firm to expand, even temporarily, its output.

Assume that for every extra 10 passengers after a price decrease, an airline retains one passenger when the price is brought back to its original level. Using the numbers above, 20 extra passengers when the ticket price is nine result in two extra passengers when the price is restored to 10. But at 102 passengers, the revenue of the airline is R = 10×102 = 1020, while its total cost is TC = 700 + 3×102 = 1006. Now it makes a profit of R – TC = 1020 – 1006 = 14.

Conclusions

Recovery of State aid that is incompatible with the internal market should always take place. It is the only form of penalty for firms that are granted illegal aid. The knowledge that incompatible aid will eventually have to be repaid with interest should incentivise firms not to accept aid that is given to them illegally.

The problem is that firms always derive a benefit which is at least as large as the amount of aid they receive and in most cases retain a small benefit even after they repay the aid.

Firms can derive a benefit also when they pass all aid to their customers. Otherwise they would not be so keen to receive the aid in the first place. It cannot be presumed that firms are in the business of extracting benefits from the government, which they can then fully transfer to their clients. Surely, their intention is to keep something for themselves even when they appear to pass benefits to their customers.

If aid recipients enjoy economies of scale they can make extra profits even if they transfer all aid. But perhaps most importantly, they can benefit from irreversible effects which the repayment of aid cannot eliminate such as extra publicity and strengthened customer loyalty.

Annex: Pricing by a monopolist before and after tax

Assume that each of the two Irish airlines enjoyed monopoly positions in their respective internal routes. Let the demand per flight per route be

P = a – bN

where P is price and N is the number of passengers.

A firm maximises its profits when its marginal cost equals marginal revenue, MC = MR. The marginal revenue, given the demand above, is MR = a – 2bN. If we assume that the firm has a constant marginal cost, m, then for maximum profits, MC = m = MR = a – 2bN. Therefore, the firm maximises its profits when the number of passengers is

N* = (a – m)/2b

If we plug this value into the demand equation we derive the profit-maximising price

P* = (a + m)/2

Now assume a fixed tax, t, is imposed on airline tickets. If P’ is the price charged by the airlines, then the price paid by consumers is P’ + t. Therefore, the demand for the airlines is

P’ + t = a – bN’

By solving again for the profit maximising price and number of passengers we derive

N’ = (a – m – t)/2b = (a – m)/2b – t/2b = N* – t/2b

P’ = (a + m + t)/2 = (a + m)/2 + t/2 = P* + t/2

We see that even in a monopoly situation where the firm has power over prices, the price increases by half of the tax. It follows that when the tax is removed, the price will automatically decline by half of the tax because this is how the firm maximises its profit.

A numerical example can illustrate these results more vividly. Assume that the airlines have marginal costs, MC = 70 and face demand P = 170 – 0.5N. This means that the profit maximising price for tickets is P* = 120, with N* = 100. Profits are π = 12000 – 7000 = 5000.

When a tax of t = 10 per ticket is imposed, the price rises to P’ = 115 but the airlines charge only (P’ – t) = 115 – 10 = 95. The number of passengers declines to N’ = 90. Profits also drop to π’ = 2250 [= (95 x 90) – (70 x 90)].

We see that profits are significantly susceptible to small changes in prices and that, again, the tax is shared between airlines and passengers.

——————————————————————————

[1] The text of the judgment can be accessed here:

http://curia.europa.eu/juris/document/document.jsf?text=&docid=162086&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=330607.

[2] The text of the judgment can be accessed here:

http://curia.europa.eu/juris/document/document.jsf?text=&docid=162087&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=330607.

[3] The article can be accessed here: http://stateaidhub.eu/blogs/stateaiduncovered/post/1625.

[4] See Oxera, State aid practice under challenge? Implications of landmark court judgments, Agenda September 2015. It can be accessed here:

http://www.oxera.com/getmedia/2c85df17-5c0e-4304-8aff-f41c5369879a/State-aid-under-challenge_1.pdf.aspx?ext=.pdf&utm_source=Agenda&utm_campaign=0ea442e0be-Agenda&utm_medium=email&utm_term=0_30f4ff7c95-0ea442e0be-2071957.

 

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Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He presently holds positions at the College of Europe and the University of Maastricht. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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