State aid to attract FDI and the European competition policy: should variable cost aid be banned?

The purpose of this paper is to analyze the European Commission's approach to state aid for foreign direct investment in a competition policy framework. The Commission shows to consider variable cost aid (VCA) to be more distortive than start-up or fixed cost aid (FCA). This paper addresses that issue and checks whether allowing FCA while banning VCA is a …first-best strategy for a rational Authority maximizing welfare. The model shows that a rational forward-looking government maximizing domestic welfare always prefers VCA to FCA if both the incumbent and the entrant are foreign firms and if granting VCA does not cause to the incumbent …firm to exit the market. On the other hand, a VCA which causes the incumbent …firm to be crowded out by the entrant never occurs at the equilibrium. The model shows that the Commission's approach may lead to sub-optimal equilibria where market competition and consumers' welfare are not maximized.