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

Phedon Nicolaides, 6 October 2015

On 5 February 2015, the General Court, in cases T-473/12, Aer Lingus v Commission and T-500/12, Ryanair v Commission, partly annulled 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 for 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.”

When the judgment was issued I wrote an article criticising it for misinterpreting the concept of advantage and for misunderstanding how airlines could exploit the reduced tax even they could pass it on to passengers.[1] If the two airlines were passing 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.”[2]

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 products.

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.

However, it is not a good idea 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 incentives 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, indeed even by passing on all aid to passengers the airlines could still derive a number of advantages. The next section outlines several possible advantages.

Advantages from passing on all aid to consumers

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 close to 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.

i) 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. 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 it 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. This is illustrated by the following diagram.

Itdig shows the demand facing an airline and the average total cost, ATC, of the airline. The price initially charged, inclusive the tax, is A. The tax is equal to the distance BC. The number of passengers carried is N1. As seen, the airline merely breaks even. Then the tax is removed and the airline can reduce its price by BC to D. Demand at the lower price expands to N2. Now, as a result of economies of scale, the ATC of the airline for N2 passengers is lower. It makes a profit of EF per passenger and a total amount of profit of DEFG. To avoid unnecessary complication, I do not examine whether at N2 the airline maximises its profit. This is because, the purpose of this exercise is to show that the airline can make profit, starting from a break-even point, even if it passes on all the aid to the passengers.

ii) 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 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 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 always 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. Surely they are not in the business of extracting benefits from the government, which they can then fully pass on to their clients. In the process they keep something for themselves.

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

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

[2] 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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