Impact of CAP subsidies on productivity

I recently had an exchange on Twitter with Martin Crowe, an Irish dairy farmer and agri-consultant, over the apparent stagnation in Irish agricultural output over the past 20 years (follow on @xAlan_Matthews and @martincrowe). I attributed this, in part, to the role that direct payments play in Irish farm incomes. I argued that “If 70% of your income is coming as a cheque in post there is less incentive to innovate to grow the remaining 30%” (direct payments make up around 70% of Irish farm income in an average year). Martin tweeted back that the “70% gives the security and confidence to try and improve the 30%”.
At issue here is the impact of CAP direct payments on farm productivity. As the Twitter exchange indicates, there are potentially both positive and negative effects.
How direct payments might affect productivity

In the agricultural economics literature, the positive effects rely on credit constraints and assumptions about risk behaviour in agriculture. If farms find it difficult to access credit, then subsidies may provide an additional source of financing, either directly by increasing farms’ financial resources or indirectly through improved access for formal credit (your local bank manager may look more kindly on your request for a loan if she is aware that most of your income is a stable cheque guaranteed by the government). Even if farms are not credit-constrained, subsidies may represent a cheaper source of financing than the credit available from your local bank.
Subsidies can also positively affect farm behaviour under uncertainty through a wealth effect. Farmers may be more willing to expand production through certain types of activities that would otherwise be viewed as too risky in the absence of the guaranteed income from the direct payment.
On the other hand, subsidies may negatively affect farm productivity because they distort the production structure of recipient farms. An obvious example is a coupled subsidy which keeps farmers engaged in a loss-making enterprise (which might be keeping suckler cows, for example) simply in order to draw down the subsidy.
Subsidies may give rise to technical inefficiency if higher profits lead to slack, a lack of effort and disinclination to seek cost-reducing methods. Subsidies also lead to a soft budget constraint, meaning that farmers might be inclined to over-invest leading to inefficient use of resources. The number of shiny new tractors on Irish farms despite the evidence of low incomes testifies to this effect. More generally, subsidies help to keep existing resources in the industry and slow down the rate at which resources are reallocated to more productive uses in response to new technologies or market conditions.
Thus, whether the positive or negative effects dominate is an empirical question. By chance, a new study by three agricultural economists, Marian Rizov, Jan Pokrivcak and Pavel Ciaian, attempts to answer exactly this question. The authors investigate the impact of CAP direct payments on farm productivity in the EU-15 member states (the absence of sufficiently long data time series precluded covering the new member states).
Measuring the productivity effects of direct payments
Previous attempts to examine the relationship between CAP subsidies and farm productivity used a two-stage approach. First, a production function is fitted to farm-level data and estimates of productivity are derived. In a second stage, those productivity estimates are regressed on subsidies to try to identify the impact of the subsidies on the level of productivity.
The problem with this approach is that, if it is assumed that subsidies affect productivity, then subsidies should also be included in the first stage estimation of productivity levels, as otherwise the estimates will be biased.
The authors of the new study use a methodology which explicitly incorporates subsidies in estimating farm-level productivity. They also controlled for the selection bias which might arise due to the exit of farms over time (it is likely that those farms that exit have lower productivity on average than those farms that remain, so failing to take this effect into account will also bias the productivity estimates). Their methodology further takes account of the well-known simultaneous relationship between productivity levels and input demands (the choice of inputs will be correlated with the farm’s productivity level). With their approach, they are able to test for the impact of direct payments both before and after decoupling was introduced in the period 2005-06.
For their study the authors use FADN data for six main farm types for the 15 old member states over the period 1990-2008 (for Austria, Finland and Sweden which entered the EU in 1995, the period of analysis is 1996-2008). Their empirical strategy is to run regressions within the six farm-type samples for each country, which gives them 83 farm-type country samples; this approach allows for flexibility and variation in technology choices across farm systems and countries.
In order to test for the relationship between farm productivity and subsidies, the authors first estimate farm-level productivity levels and growth rates. Productivity is measured as the growth in output after all measured inputs are accounted for (a measure known as total factor productivity, or TFP). These are aggregated to national levels using output weights, thus giving bigger weight to productivity levels/growth rates on larger farms.
The calculated average annual percentage TFP growth rates by member state are shown in the figure. The southern European countries Italy, Spain and Portugal all show rapid TFP growth over the period; perhaps surprisingly, the countries in north-west Europe (Belgium, Netherlands and Ireland) as well as the Nordic countries (Finland, Sweden and Denmark) show negative productivity growth (either 1990-2008 or 1996-2008 depending on the date of EU accession).

How important are the productivity effects of direct payments?
The main purpose of the study was to identify the impact of CAP direct payments on productivity levels and growth. Here the authors find evidence that coupled payments (prior to 2005) had a clear negative effect on productivity (the finding is statistically significant even if economically the magnitude of the effect is not great – a doubling of subsidies leads to a reduction of between zero and 3.7 per cent in TFP depending on the country).
However, for the period when subsidies were decoupled, a more varied pattern of results is found. For ten of the EU-15 countries there is a positive relationship between subsidies and productivity although this relationship is statistically significant for only six countries for both productivity level and growth. Overall, they conclude that decoupled subsidies after 2005 either have no effect or a small positive effect on productivity in the majority of EU-15 countries.
These findings are consistent with the study by Kazukauskas, Newman and Sauer of Danish, Dutch and Irish farms using a similar methodology but with a uniform production function for each of the member states. They also found that decoupling had a positive and significant effect on productivity.
These are net effects; the methodology does not distinguish between the separate effects of the allocative and technical inefficiency losses and the investment-induced productivity gains. What the results suggest is that, with decoupling, the allocative and technical inefficiency losses are reduced, and/or the positive investment effects due to the interaction of the subsidy with market imperfections are increased. However, in all cases, the economic importance of the effects identified is very small.
Going back to my Twitter debate with Martin Crowe, the results of this study suggest that, in the era of decoupled payments, Martin’s point that the “70% [of income coming from direct payments] gives the security and confidence to try and improve the 30%” trumps my concern that “If 70% of your income is coming as a cheque in post there is less incentive to innovate to grow the remaining 30%”. However, the economic importance of the productivity effect is small.
Whether decoupled subsidies impact on output levels by encouraging higher levels of investment and/or variable input use is also of interest but this is not a question addressed by this study.

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