Income Distribution Effects of EU Rural Development Policies: The Case of Farm Investment Support

Transcription

1 Income itribution Effect of EU Rural evelopment Policie: The Cae of Farm Invetment Support Pavel Ciaian 1 and Tomáš Ratinger 1 IPTS-JRC European Commiion and Slovak Agricultural Univerity UZEI - Intitute of Agricultural Economic and Information Verion: 6 March 009 Abtract Thi paper analye income ditribution effect of invetment upport granted under the EU RP. It how that implementation detail of the upport (the ize of allocated fund, enforcement of additionality, eligibility limit) and market condition (farm heterogeneity, farm acce to credit, hort-run veru long-run effect) affect income ditribution effect of farm the invetment upport. With certain implementation of the upport farm may gain part or even full upport (when the additionality i not enforced and the total upport i relatively mall), while under different condition farmer may looe (with perfect enforcement of the additionally and with ignificant increae in capital price). The implementation detail interact with market tructure and alo determine the income ditribution effect of the invetment upport. Introducing minimum threhold a eligibility criteria may deter mall farm from uptaking the invetment upport while imum eligibility threhold may retrict big farm to take deired level of upport. Benefit from invetment upport are hared with capital upplier. Gain of capital upplier depend on the ize of the capital upply elaticity and are conditional on the EU upport to increae capital price. ey word: rural development policie, policy rent, policy modelling, farm invetment. JEL claification: Q1; Q18 Paper prepared for the GTAP Twelfth Annual Conference, Santiago (Chile), June We acknowledge financial upport from the European Commiion FP7 project New Iue in Agricultural Trade" (AGFoodTrade)" and from the Minitry of Education of the Slovak Republic project APVV, EGA and VEGA. The view expreed are purely thoe of the author and may not in any circumtance be regarded a tating an official poition of the European Commiion. 1

2 Income itribution Effect of EU Rural evelopment Policie: The Cae of Farm Invetment Support Pavel Ciaian and Tomáš Ratinger Introduction The Common Agricultural Policy (CAP) of the EU upport agricultural ector through two mechanim. Firt, farm receive upport through market intervention policie which are alo known a firt pillar policie. The firt pillar policie include direct coupled and decoupled income upport and other market intervention policie (e.g. market price upport, trade meaure, production quota, etc.). Second, the CAP upport rural economy through the Rural evelopment Policie (RP), known a econd pillar policie. The RP include variou meaure targeted either at farm (e.g. invetment upport, agri-environmental upport) or at rural community (e.g. infratructural invetment). In 007 the total EU budget pending on CAP wa around 5 billion, out of which 0% went to RP (EUR-Lex 008). There i extenive literature analying the income ditributional effect of the firt pillar type of agricultural policie (Alton and Jame, 00; Ciaian and Swinnen 006, 009; Ciaian, anc and Swinnen 008; Ciaian et al. 001; ewbre, Anton, and Thompon 001; Gardner 1983; Guyomard, Mouël, and Gohin 004; Salhofer 1996). Among other, tudie have analyzed how thee effect differ among policie and how reult are affected by market imperfection and policy detail (McCorriton and Sheldon 1991; Salhofer and Schmid 004; de Gorter 199; Munk 1994; OEC 007). However, little attention ha been paid to income ditribution effect of RP in thi literature. The RP differ in everal repect with the firt pillar type of policie. The key difference are that the RP have large diverity in policy focu and in implementation, the allocation of upport i baed on the additionality principle, the eligibility limit are impoed at beneficiary level, ome RP meaure are allocated to non-agricultural activitie, and in mot cae the granting of EU upport i not automatic but project baed and ubject to competition. There are everal tudie in the literature which apply variou type of modelling approache with the aim of imulating the impact of RP on the rural economy (ee table 1). However, thee applied RP model contain everal weaknee. One important weakne i the aumption of how RP meaure are incorporated in the model. The modelling of RP i not conitent among different tudie and differ by tudy. Often tudie group variou RP meaure in a ingle variable and aume that all RP meaure included in the variable affect farm incentive in the ame way. Concerning the farm invetment upport, mot tudie do not imulate the effect of the invetment upport individually but aggregated with other meaure (e.g. Balamou and Paltopoulo 006; Haile and Slangen 007; Oglethorpe and Sanderon 1999; Verburg et al. 008).

3 The policy on which thi article focue i farm invetment upport granted under the EU RP. Farm invetment upport i the econd larget meaure within the RP accounting for more than 10% of the total RP pending in the programming period (European Commiion 007). We how that implementation detail of the invetment upport (the ize of allocated fund, enforcement of additionality, and eligibility limit) affect income ditribution effect of farm invetment upport. Variou tudie have documented that implementation detail of agricultural policie matter on how the policy change farm incentive and affect income ditribution (e.g. Alton 007; Ciaian, anc and Swinnen 008; Ciaian and Swinnen 009; ilian and Salhofer 008). Additionally, the implementation detail interact with farm heterogeneity and farm acce to credit. We how that farm heterogeneity and farm acce to credit have important implication for the income ditribution effect of the EU farm invetment upport. To our knowledge, thi paper i the firt attempt to analye the income ditribution effect of EU RP. The paper i organized a follow. We begin with a brief literature review on RP modelling. Next, we preent the underlying partial equilibrium capital market model which we ue for analyzing the income ditributional effect. In ection four we analyze the ditributional impact of farm EU invetment upport in the hort-run conidering different implementation characteritic of the upport. Section five, ix and even extend the analye taking into conideration heterogeneou farm, imperfect rural credit market and the long-run effect, repectively. The final ection conclude by ummarizing the key finding of the tudy. The Current State of the Art in RP Modelling The RP repreent the econd pillar upport meaure of the CAP. The RP differ in everal repect with the firt pillar CAP market intervention policie: (i) the RP include large number of meaure each focuing on different area of rural economy; (ii) implementation differ between meaure and Member State; (iii) ome RP meaure are allocated to nonagricultural activitie; (iv) for the majority of meaure not all farm are eligible for RP upport, the upport i retricted per farm and at the Member State level, and i baed on the additionality principle; (iv) the granting of the majority of RP upport i not automatic but i project baed and i ubject to competition. According to EU regulation 1698/005, the RP upport i divided in four Axe. 1 Each Axi i further plit in everal policy meaure with each focuing on a pecific area of rural development. In general, RP meaure can be grouped in eight ocioeconomic area of rural development: farm retructuring and competitivene; improvement of human capital; innovation; proviion of baic rural ervice and related infratructure; improving the quality of agricultural product; upport for utainable ue of agricultural land; diverification of the rural economy; and upport for improvement of environment (Copu 007; wyer 005). There i a growing body of reearch on the modelling of RP. A ummary of the literature i provided in Table 1. Mot thee tudie are empirical and mot of them imulate the effect of RP on the rural economy. Little work wa done to provide a conitent theoretical modelling framework of RP. 1 Axi 1: improving the competitivene of the agricultural and foretry ector; Axi : improving the environment and the countryide; Axi 3: quality of life in rural area and diverification of the rural economy; and Axi 4: Leader intrument. 3

4 However, thee empirical model contain everal hortcoming. Variou type of model were applied to imulate the effect of RP: for example econometric model; regional SAM; general equilibrium model; partial equilibrium model; integrated aement model, etc (Table 1). In general, thee model focu on more than one RP meaure. Often the tudie combine everal RP meaure in one policy group (e.g. SCENAR 00), group them by axi (e.g. Bergmann and Thomon 008) or by area of RP upport (e.g. Paltopoulo and Balamou 006; Vollet 1998). To reduce the complexity of the model, the grouped meaure are normally treated a one policy variable and are aumed to affect farm in the ame way. Thi i an important weakne ince different RP meaure are expected to create different incentive in the agricultural ector. Variou tudie have documented that implementation detail of agricultural policie matter on how policie change farm incentive and how they affect the agricultural ector (e.g. Alton 007; Ciaian, anc and Swinnen 008; ilian and Salhofer 008). Additionally, an important weakne of the applied model i related to the farm behavioural aumption of RP. Particularly thi concern the aumption made on the way the RP meaure are conidered to affect farm incentive (table 1 ). Often ame RP meaure are modelled differently in different tudie implying that the modelling of the RP differ by tudy (table 1). For example, Paltopoulo and Balamou (006) model the agri-environmental meaure imilarly a the income upport policie. On the other hand, Oglethorpe and Sanderon (1999) are more explicit. They aume that agri-environmental policie lead to adjutment of farm management practice (e.g. retricting tocking denity, fertilizer ue, etc.). In ome cae the modelling of RP appear to be ad-hoc and overimplified. For example, Balamou and Paltopoulo (006) aume that RP payment exogenouly increae output demand of the contruction ector in the analyed region (table 1). In mot cae, the choice of behavioural aumption i a compromie olution between variou contraint faced by modeller uch a the focu of the tudy, type of the model, model tructure, data availability, or/and difference in regional implementation of RP meaure. Many of the applied model are cae or region pecific (e.g. Haile and Slangen 007; Oglethorpe and Sanderon 1999), retricting their ue for other policie, problem and/or region. Often thi i caued be the fact that the modelling of RP require a large et of region/ituation pecific data which are not available at EU level. Another reaon i that RP impact are cae or region pecific. Thi i particularly the cae of model focuing on agrienvironmental meaure (van Itterum et al. 008). For example, Contingent Valuation Method i ued to etimate the conumer' willingne to pay for environmental benefit (rake 199). The etimated willingne to pay for environmental product in one region i not applicable in other region. Thi i becaue environmental product are heterogeneou good and their upply quality and quantity i region pecific depending on local characteritic. Concerning the farm invetment upport, from all tudie reviewed in table 1 only Felici et al. (008) explicitly imulate the impact of the farm invetment upport on rural economy. They ue regional economic model REMI-IRPET. They aume that the invetment upport (moderniation of agricultural holding) reduce capital cot in agricultural ector. Baed on the reult derived in thi paper, thi aumption hold in the cae when the invetment additionality i perfectly enforced. Mot other tudie do not imulate the effect of the invetment upport individually. Often the tudie aggregate the invetment upport with other RP meaure in one policy variable. For ome model it wa not poible to indentify how RP were modelled. 4

5 The model In thi ection we develop a partial equilibrium model to analye income ditribution effect of farm invetment upport granted under the RP. Thi approach i widely ued in the literature to invetigate the income ditribution effect of agricultural policie (Alton and Jame, 00; Ciaian and Swinnen 006, 009; Gardner 1983; Guyomard, Mouël, and Gohin 004; Salhofer 1996). A key advantage of uing partial equilibrium model a compared to the general equilibrium model i that it reduce the complexity of the analye and it allow identifying the effect of the invetment upport on agricultural ector. The hortcoming of the partial equilibrium analyi i that it doe not take into account inter-ectoral effect. epending on the type of the effect, the partial equilibrium reult may be trengthened or offet by the inter-ectoral effect. The hare of the agricultural ector i mall in the overall economy in the EU implying that the inter-ectoral effect hould be relatively mall. The repreentative farm output i aumed to be a function of the amount of capital ( ) and non-capital input ( A ), which we refer to a land but which capture alo other non-capital input ued by the farm (e.g. labor). The production function i repreented by f ( A, ) with f i > 0, f ii < 0, f ij > 0, 3 for i, j = A and. We aume decreaing/contant return to cale production function. We aume that the purchae of capital () i financed from the bank loan (L) at interet rate i aumed to be fixed. Farm are aumed to have uncontrained acce to loan. 4 Thi model i baed on the notion that capital price will equal the dicounted preent value of future rent. More preciely, thi model implie four agent in the agricultural capital good market: repreentative farm, loan upplier (bank), capital upplier (e.g. tractor upplier), and the government. Loan upplier provide loan to farm. Farm ue loan to buy capital good from capital upplier. Farm ue the ervice of the capital good to produce agricultural product. Government intervene in the capital market. The farm profit function i given a follow: (1) = pf ( A, ) ra k where k = R( i + δ ), p i the price of the final product 5, r i the price of non-capital input, k i rental price of capital and R i unit price of capital. The farm capital rental cot per unit of capital include interet cot (payment) ir and the depreciation cot δ R. Farm equilibrium condition are given a follow: () = k = R( i + δ ) pf Farm capital ervice FOC condition 3 f i and ii f are firt and econd derivative of the production function with repect to it argument, repectively. 4 We will relax thi aumption later. 5 We aume that the economy i mall and open, which implie that the output price i fixed. 5

6 (3) pf A = r Farm land FOC condition (4) L = R Farm loan demand (5) = S Capital good market equilibrium condition (6) A A = S Land market equilibrium condition A where S i capital upply function and S i land upply function. Equation () and (3) repreent the repreentative farm capital and land marginal condition, repectively, derived from the farm profit imization problem. The equilibrium condition () yield tandard capitalization formula (i.e. R = pf ( i + δ )) which implie that capital price i equal to the preent value of the future capital rent. The total farm loan demand ( L ) in equation (4) i determined by the capital price and quantity of capital demanded by farm ( R ). With perfect credit market the farm acce to loan i uncontrained which implie that farm can obtain loan for all it capital requirement. Equation (5) and (6) are market clearing equilibrium condition for capital good and land, repectively. The capital market i illutrated in Figure 1. The condition () and (3) determine the farm (annual) demand for capital ervice. The total demand of capital ervice i repreented by the curve in the quadrant I in Figure 1. 6 The curve how capital rental price k which farm i willing to pay for capital ervice ued in the production proce. We aume that the purchae of capital i financed from bank loan. The quadrant II how the total farm loan demand L. The combination of farm capital demand () and farm willingne to pay for capital rental price (k) - given alongide the curve - determine the farm loan requirement. More pecifically, the farm willingne to pay the capital rental price k determine the per unit interet payment for loan ( ir = k δr ). The total farm loan L i then determined by the interet payment and total farm capital demand given along the demand curve. 7 With perfect credit market all farm credit requirement are fulfilled. Thi implie that the hape of farm loan L i determined by the farm demand of capital ervice. The L increae with farm capital demand () and decreae with capital rental cot (k) a hown by the downward lopping curve L in quadrant II. The quadrant III how the capital price curve (R ) which repreent the farm willingne to pay for capital. For a given interet rate and depreciation rate, the capital price i determined imultaneouly with the value of farm loan L. Thi i becaue capital price i determined by the farm willingne to pay for capital rental price given in equation (). In the ame time the capital price repreent the loan per unit of capital which farm can obtain in return for paying the interet payment ir. Thi implie that the loan per unit of capital i equal to the capital price. Similarly to L, the hape of the farm capital price curve R i determined by the farm demand of capital ervice which implie downward loping R. The quadrant IV how market for capital good. Farm capital good demand i determined by the combination of farm willingne to pay for capital good R (hown in the quadrant III) and demand for capital ervice (hown in the quadrant I). Farm ue the loan to pay the 6 One can extend the graphical expoition to land market. We retrict our attention only to capital market a farm capital i the main focu of the paper. 7 Becaue the price of capital (R) i equal to the preent value of future tream of capital rent (equation ()), thi implie that for interet rate i farm can obtain per unit of capital a loan equal to the price of capital. 6

7 purchae of capital (hown in the quadrant II). The farm demand of capital good ha a negative lope imilar to the farm demand of capital ervice () hown in the quadrant I. For example, if the capital rental price i k 1, the optimal farm capital ue i 1 (quadrant I). For a given interet rate i and capital depreciation rate δ, then k 1 implie that with perfect credit market farm can obtain bank loan of ize L 1 (quadrant II). Further, k 1, 1 and L 1 imply that farm i willing to pay for capital 1 the price equal to R 1. Similar can be hown for the ret of equilibrium ituation which implie downward loping capital good demand. Finally, the curve S in the quadrant IV repreent upply of capital good. In an analogou way to farm capital demand, one can derive from the upply of capital good S the (annual) upply of capital ervice (S) (quadrant I). For example, capital upplier are willing to ell for the price R (given along the curve R S in the quadrant III). The and R imply loan L (given along the curve L S in the quadrant II) 8 which i needed to pay to capital upplier for the upply of capital. Thi loan further implie unit capital rental cot equal to k. Similar can be hown for the ret of equilibrium ituation which implie upward loping upply of capital ervice S hown in the quadrant I. The interection between the demand (, ) and the upplie (S, S ) yield the equilibrium bundle of capital rental price, loan, capital price and quantity of capital (k, L, R, ), repectively (Figure 1). The quadrant I how (annual) capital rent and upply and demand of capital ervice while the quadrant IV how the dicounted preent value of annual capital rent and upply and demand of capital good. In further analye we retrict our attention to annual rent and upply and demand of capital ervice hown in quadrant I in Figure 1. Thi i conitent with the other tudie on income ditribution effect of agricultural policie (e.g. Alton and Jame, 00; Ciaian and Swinnen 006; ewbre, Anton, and Thompon 001; Gardner 1983; Guyomard, Mouël, and Gohin 004). To implify the analye we plit the analye in two effect: (i) hort-run direct effect and (ii) long-run indirect effect. 9 We aume that in the hort-run the invetment upport affect only capital market. Land input i aumed to tay fixed. Thi implie a ituation where the farm react to the policy by adjuting capital ue while it keep other input unchanged. In the long-run it i aumed that the capital upport induce indirect change on the other agricultural market. In term of our model thi implie that farm may alo adjut non-capital input (land). 10 The impact of farm EU invetment upport in the hort-run 8 Note that the loan requirement correponding to capital upply L S differ with the loan requirement correponding to the capital demand L except at the equilibrium point L. Thi i becaue the bundle of quantity of capital and capital price (or rental price) along demand and upply differ except at point L. 9 Thi i only for expoition purpoe. The general reult of the paper are not affected. 10 Thi i omehow inconitent with the general ue of thi term in the literature. In general variable input are aumed to change in the hort-run while capital i aumed to change only in the long-run. Becaue our objective i to analye the effect of capital invetment upport, the change in farm capital i a hort-run effect of the policy. Then in the long-run the farm adjut other input taking in conideration the capital invetment upport. 7

8 In thi paper we focu on the following three implementation detail of the farm invetment upport granted under the EU RP: (i) the invetment upport rate; (ii) farm eligibility limit (minimum and imum threhold impoed on the ize of invetment upport a farm can obtain); (iii) the enforcement of invetment additionality. Under the EU RP invetment upport programme farm can obtain a grand to partly finance the cot of capital purchae. The farm invetment upport i co-financed from the EU RP budget and from the national budget. The upport rate range between 40% and 75% of the total value of capital purchae cot. The upport rate vary by region and by farm characteritic. Farm located in le developed/productive region and younger farm may benefit from a higher upport rate than other farm. The ize of the invetment upport i limited at farm level, regional level and EU level. For example, in England the imum rate of grant per beneficiary i EUR outide Le Favoured Area (LFA) and EUR within LFA. In Bavaria, Germany, the minimum grant eligible for thi upport i EUR while the imum grant i EUR. Other MS impoe imilar eligibility limit. In general, the policy objective i to increae the quantity or/and the quality of the farm capital, i.e. to create additionality effect. In term of our model thi implie that the policy objective i to increae the tock of capital relative to the capital tock ued by farmer at the prevailing market price of capital. We conider two cae in thi paper: perfect enforcement of the additionality and imperfect (no) enforcement of the additionality. We how that thee implementation detail importantly affect income ditribution effect of the invetment upport. Additionally, we how that the impact are affected by farm heterogeneity and farm exce to credit. In thi ection we analye the effect of invetment upport in the hort-run (the direct effect) by auming one repreentative farm and perfect credit market. In the next two ection we extend the analyi by taking in conideration farm heterogeneity, imperfect credit market and long-run (indirect) effect, repectively. Perfect enforcement of additionality and no eligibility limit In thi ection we aume that policy maker can perfectly enforce the additionality of invetment and we aume that there are no limit impoed on the ize of the eligible upport. In the next ection we will relax thee aumption. The perfect enforcement of the additionality implie that the policy maker are able to enforce a ituation where farm increae capital ue by the ize of the upported invetment relative to the capital ue at the prevailing market price of capital. In other word, not all farm capital benefit from farm invetment upport. The upport benefit only the additional farm capital. Let α denote the invetment upport rate of the EU RP programme. The upport rate α i repreented a the hare of the total value of the upported invetment (purchae cot of upported capital invetment). With the invetment upport and perfect enforcement of the additionally the farm profit function (1) change a follow: 8

9 (7) = pf ( A, o + ) ra ( i + δ ) R o [( R αr) i + δr] = pf ( A, o + ) ra k o ( k αri) where k = ( i + δ )R, o i the farm capital ue at prevailing market rental price of capital in the abence of the invetment upport, and i capital which benefit from the invetment upport. The value of upport per unit of capital i equal to the capital price multiplied by the upport rate ( α R ). Then the unit purchae cot of capital with the upport i equal to ( R αr). The invetment upport reduce capital purchae cot. Thi further implie that capital interet cot with the upport change to ( R αr) i = ( 1 α )ir. 11 Becaue we aume perfect enforcement the additionally only the farm capital in exce of o i eligible for the upport (i.e ) a repreented in the profit function (7). The farm capitol FOC change a follow: 1 (8) pf ( k αir) = pf ( 1 α ) Ri δr Equation (8) implie that the marginal interet cot of capital are reduced by the upport rate α. Hypothei 1: in the hort-run, with perfect enforcement of invetment additionality, with upport rate α, with no eligibility limit, and with perfect rural credit market (i) farm may gain or loe from invetment upport; (ii) total welfare decreae and (iii) the optimal level of upport uptake by farm depend on the upport rate. Following the capital market illutrated in Figure 1 we focu our graphical expoition on the quadrant I which how the relationhip between the upply and demand of capital ervice and (annual) the capital rental price. The equilibrium bundle of capital rental price and the quantity of capital without upport i (k, ) (Figure ). If the invetment additionality i perfectly enforced and if the total upport i not contrained then the equilibrium with the upport hift to (k 1, 1 ). The rental price of capital and the farm capital ue increae. The capital repreent the optimal (imum) amount of upported invetment which farm are willing to undertake in the equilibrium. Farm are willing to uptake the invetment upport up to the point where the upport rate i equal to the gap between the market rental price ( k 1 ) and the farm willingne to pay for capital ( k 3 ) given by the curve. In Figure thi i the cae at 1 where α ir1 = k1 k3. 13 Higher or lower uptake of the invetment upport will reduce farm gain. With the additionality perfectly enforced only part of the capital ( ) receive invetment upport while the ret of the capital equal to doe not receive the o 11 We conider the cae when the upport affect only the farm interet cot. Thi i conitent with the implementation of the RP invetment upport. The upport finance cot of purchae of capital. The depreciation cot (δr) are not eligible for the upport. 1 Note that land (A) in the hort-run i aumed to be fixed. 13 The imum (optimal) amount of upport which farm i willing to undertake i at the point where the curve interect the capital upply curve S. The curve repreent farm capital demand with the invetment upport. The curve i not parallel with the capital demand without the upport becaue the upport rate α i a hare parameter. 9

10 upport. The perfect enforcement of the additionally implie that only capital in exce of capital which farm would ue at the market prevailing rental price k 1 (i.e. 1 o = ) i eligible for the upport. Note that the equilibrium increae in capital i maller than the ize of the upported invetment. Thi i becaue a capital price increae, farm reduce the capital ue by o. In equilibrium, capital tock increae only by 1 (< ). In order to offet the price effect, the upported invetment mut be higher than the ize of the equilibrium capital increae, > 1. Area BC repreent farm loe due to capital price increae. Area CEFG i total rental cot of upported invetment. Area CEF i the farm gain from the upport received for. Finally, the area CFG i farm return from uing in production proce. Subtracting farm cot from farm gain, the total farm net gain from the invetment upport equal area F area B. Whether the farm gain or loe depend on the capital upply and demand elaticitie. If area F i larger than area B then the farm gain otherwie the farm loe from the invetment upport. 14 The capital upplier gain (area BC) becaue of higher capital price. The net welfare effect i a lo equal to area E. The area E i deadweight lo reulting from the miallocation of capital recoure. In Figure 3 we how the cae with perfect elatic capital upply S. Thi implie that farm ector cannot affect capital good price. The equilibrium without the upport in Figure 3 i (k, ) and with the upport i (k, ). Now the increae of capital i equal to the ize of the upport invetment =. Thi i becaue with perfect elatic capital upply, higher demand for capital doe not affect the capital rental price. Farm gain equal to area B. The capital upplier do not gain becaue the capital rental price doe not change. Total welfare decreae by area A. Perfect enforcement of additionality and eligibility limit In thi ection we till aume that policy maker can perfectly enforce the invetment additionality but now we add the eligibility limit. The eligibility limit implie that the upport ize a farm can receive i contrained by a lower and/or upper bound. We aume that the minimum and imum ize of the invetment eligible for the upport i min and, repectively. Thee eligibility limit imply that farm' upported invetment mut be larger than min but maller than, min < <. Hypothei : in the hort-run, with perfect enforcement of invetment additionality, with upport rate α, and with perfect rural credit market, minimum and imum eligibility threhold affect ditribution of policy rent and may deter farm from uptaking the upport. 14 Area F increae with farm capital demand elaticity and with capital upply elaticity. Area B decreae with capital upply elaticity and i not affected by farm capital demand elaticity. 10

11 To implify the figure and the analye we aume a perfect elatic capital upply. The effect i hown in Figure 4. The equilibrium without the upport i ( k, ). The eligibility limit determine farm upport uptake and the farm gain from the upport. Firt, we aume that the minimum and imum ize of invetment eligible for the upport i uch that min and, repectively, where i the equilibrium with no eligibility limit and with the upport a hown in Figure 3. With thee eligibility limit, the farm will not be contrained in term of the upport ize it wihe to uptake. The equilibrium with the upport hift to ( k, ) (Figure 4). Thi i the ame equilibrium a in the cae with no eligibility limit hown in Figure Farm' equilibrium upported invetment i equal to, where =. The equilibrium upported invetment i lower than the imum threhold and larger than the minimum threhold required, min < <. The equilibrium farm upport uptake i determined at the point where the upport level jut cover the gap between the market rental price of capital and the farm marginal return to capital (i.e. at where α ir = k k1 (ee hypothei 1)) and thi i not affected by the edibility limit. The farm gain from the upport in Figure 4 i equal to area BE (which i equal to area B in Figure 3 with no eligibility limit). Total welfare decreae by area A. The equilibrium ( k, ) will be affected by the eligibility limit only when the minimum eligibility threhold i larger than ( min > ) and/or when the imum threhold i maller than, < (Figure 4). For example, if the minimum threhold i min1 (where min1 > ), the farm mut invet minimum min1 in order to be eligible for the upport. With min1 farm profit change by area BE area G. If area BE i larger than the area G, the farm gain. If area BE i maller than area G, the farm loe and will not uptake the invetment upport. In the former cae the equilibrium with the upport hift to ( k, 4 ). In the latter cae the equilibrium with and without the invetment upport i the ame ( k, ) and farm will not uptake the upport. Conider the econd cae when the imum threhold i lower than <. For example, if the imum eligibility threhold i 1 equilibrium with the upport i ( k,, i.e. in Figure 4, the 3 ). Becaue of the eligibility contraint the farm cannot obtain more upport than 1, where 1 = 3 <. In thi cae the imum threhold 1 reduce the uptake of the upport and thu affect alo farm gain/loe from the upport. In Figure 4 the farm gain equal to area B which i le than the gain with no eligibility limit given by the area BE. Total welfare decreae by area A. Imperfect enforcement of additionality and no eligibility limit 15 The equilibrium ( k, ) in Figure 4 i the ame a in Figure 3. 11

12 In thi ection we conider a ituation when policy maker are not able to enforce invetment additionality. We alo aume that there are no eligibility limit. With the invetment upport and no enforcement of the additionally the farm profit function (1) change a follow: (9) = pf ( A, ) ra [( R αr) i + δr] = pf ( A, ) ra ( k αri) Now all capital benefit form the upport. The farm capitol FOC i given by equation (8). Hypothei 3: in the hort-run, with upport rate α, with no eligibility limit, with perfect rural credit market and if the invetment additionally i not enforced farm and capital upplier gain and total welfare decreae. Thi effect i hown in Figure 5. The equilibrium without the upport i (k, ). The equilibrium with the upport hift to (k, ). In equilibrium total upport uptake i equal to, where =. Similar to the cae of perfect enforcement of invetment additionality hown in Figure, the farm i willing to uptake the invetment upport up to the point where the upport level i equal to the gap between the equilibrium rental price of capital and the farm willingne to pay for capital. In Figure 5 thi i the cae at where α ir = k k3. However, farm receive upport for all capital in Figure 5 becaue we aume no enforcement of the additionality. Becaue policy maker are not able to enforce the additionality, farm ue all capital to claim the upport. The upport increae farm capital by. Now, farm gain from the upport. Farm gain equal to area HF. 16 Capital upplier gain area BC becaue of higher capital price. Total welfare lo i equal to area E. In Figure 6 we how the cae with perfect elatic capital upply S. The equilibrium without the upport i (k, ) and with the upport i (k, ). Total upport i equal to = and the capital ue increae by. Farm gain equal to area C. The capital upplier do not gain becaue the capital rental price i not affected by the upport. Total welfare decreae by area A. Imperfect enforcement of additionality and eligibility limit In thi ection we aume that policy maker cannot enforce the additionality and that there are limit impoed on the upport ize a farm can receive. Again we aume that the minimum and imum ize of the invetment eligible for the upport i min and, repectively. Hypothei 4: in the hort-run, with no enforcement of invetment additionality, with upport rate α, and with perfect rural credit market, minimum and imum eligibility threhold affect ditribution of policy rent and may deter farm from uptaking the invetment upport. 16 Thi i becaue with no enforcement of the invetment additionally higher farm capital cot induced by higher capital rental price (given by area B in Figure 5) are covered by the upport a now all capital i eligible for the upport. In the cae with full enforcement of the additionality, the farm did not receive upport for all capital. For example, in Figure the upport did not cover the farm capital cot given by area B which were induced by higher capital rental price (area B in Figure 5 i equal to area B in Figure ). 1

13 To implify the analyi we aume perfect elatic capital upply. The effect i hown in Figure 7. The equilibrium without the upport i ( k, ). Firt, we aume that the minimum and imum ize of invetment eligible for the upport i uch that min and, repectively, where i the equilibrium capital with the upport and with no eligibility limit (ee hypothei 3). Thee eligibility limit do not contrain farm in term of the ize upport it wihe to uptake. Thi implie that the equilibrium with the upport and with and without the eligibility limit i the ame at ( k, ) (Figure 7 and Figure 6). The farm ue invetment upport equal to, where =. The farm gain from the upport equal area CBE. Total welfare effect i a lo equal to area A (Figure 7). The equilibrium ( k, ) will be affected in all cae when the minimum eligibility threhold i larger than (if min > ) and/or when the imum threhold i maller than (if < ) (Figure 7). For example, if the minimum threhold i min1 (where min1 > ), the farm mut invet minimum min1 in order to be eligible for the upport. With min1 the farm profit change by area CBE area G. If area CBE i larger than area G, the farm gain. However, if area CBE i maller than area G, the farm loe and will not uptake the upport. In the former cae the equilibrium with the upport hift to ( k, 4 ). In the latter cae the farm will not uptake the invetment and the equilibrium with and without the upport i the ame ( k, ). The imum threhold affect the equilibrium ( k, ) if < (Figure 7). We ditinguih two cae: 1) < < and ) <. In the firt cae when < < the invetment upport will till ditort the capital market and the equilibrium capital ue will be between and depending on the ize of. Farm will be able to uptake le upport than deired and thu farm policy gain will be reduced relative to farm gain with no eligibility limit hown in Figure 6. In the econd cae when < the farm take the deciion on either to increae capital or to keep capital unchanged relative to the equilibrium capital without no upport. The farm will weight benefit of both option. If the benefit from keeping capital unchanged are larger than the benefit from the capital increae, the farm will chooe not to increae capital. Hypothei 5: in the hort-run, with no enforcement of invetment additionality, with upport rate α, with perfect rural credit market, and if < farm do not increae capital ue and benefit all invetment upport. We how the effect in Figure 8. The equilibrium without the upport i ( k, ). We aume that imum eligibility threhold i, where <. 17 The farm cannot obtain more upport than. 17 Thi implie that min <. 13

14 In the cae when the farm keep capital unchanged at and receive upport it gain i equal to area. Farm ue capital 3 to claim the upport, where 3 =. However, if farm increae it capital ue by the ize of the imum eligibility threhold, the equilibrium hift to ( k, 3 ). In thi cae farm gain i equal to area B. Becaue area i larger than area B, the farm' optimal deciion i not to increae capital. Hence, the equilibrium with and without the upport i ( k, ) and all the upport (area ) benefit farm. The upport doe not create ditortion in the capital market. The intuition behind thi reult i that with perfect credit market farm can exploit all profitable invetment opportunitie even without the upport. Perfect credit market allow farm to finance all invetment deired. Providing invetment upport to farmer doe not alter invetment opportunitie available to farm. Farm optimal behaviour i to ue the ame quantity of capital with and without the upport. We how in the ection ixth that thi will change if farm are credit contrained. The impact of farm EU invetment upport with heterogeneou farm and eligibility limit In thi ection we extend the analye by taking in conideration farm heterogeneity. The impact of the invetment upport may be affected by farm heterogeneity in the cae when the eligibility limit are impoed. Under certain condition, the eligibility limit may either deter mall farm from uptaking the upport or it may contraint big farm in uptaking the deired level of the upport. Farm ize varie ignificantly acro EU. In old EU Member State farm ize varie from mall ize to medium ize while in the New Member State the farm ize varie from ubitence farm (1-6 ha) to large farm (up to 1000 ha). In thi context, depending on the ize of eligibility limit, the impact farm invetment upport may differ trongly among EU Member State. To analye the effect of farm invetment upport with heterogeneou farm, we aume two repreentative farm, farm 1 and farm, repectively. We alo aume that the minimum and the imum ize of the invetment eligible for the upport i min and, repectively. The effect i hown in Figure 9 where 1 and repreent capital demand of farm 1 and farm, repectively. repreent aggregate capital demand. 18 A before S repreent capital upply. For implicity we aume perfect elatic capital upply. 19 The equilibrium without the upport i ( k, 10 ) and ( k, 0 ), for farm 1 and farm, repectively. 0 For the aggregate market, the equilibrium without the upport i ( k, ). Hypothei 6: in the hort-run, with upport rate α, with perfect rural credit market, and with heterogeneou farm, whether farm uptake upport or not and whether farm benefit 18 The aggregate capital demand i obtained by horizontal aggregation of farm 1 and farm capital demand. 19 The effect with inelatic capital upply can be obtained analogouly. 0 In term of capital ue Farm 1 i maller than Farm, <

15 from the upport on depend on the ize of minimum/imum eligibility threhold and on the enforcement of invetment additionality. We analye the cae when invetment additionality i fully enforced. 1 The eligibility limit may affect farm differently depending to what extent farm are heterogeneou and on the ize of the eligibility limit. The minimum eligibility threhold may deter ome (mall) farm (i.e. farm 1) from uptaking the upport if it i et to high. On the other hand, the imum threhold may contraint ome (big) farm (i.e. farm ) in uptaking the deired level of the upport if it i et to low. For example, conider the minimum eligibility threhold min uch that min < 1 0 and min > where 11 and 1 are farm 1 and farm equilibrium capital ue with the upport but without the edibility limit, repectively (Hypothei 1). Without the edibility limit the optimal upport uptake of farm 1 i maller than the optimal upport uptake of farm, < The eligibility limit min doe not affect farm invetment upport uptake. With the invetment upport and with and without the eligibility limit, farm equilibrium i ( k, 1 ). Farm gain equal to area B (Figure 9). However, the eligibility limit min ha different impact on farm 1. The difference between farm 1 and farm i that the marginal productivity of capital decreae fater with capital for farm 1 than for farm. The optimal level of upport which farm 1 would be willing to undertake i if the eligibility limit i not impoed. However, the minimum threhold i larger than 11 10, min > Farm 1 mut invet minimum min in order to be eligible for the upport. The effect of uptaking the upport for capital min on farm 1 profit i given by area B 1 area E 1. If the area B 1 i larger than the area E 1, farm 1 gain from the upport. Otherwie farm 1 loe. In Figure 9 we aume that the area B 1 i maller than the area E 1, 3 implying that farm 1 would loe from the upport and thu will not apply for the upport. The minimum threhold i et too high for farm 1 and make the upport uptake unprofitable. Hence, the farm 1 equilibrium with and without the upport i ( k, ). 10 Now we look at the impact of the upport on the aggregate market. If reading Figure 9 from the left hand ide to the right hand ide, the aggregate capital demand hift from (which i the aggregate demand without the upport) to (which i the aggregate demand with the upport). For aggregate capital ue larger than, the lope of the aggregate capital demand with the upport i determined only by farm capital demand. The equilibrium capital ue of farm 1 will tay fixed at 10. Thi i becaue farm 1 doe not apply for invetment upport and it doe not increae it capital beyond. The aggregate market equilibrium hift from 10 1 Similar analyi can be conducted for the cae when the invetment additionality i not enforced. For well behaved production function thi implie that farm 1 i maller than farm. 3 We acknowledge that viually thi i not the cae. 15

16 ( k, ) to ( k, ). The aggregate capital increae. The capital increae i equal to the farm capital increae, = =. 1 0 The imum eligibility threhold affect farm invetment uptake if it i et too low. For example, if < 1 0 and > 11 10, then the imum eligibility threhold will contraint farm in obtaining the deired level of upport. The farm optimal level of upport uptake i 1 0 but it can obtain upport only for capital. Farm 1 i not affected by (Figure 9). Similar analyi can be conducted for the cae when the invetment additionality i not enforced. The minimum eligibility threhold may deter ome (mall) farm from uptaking the upport while the imum threhold may contraint ome (big) farm in uptaking the deired level the upport. For example, conider the minimum eligibility threhold d min1 in Figure 9 uch that min1 > 11 and d min1 < 0. In thi cae farm 1 gain equal to area F B 1 1 area E 1. If the area F B i larger than the area 1 1 E 1 farm 1 gain. However, if the revere hold, farm 1 loe implying that the farm will chooe not to uptake the upport. In the former cae the equilibrium with the upport hift to ( k, 1 ). In the latter cae the farm will not uptake the invetment and the equilibrium with and without the upport i the ame ( k, ). 10 The impact of EU farm invetment upport with imperfect rural credit market With the preence of rural credit market imperfection, invetment upport can have an important impact on farm behaviour and hence on farm income. Acce to rural credit i particularly the problem in new MS (e.g. Curti et al. 007; Latruffe 005; Petrick 004; World Bank 001). However, there i evidence that farm in developed economie are alo credit contrained (e.g. Benjamin and Phimiter 00; Blancard et al. 006; Färe, Grokopf, and Lee 1990). 4 We follow the approach of Mihra, Mo and Erickon (008) and Ciaian and Swinnen (009) to introduce farm credit contraint in the model. We analyze the impact of farm invetment upport with imperfect rural credit market in the hort-run. It i aumed that the imum amount of credit that the farm can borrow ( L c ) depend on farm characteritic (W ) uch a reputation and aet, i.e. Lc = Lc ( W ). With credit contraint the loan equation (4) change a follow: 5 (10) R L (W ) c 4 There i vat theoretical and empirical literature on imperfection in rural credit market, including the eminal work of Stiglitz and Wei (1981). 5 Thi modeling of credit contraint implie that farm total capital ue i contrained. The ize of the contraint depend on variou factor uch a the ability to obtain credit from a bank which depend on the ize of collateral, own aving, the ability to obtain credit through informal market, etc. 16

17 In the hort-run with a credit contraint the deciion-making problem of the farm i the imization of the profit function Π = pf ( A, ) ra k, for a given land A, and ubject to the credit contraint (10), a repreented by the LaGrangean function: (11) Ψ = pf ( A, ) ra k λ( R ) where λ i the hadow price of the credit contraint. L c When the credit contraint i binding farm cannot ue the uncontrained optimal level of capital and capital ue i determined by = Lc ( W ) R. The farm optimal condition with binding credit contraint ( λ > 0 ) are given by: (1) pf k λ R = 0 (13) R L = 0. c From equation (1) it follow that the farm marginal value product of capital i higher than the marginal cot of capital k: pf > k. By increaing capital ue the farm could increae it profit but it cannot ue more capital becaue of the credit contraint. The effect i illutrated in Figure 10. We ue the complete capital model a hown in Figure 1 but with added credit contraint. The farm credit uncontrained loan ize i given by the curve L L in quadrant II in Figure 10. With credit contraint the farm loan curve hift to L L c. Up to loan ize L c (and capital ue c ) farm i not credit contrained. At low level of capital ue the credit contraint i not binding, and the contrained loan curve L L c coincide with the uncontrained curve L L. 6 The L c repreent the imum loan which farm can obtain which implie vertical farm loan curve L c at L c in quadrant II. The credit contraint implie that the farm demand of capital ervice hift from to c in quadrant I. Thi correpond to a hift in the farm demand of capital good from to c in quadrant IV. The equilibrium without the credit contraint i (k, L, R, ). The equilibrium with the credit contraint hift to (k c, L c, R c, c ). With credit contraint farm ue le capital ( c < ). The impact of the farm invetment upport When farm are granted invetment upport an important iue i how the upport affect farm acce to credit. One may expect an improvement of farm acce to credit a the upport reduce rik aociated with the repayment of the loan. However, the ize of the increae in the credit depend on variou farm characteritic and market condition. With the upport the farm credit contraint change a follow: (14) R Lc ( W ) + βr 6 The hape of the farm loan curve with the credit contraint L c L depend on the elaticity of farm demand of capital ervice. 17

18 where i total upported invetment, and β meaure the extent to which the upport affect farm acce to credit. If β = 1 then farm acce to credit increae by the value of the total upported invetment. In the cae 0 β 1 farm' credit increae by le than the ize of total upported invetment. Hypothei 7: in the hort-run, with upport rate α, and with imperfect rural credit market, (i) farm will have incentive to increae capital tock even without the enforcement of additionally, (ii) farm may gain or loe, and (iii) total welfare may increae. Next we conider two cae: (i) when the farm acce to credit increae by the ize of the upported invetment ( β = 1) and (ii) when the acce to credit increae by le than the ize of the upported invetment ( 0 < β < 1). We aume that total upported invetment i. Further we aume that = min =. We illutrate the effect in Figure 11. Again we focu only on the quadrant I of Figure 10. For implicity we aume perfectly elatic capital upply. Note, that with credit contraint farm have alway incentive to increae capital ue. Thi i becaue at the equilibrium with credit contraint (k c, c ), farm marginal willingne to pay for additional capital ( k 1 ) i larger than the rental cot of capital, k 1 > k. Thi implie that it i profitable for farm to increae capital if acce to credit increae. Moreover, the upport marginally increae profitability by α ir c. With the upport farm marginal benefit from the additional capital i equal to k1 k + αirc. Hence farm ha incentive to increae capital if the upport improve farm acce to credit. In the hypothei 1 and 5 where it wa aumed perfect credit market, it wa hown that if the total invetment upport i not ignificant, farm' optimal deciion wa not to increae capital ue. Farm increaed capital only when the additionality wa enforced. The intuition i that with perfect credit market farm were able to exploit all profitable opportunitie even without the upport. With imperfect credit market, unexploited profitable invetment opportunitie are available. Farm would like to ue thee opportunitie but they cannot becaue of credit contraint. The upport give farm the poibility to invet in thee invetment opportunitie. Thi will be the cae only when the upport alleviate farm acce to credit. Firt, we analye the effect when the farm acce to credit increae by the ize of the upported invetment ( β = 1). We illutrate the cae with the perfect elatic capital upply. The effect with imperfect elatic capital upply can be howed analogouly. If the total invetment upport i equal to and the farm acce to credit increae by the ame amount, the equilibrium in Figure 11 hift to (k, c ). The farm gain from the invetment upport equal to area B (Figure 11). Area B i productivity gain and area i policy gain. 7 Now total welfare effect i poitive and equal area B. Total welfare increae becaue the invetment upport olve the credit market imperfection and thereby increae farm productivity. Second, we analye the effect when the farm acce to credit increae by le than the ize of the upported invetment ( 0 < β < 1). The effect i illutrated in Figure 1. If the total upported invetment i equal to, then the equilibrium hift to (k, c4 ). Now the capital 7 Note that with imperfectly elatic capital upply, capital upplier will gain from the upport and farm may loe or gain becaue of rental price of capital increae. 18