Here at CGD we have researchers working on the question of how public money can be used to stimulate more private investment and researchers worrying about public money being wasted when doing so. And that’s exactly right! When investing public money in private enterprises, we confront a problem with two faces as we do not want to miss out on opportunities to buy benefits for society, but we also do not want to spend scarce resources needlessly. Waste is all the more painful when the money is coming from a pot—foreign aid—that exists to assist the poor.
To slip into economese, we want two conditions to be satisfied: social returns to investment that exceed private returns, and private returns that are below private investors’ hurdle rates. The risk of spending scarce resources needlessly arises because the expected returns of an investment—and private investors’ hurdle rates—are private information. Outsiders cannot observe them, and if subsidies are on offer, businesses and investors will want them even if they do not need them. We may even suspect politicians and development banks—who like to report apparent successes—of playing along. To make matters worse, it’s terrifically difficult to figure out afterwards whether public support made a difference.
Development finance institutions and the multilateral development banks have signed up to principles that include subsidy minimisation— their objective is to offer only what’s needed and no more. Today we mostly rely on these being mission-orientated institutions that are making decisions in good faith, doing what they can to assure themselves that their money is needed.
However, there are alternatives. One is to use competitive processes to minimise subsidies—an auction. But that works best when using public funds to buy something from many potential suppliers; it’s less easily applicable when trying to minimise the subsidy—or maximise the cost of capital—for a given project or entrepreneur. Another possibility is to reconcile oneself to the inevitability that subsidies will occasionally be redundant, and move in the direction of maximising transparency and simplicity by offering pre-specified subsidies to all comers, for pre-specified actions. If the total benefits exceed the total costs, after accounting for some redundancy, that could be the better option.
But the economics of mechanism design offers the tantalising prospect of another option: clever contract design that prompts those who genuinely need a subsidy to sort themselves from those who don’t. We’ve been seeking a solution like that for some years, and now we think that we might have found it. It comes in the form of contract that the economists Saul Lach, Zvika Neeman, and Mark Schankerman originally designed to be used in government support for R&D. In our CGD note The Subsidy Sorting Hat, we explain how the idea works and discuss some of the challenges in turning idea into reality. The contract would require an innovative investment instrument—something like an equity investment in which the distribution of returns between the public and private participants responds to the success of the project. The goal is to lower barriers to entry—to attract as many socially beneficial investments as possible—whilst also capping private returns, so that if the entrepreneur does not really need the subsidy, they will go elsewhere.
So much for theory. But will it work in practice? That’s where we need your help. We want to speak to professionals with experience of structuring investments, and who also know the incentives and the constraints that people face that might not have entered the theoretical treatment. We need you to explore with us whether this idea could work. And if it could, what a prize! We could spend scarce public funds with confidence that if the subsidy wasn’t necessary it wouldn’t be taken. Please do get in touch with your thoughts.