Dealing with the Second Wave: Subsidies, Instead of Ordering Closures

Yves here. We’ve banged on about the need for income replacement if/when governments need to restrict activities to combat Covid. And Congress is still unable to agree on what the next round of stimulus should look like. Subsidies would certainly be an easier pill to swallow than yet more lockdowns and mandatory closures and would help more firms make it though the crisis. But it’s not clear the US would do something so sensible, or have the capacity to monitor compliance.

By Daniel Gros, Director of the Centre for European Policy Studies, Brussels. Originally published at VoxEU

In the autumn of 2020, many European governments are imposing ‘lockdowns light’, which usually contain limitations on the operations of restaurants, bars, and some shops considered non-essential. This column argues that pandemic control cannot be limited to lockdowns. Activities like providing restaurant meals or retailing increase the risk of infection and thus involve a large difference between private and social cost. The efficient solution to this problem would be incentives for shop and restaurant closures, rather than mandated lockdowns.

In the autumn of 2020, many European governments are imposing ‘lockdowns light’, which usually contain limitations on the operations of restaurants, bars, and some shops considered non-essential.  The assumption behind these (often partial) closures is that the risk of infections is high wherever people mingle in closed spaces.¹

The mandated closures have led to strong popular protests (especially in France and Italy) because they threaten the livelihood of many small individual shop or restaurant owners.  These two sectors are already under pressure from e-commerce.  There are thus many marginal operators who feel that they cannot survive this second lockdown, even if only light.  Governments have of course been trying to provide help and compensation for lost income. But in many cases, this compensation has been late and partial, and it has proven difficult to target it at the most (economically) vulnerable.

Governments have instinctively reacted with mandated closures, but this step might not be needed if one considers the alternative of taxes or subsidies.  Taxes or subsidies have so far played no role in the so-called non-pharmaceutical interventions (NPIs), although they could achieve the same target in terms of social distancing.

In concrete terms, this could mean the following. The government could announce a subsidy to any store or restaurant owner willing to close their establishment for a certain time (e.g. 1-3 months).  A longer period of closure would be better because it would help keeping infections low for the rest of the winter.

One needs to avoid the problem of remaining stores becoming more crowded once a large proportion close. Overcrowding was already regulated prior to the new second wave restrictions as customers were asked to keep a minimum distance apart.  This type or regulation should be maintained in the simplest form possible: no more than a certain number of customers on the premises per square metre.

The government could thus start with a subsidy offer which could be specified in terms of a lump sum per square metre, paid up front to the owner of any retail establishment willing to close (for in-store shopping or dining) for a number of months.  Take-away and internet sales would still be permitted.  Each individual operator will then calculate herself the opportunities from other sales channels. For those least able to adapt, accepting the subsidy might be the best option.

In principle, it would be preferable to conduct a reverse auction under which retailers could submit the price at which they would be willing to close.  Successive rounds could then be held until the desired reduction in retail space supply has been reached. However, there might simply not be enough time to organise this now.

Applying the Lessons of Pigou and Coase

Climate change provides another example of a discrepancy between social and private interests. It has been widely recognised that a ‘Pigouvian’ tax on emissions can achieve the desired outcome more efficiently than direct regulation of polluting activities (Nordhaus 2018).  This lesson should also be applied for pandemic control.

In the case of climate change, it is widely agreed that a tax on emissions is more appropriate than a subsidy for not emitting.  In the case of pandemic control, the choice is not so clear.

Coase (1960) argues that provided transaction costs can be neglected, the efficient solution to a problem involving a difference between social and private cost should be independent of the allocation of property rights. In pandemic control, the interests of society are represented by the government, which keeps transaction costs low. The key question, then, is whether the right to keep a store open is held by the owner or whether it belongs to society.  The fact that governments provide compensation indicates that they recognise that the right to stay open should belong to the owner. It follows that a subsidy for closure would be more appropriate than a tax on restaurants.²

Political Advantages of a Closure Subsidy

In more practical terms, a closure subsidy offers a number of advantages.  It would constitute a way to provide income compensation to the most marginal businesses at a reasonable fiscal cost, while still reducing social interactions in stores and restaurants.  The subsidy for closure (of in-store activity) should be especially attractive for marginal shops or restaurants (the ones which have most reason to protest).  The subsidy would also obviate the need to make arbitrary distinctions between essential and non-essential goods.

Another, more longer-term advantage of this approach is that it would encourage small shop owners to switch to modern techniques (or quit the market).  The resistance to structural change which is so strong in this sector might then be overcome.

The remainder of column discusses some practical issues that arise in the implementation of the approach proposed here.

Practical Issues

Example 1: Restaurants

Meeting for a meal in a restaurant is widely assumed to favour infections.  Theoretically the appropriate policy action would be to reduce supply by taxing restaurants or restaurant meals (for example, by increasing VAT on restaurants).  However, this has not been politically feasible because, as argued above, the right to stay open belongs to the restaurant owner.

In Germany, the government has ordered restaurants to close for the month of November, offering them as compensation a grant equivalent to 75% of their turnover for November of the previous year.  This ‘closure’ does not affect take-aways or delivery, which remain possible.  This means that for some restaurants, turnover might actually not be that much affected by this ‘closure’ and profits might actually increase.  Other countries have followed a different approach, promising only to reimburse some ‘normal’ profit from the past.

One month is unlikely to suffice to ‘break the wave’, but it would become quite expensive to prolong the present compensation payments for much longer.  A change in approach is thus required.  One way to permit a partial lifting of the closure while keeping the fiscal and social cost under control would be to offer a subsidy for temporary closure under which the government pays restaurants a certain lump sum per square metre of indoor space (and per month) if they close.

The subsidy per month could be lower the longer the closure time. The reason for paying a lower proportion of turnover for longer closures would be that with more time to prepare, the variable costs should be higher and many marginal establishments might take this offer. Longer periods of closure (say, 3-6 months) would be preferable as it is now clear that the virus is so widely distributed that it will take months to get it back under control.

The fiscal cost of such a measure should be bearable. The restaurant sector (restaurants, bars and caterers) account for only 1% of GDP, and only about 12% of the total costs in the restaurant sector consist of rent or the cost of premises, with over 60% going to inputs and labour costs.  Even a modest subsidy should thus make it attractive for many restaurant or bar owners to close.

The same procedure could be applied to other activities for which it is desirable to reduce supply, like hotels, travel agencies, hair cutters as well as any other places with a high infection risk.

It is, of course, possible that the longer periods of closure are not needed, for example because an effective vaccine becomes available sooner than expected today.  But the government is better placed than individuals to take this risk and uncertainty justifies prudence (Eeckhoudt and Gollier 2005).

Example 2: Retail trade

Retail trade represents a particular problem at this juncture because, traditionally, a large proportion of total sales and revenues are made towards the end of the year.

Retail trade is a much bigger sector than food (and accommodation), accounting for 8-9% of employment, but only 3.5-4% of GDP.  In this respect, the differences across EU member states are small.  However, there are large differences across member states in the structure of the sector.  For example, in Italy microenterprises (fewer than ten employees) account for over 63% of total employment in the sector, versus only 25% in Germany. Small shops account thus for over 5% of total employment in Italy, versus about 2% in Germany.  In France this ratio is about 3%.  This might explain why the opposition to the new lockdowns has been so strong and widespread in France and Italy.

The other extreme, namely, large enterprises, are also important in this sector, usually accounting for about a third of total employment (and a higher proportion of value added).  The retail sector is thus characterised by a prevalence of both very small and large establishments, with many of the very small ones in a marginal position.  These marginal operators are the ones most prone to protest, but also the ones which would benefit most from a subsidy for closure, which might in many cases be permanent – thus accelerating the structural change which is unavoidable in the long run.

As for restaurants, the ‘closure’ would concern only in-store sales.  Web sales and ‘click and carry’ would still be permitted.  This should reduce the cost of ‘closure’ even for shops with some inventory, but only if they try new channels of distribution.

Speed of action seems crucial now since many retailers must be close to ordering their wares for the Christmas/end-of-year season.  Once they have placed these orders, it will difficult to keep shops closed (or expensive to induce them to close).

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See original post for references