EU Financing and Regional Policy: Vertical Fiscal Externalities when Capital is Mobile

This paper considers the EU regional policy and analyzes two kinds of externalities that can explain why matching grants are used to subsidize regional infrastructure: horizontal pecuniary externalities via capital markets, and positive vertical fiscal externalities created by the financing of the EU budget. Matching grants should correct for both externalities. As an extension the paper considers possible alternatives of the EU financing system and malevolent governments. While a tax on the GDP of the member states would increase the vertical fiscal externality, governments that misuse funds decrease it. However, calculations of the size of externalities show that matching grant rates needed for internalization are quite low.