Subsidiarity may be the most abstract concept in the European political vocabulary: it is certainly the most contentious. The fourth issue of the annual CEPR Report, Monitoring European Integration, draws out its economic implications and applies it to specific policy issues.

Subsidiarity is ultimately about the distribution of power. The lack of coherence in existing principles to govern this distribution is disturbing, because the Single European Act of 1986, with its qualified majority voting, already represents a decisive step towards federation. `Competences' belong to the member states but can be delegated to the Community. In contrast with most federal states, however, there is no formal mechanism to allocate competences within the Community (except those in the Treaty of Rome). Unfortunately the Maastricht treaty did not define subsidiarity precisely enough, so it remains a general political principle rather than explicit guidelines. If its application is not specified by the member states, the European Court of Justice will have to implement it, but this is essentially a political task, beyond the capacity of the Court.

The CEPR Report therefore spells out principles that can apply subsidiarity to specific economic policy issues. Economic theory suggests that coordinating policies yields benefits when scale economies or spillovers between member states are important. This coordination may sometimes be achieved by collective agreement on rules which are then implemented at national level. Centralization of powers at the EC level is essential only when coordination is desirable but such decentralized implementation is not credible.

Centralization also has costs. With less accountability, centralized policies diverge from local preferences. The appropriate location of power therefore reflects a trade-off between the costs and benefits of centralization. By laying the burden of proof on those wishing to centralize, subsidiarity recognises national sovereignty and emphasizes problems of accountability and of `government failure' at the centre.

Has the Community applied the subsidiarity principle properly? The Report gives a mixed verdict. In the area of merger policy, the Community has acted correctly by basing centralization on the extent of the spillovers between member states (see the following article by Neven and Seabright).

But the subsidiarity criterion gives a less favourable assessment of some European environmental policies. The regulation of drinking water standards is contentious - rightly so, says the Report. States may try to attract mobile factors of production by lowering environmental standards, but governments cannot possibly relax drinking water standards for mobile factors without relaxing them for all factors. Any government wishing to attract mobile factors would be crazy to do so by allowing its drinking water be polluted. This kind of environmental dumping is not a serious threat. Subsidiarity, correctly applied, suggests that the Community scrap its regulation of drinking water.

Should social policy and labour market regulation be a national or a Community responsibility? There are perfectly valid reasons, the Report says, to regulate contracts between workers and employers. It may be difficult, for example, for a worker to evaluate the health and safety risks entailed by a proposed job. In case of accident or illness, national health care systems, not employers or workers, bear the full cost of treatment. This externality encourages firms to provide lower safety standards than is socially efficient. Thus there is a case for government intervention, but at the national, not the European level. When labour markets function properly there are no cross-border spillovers which would prevent individual member states from making appropriate regulatory decisions in accord with their national preferences.

In the presence of labour market imperfections, there may be cross-border spillovers - `social dumping'. Governments may try to lure mobile capital by lowering health and safety standards, for example. The Report concedes that social dumping may occur but argues that it is unlikely to be significant. Governments have little incentive for such competitive deregulation. Capital is already highly mobile and confers little social profit on a country seeking to entice it: the public goods that mobile capital can successfully extract are almost as expensive as the tax revenues it provides.

Market integration within the EC has already eroded the fiscal sovereignty of individual member states. Enhanced mobility of capital and labour leads to `fiscal competition' among member states, which attempt to lure mobile factors (such as capital) through lower tax rates and looser regulation.

Fiscal competition threatens the welfare state. Mobile factors flee taxation and regulation. Government must contract as the tax base falls. Redistribution is more difficult as well, because some mobile factors no longer pay high taxes. And each member state, by neglecting the effects of its actions on other member states, may drive tax rates and the provision of public goods and the level of regulation below the levels that best reflect the wishes of EC citizens as a whole.

Here centralization could help. If factors are mobile within the EC but not across its external borders, fiscal and regulatory competition would not affect the EC as a whole. The choice may therefore lie between a decentralized Community with much less extensive national welfare states and a centralized Community that can preserve the welfare state at its present levels of provision.

The Report argues that the choice is not yet so stark. Evidence that labour mobility is limited not only within the EC but even in countries such as Switzerland suggests that European labour is likely to remain less than perfectly mobile, so broadly based taxes on workers' income and spending can continue to finance national governments. Second, because capital mobility within the EC is already high, corporate tax rates have already fallen substantially, so there is not much more revenue to lose from this source. Thus the national welfare state can survive - for now.

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