EU Science Hub

Clampdown on delayed government payments provides tangible boost to EU economy

Deferred payments can sometimes enhance efficiency in markets.
Deferred payments can sometimes enhance efficiency in markets.
Jul 08 2020

Regulating late payments from governments to their suppliers in the aftermath of the 2008 financial crisis and the subsequent recession slashed bankruptcies, lifted employment levels and advanced innovation in the EU.

This is the finding of a recently published study by researchers from the JRC, the University of Genoa, and the Marche Polytechnic University.

They looked at the impact of the EU’s 2011 Late Payment Directive, which - amongst other provisions - narrowed the payment window to thirty days in business relations between public bodies and their suppliers.

The additional rigour proved to be beneficial. As a result of the directive, the rate of firms going bust declined faster in sectors providing products and services for governments than those relying less on public purchases.

For instance, the authors of the study observed the rate of companies going out of business to be 0.32 percentage points lower in Ireland’s printing industry, which is more reliant on government orders, than in the French machinery sector, where business-to-business interactions are more common.

Since an average of 8 % of the companies go under overall, this is a significant difference.

Furthermore, employment grew by 0.7 percentage points faster in branches dealing more with the public sector, in comparison to those where transactions between private entities predominate.

Investment increased as well, by about 0.17 percentage points, though this effect is not robust enough.

Such dividends can be maximised in the coronavirus-induced economic downturn. By smoothening cash flows and curbing volatility, prompt payment and repayment of arrears  will contribute to stemming the tide of firms having to fold because of overdue payments.  

Government payments: better now than never

Deferred payments can sometimes enhance efficiency in markets. Trade credit is widespread, since suppliers know their business partners better than credit institutes and can offer more advantageous conditions.

By helping their customers to grow with credits, suppliers can lock in market share for both themselves and their partners.

However, when payment deferral is unwanted, it can be ruinous, literally. Firms whose bills are not settled in time are often forced to lay off personnel, to hold back capital spending, to delay investments, to refrain from scaling-up, and, eventually, to shut down.

These effects are more damaging for SMEs (small and medium-sized enterprises), as they do not have the same access to finance that larger enterprises, and have to instead  rely on constant streams of cash flow to survive.

A culture of late payments shows through in macroeconomic data as well, as profits and economic growth are curtailed.

Prior to 2010, suppliers in Southern European countries were kept waiting for an average of 5-6 months before public authorities paid them.

The EU’s Late Payment Directive was adopted against this backdrop in 2011. It mandated that public bodies must pay their suppliers within thirty days.

Otherwise, they are liable for interest rates at least 8 percentage points higher than the European Central Bank’s reference rate.

Rules for business-to-business transactions were kept laxer, permitting a period of double length before sanctions kicked in.

This difference enabled the researchers to treat economic sectors dominated by such interactions as a "control group", enabling comparisons as if they conducted a study with experimental design.

As the graph below shows, the more an economic sector depended on business with public authorities, the fewer bankruptcies it suffered since the directive was implemented, relative to branches relying less on public deals.

Comparing bankruptcy rates in the Spanish wholesale trade sector, in which transactions with the government don’t even make up 1 per cent of the total, to those in Romanian warehousing, which with 9.6 % lies at the far end of the spectrum, results in a difference of 0.7 percentage points.

Such a reduction in exit rates sent a ripple effect through economies, reducing unemployment and sustaining economic growth. Faster payments by public administrations is the fastest and most effective form of injecting much-needed liquidity to firms to tackle the downside of this lockdown.

Researchers now hope that the lessons learnt from the implementation of the Late Payment Directive can unfold a similar spillover effect and lessen the impact of the coronavirus on businesses.

Making prompt payments to businesses must become the norm and should be at the top of the policymakers agenda to promote the development of a fairer economy.