Direct payments were introduced during the CAP reform of 1992, allowing a transition from the earlier production-oriented CAP toward policies intended to promote rural restructuring and the positive externalities that can result from farm-related activities. Direct payments introduced in 1992, as farm income support instruments, were subsidies per hectare of crops or per head of animal. Current direct payments, which are partially decoupled from production and based largely on historical levels of farm support, have been criticized for perpetuating inequalities and inefficiencies. Since the 1992 CAP reform, the EU has strived to place limits on direct payments by only partially compensating for the lowering of guaranteed prices, by capping the total amount of animal subsidies a farm can receive, or by simply enforcing an across-the-board reduction in direct payments. Also, until 2013, first-pillar spending cannot increase above budgetary ceilings established in 2002.

Under Agenda 2000, the Commission and Member States agreed to a modulation scheme as a means to shift up to 20% of direct payments to rural development programs. The scheme was voluntary, and only the United Kingdom and France took advantage of this provision. France opted to tailor payments to the individual situation of each farm, based on the amount of subsidies it received, the extent of on-farm labour it employed, and the prosperity of the farm. However, the French experiment in voluntary modulation was suspended in 2002 because roughly three quarters of the money collected over the two years had not been spent.
 
In June 2002, the Commission set out a proposal that would have progressively reduced all direct payments, in favour of rural development schemes, in arithmetic steps of 3% per year, up to a total of 20% over seven years. However, the first € 5,000 received by each beneficiary - or more, depending on how many workers a farm employs - would have been exempted from modulation. In addition, direct payments would have been capped at € 300,000 per farm. (Some 60% of the farms that would have been affected by this cap are located in Germany, and most of the rest in the United Kingdom, Italy and Spain.)
 
In January 2003 the Commission suggested dropping the concept of capping, and instead recommended a dynamic and differentiated modulation scheme. By the end of a seven-year implementation period, farms receiving between € 5,001 and € 50,000 would have seen a reduction in their annual payments of 12.5%, and farms receiving more than € 50,001 would have seen a reduction of 19%.
 
Under the CAP reform that was adopted in June 2003, all direct payments (except the first € 5,000 received by each farmer) were reduced by 3% in 2005 and 4% in 2006, and will be reduced by 5% from 2007 to 2012 in EU-15 countries. Modulation will apply to new Member States once they reach the same payment level as the EU-15, i.e. in 2013 (2016 in the case of Bulgaria and Romania).

The implementation of this compulsory modulation rate undeniably marked a reorientation of CAP spending from the first to the second pillar. However, under the 2007-2013 budget, the CAP's second pillar has been fixed far below the Commission's initial request: roughly three quarters of the CAP budget is still allocated to the first pillar. Accordingly, the "health check" is likely to be regarded as an opportunity to increase the compulsory rate of modulation. It is expected that the Commission could recommend an increase in the modulation rate of 2%, on top of the current 5%. Under this scenario, there would be no ceiling on direct payments to farms, but farms receiving more than € 100,000, € 200,000 and € 300,000 would be subject to higher rates of modulation - respectively, 10%, 25% and 45%.
 
The financial impact of such a scheme would be limited, however, and the process perverse. By discriminating against the main beneficiaries of direct payments, it would respond to criticisms that the CAP has benefited the largest farms. But there would be threshold effects hardly justifiable by policymakers. For example, two neighbours currently receiving annual payments of, say, € 190,000 and € 210,000 would see their payments reduced to, respectively, € 171,000 and € 157,500 - i.e., the formerly higher-paid farmer would, following modulation, receive less than the previously lower-paid farmer. Farms likely change their legal structure in order to bypass discretionary thresholds.
 
Before strengthening rural-development schemes, the Commission needs to undertake a thorough review of how any money would be spent, and what European funds would be required (such a review should also be done for first-pillar money). Simply shifting more money into rural development, with no concrete plan on how the funds are to be spent, is unlikely to lead to an efficient use of taxpayer money. Such an assessment is vital, considering that only 72% (ranging from 49% for Greece to 85% for Finland) of funds allocated to the former EU-15 for rural development programmes during 2000-2006 were actually used. Moreover, increasing the modulation rate would disrupt the national rural-development plans that have already been established for the 2007-2013 period by several Member States or regions. (Rural development plans are submitted by the country to the Commission, and the Commission co-funds rural development measures only once the plans are approved). Last but not least, it raises systemic budgetary issues, which need to be examined in the 2008-2009 review of the European budget.
 
In order to provide farmers some certainty in their business operations, a sharp increase in the modulation rate should not occur before 2013. If the modulation rate is increased only slightly, its aim should be to avoid any over-run of the first pillar budget induced by the two previous enlargements, rather than to strengthen the second pillar. Ultimately, dynamic modulation should consider rewarding the provision of public goods from European agricultural and rural activities, and avoid perverse threshold effects. Characterising these public goods, and attaching a price to them, would be a prerequisite to the deep and permanent cuts to direct payments in the post-2013 CAP.
 
Pierre Boulanger
Research and Teaching Fellow, Groupe d'Economie Mondiale at Sciences Po (GEM)
http://gem.sciences-po.fr