The prohibition of state aid to investment and R&D in an integrated market such as the European Community is analysed in a Cournot oligopoly model where firms undertake investment or R&D to reduce their costs.

Both strategic and non-strategic investment and R&D are considered. Governments in the Member States give subsidies for investment and R&D, which are financed by distortionary taxation so the opportunity cost of government revenue exceeds unity.

• Prohibiting state aid to investment will always increase aggregate welfare.

• Prohibiting state aid to R&D will always increase aggregate welfare if spillovers from R&D are small.

• If spillovers from R&D are moderate then there exists a range of values for opportunity cost where governments give state aid and where the prohibition of state aid will increase aggregate welfare.

• Prohibiting state aid to R&D will reduce aggregate welfare if spillovers from R&D are large.