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Why Do Countries Subsidize Investment and Not Employment?

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  • Clemens Fuest
  • Bernd Huber

Abstract

The governments of nearly all industrialised countries use subsidies to support the economic development of specific sectors or regions with high rates of unemployment. Conventional economic wisdom would suggest that the most efficient way to support these regions or sectors is to pay employment subsidies. We present evidence showing that capital subsidies are empirically much more important than employment subsidies. We then discuss possible explanations for the dominance of investment subsidies and develop a simple model with unemployment to explain this phenomenon. In our model, unemployment arises due to bargaining between unions and heterogenous firms that differ with respect to their productivity. Union bargaining power raises wage costs and leads to a socially inefficient collapse of low productivity firms and a corresponding job loss. Union-firm bargaining also gives rise to underinvestment. In this framework, it turns out that an investment subsidy dominates an employment subsidy in terms of welfare. The reason is that investment subsidies are a more efficient instrument to alleviate the underinvestment problem and to raise the number of operating firms.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6685.

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Date of creation: Aug 1998
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Publication status: published as Fuest, Clemens and Bernd Huber. "Why Do Governments Subsidize Investment And Not Employment?," Journal of Public Economics, 2000, v78(1-2,Oct), 171-192.
Handle: RePEc:nbr:nberwo:6685

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  1. Gaute Torsvik, 1993. "Regional-incentive programs and the problem of time-inconsistent plans," Journal of Economics, Springer, vol. 58(2), pages 187-202, June.
  2. Grout, Paul A, 1984. "Investment and Wages in the Absence of Binding Contracts: A Nash Bargining Approach," Econometrica, Econometric Society, vol. 52(2), pages 449-60, March.
  3. Simon Anderson & Michael Devereux, 1985. "Trade Unions and the Choice of Capital Stock," Working Papers 600, Queen's University, Department of Economics.
  4. Michael B. Devereux & Ben Lockwood, 1989. "Trade Unions, Non-Binding Wage Agreements, and Capital Accumulation," Working Papers 743, Queen's University, Department of Economics.
  5. George A. Akerlof & Andrew K. Rose & Janet L. Yellen & Helga Hessenius, 1991. "East Germany in from the Cold: The Economic Aftermath of Currency Union," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 22(1), pages 1-106.
  6. Layard, Richard & Nickell, Stephen & Jackman, Richard, 2005. "Unemployment: Macroeconomic Performance and the Labour Market," OUP Catalogue, Oxford University Press, number 9780199279173.
  7. Austan Goolsbee, 1997. "Investment Tax Incentives, Prices, and the Supply of Capital Goods," NBER Working Papers 6192, National Bureau of Economic Research, Inc.
  8. David Begg & Richard Portes, 1993. "Eastern Germany since unification: wage subsidies remain a better way," The Economics of Transition, The European Bank for Reconstruction and Development, vol. 1(4), pages 383-400, December.
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Cited by:
  1. Thomas Moutos & William Scarth, 2000. "Work-Sharing: an Efficiency-Wage Analysis," CESifo Working Paper Series 386, CESifo Group Munich.
  2. Sarkar, Sudipto, 2012. "Attracting private investment: Tax reduction, investment subsidy, or both?," Economic Modelling, Elsevier, vol. 29(5), pages 1780-1785.
  3. Haufler, Andreas & Klemm, Alexander & Schjelderup, Guttorm, 2006. "Globalisation and the mix of wage and profit taxes," Discussion Papers in Economics 885, University of Munich, Department of Economics.
  4. Fuest, Clemens & Huber, Bernd, 2000. "Why do governments subsidise investment and not employment?," Journal of Public Economics, Elsevier, vol. 78(1-2), pages 171-192, October.

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