Subsidizing Business Entry in Competitive Credit Markets

Business creation subsidies are a means to reduce firm debt and bankruptcy risk. Do they work? To answer the question, we consider a general equilibrium model where firms are financially constrained at entry and borrow in a competitive market issuing long-term debt. The subsidy stimulates entry and market competition, which increases the bankruptcy rate of incumbent firms. If the subsidy is paid out ex-ante to finance start-up expenditures, the subsidy reduces the debt and the bankruptcy rate of start-ups; if paid out ex-post as a refund of start-up expenditures, the subsidy crowds out the equity rather than the debt of start-ups and their bankruptcy rate also increases. The model is calibrated to match North-South differences across Italian provinces. The optimal subsidy in the South is paid out entirely ex-ante and yields an increase in welfare equivalent to almost one percentage point of consumption. When the same subsidy is paid out ex-post in a proportion of 60 percent, it results in a welfare loss of a similar amount. We discuss implications for the "I Stay in the South" policy recently introduced in Italy.