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Why Do Countries Subsidize Investment and Not Employment?

  • Clemens Fuest
  • Bernd Huber

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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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. Devereux, Michael B. & Lockwood, Ben, 1991. "Trade unions, non-binding wage agreements, and capital accumulation," European Economic Review, Elsevier, vol. 35(7), pages 1411-1426, October.
  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. Austan Goolsbee, 1997. "Investment Tax Incentives, Prices, and the Supply of Capital Goods," NBER Working Papers 6192, National Bureau of Economic Research, Inc.
  4. Layard, Richard & Nickell, Stephen & Jackman, Richard, 1991. "Unemployment: Macroeconomic Performance and the Labour Market," OUP Catalogue, Oxford University Press, number 9780198284345, March.
  5. Anderson, Simon P & Devereux, Michael, 1988. " Trade Unions and the Choice of Capital Stock," Scandinavian Journal of Economics, Wiley Blackwell, vol. 90(1), pages 27-44.
  6. Gaute Torsvik, 1993. "Regional-incentive programs and the problem of time-inconsistent plans," Journal of Economics, Springer, vol. 58(2), pages 187-202, June.
  7. Begg, David & Portes, Richard, 1992. "Eastern Germany Since Unification: Wage Subsidies Remain a Better Way," CEPR Discussion Papers 730, C.E.P.R. Discussion Papers.
  8. 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.
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