Welfare and cross-border spillover effects of industrial subsidies in general equilibrium

In a simple partial equilibrium setting without externalities industrial subsidies promote manufacturing output in the subsidizing region but harm welfare, whereas spillover effects to welfare in other regions are positive if the country is large. In a general equilibrium model instead the welfare effects are ambiguous, because of pre-existing distortions and general equilibrium terms of trade effects. The aim of this paper is to analyse the welfare and spillover effects of industrial subsidies in a standard general equilibrium quantitative trade model with multiple sectors and intermediate linkages without externalities and profits by exploring counterfactual experiments of the introduction of manufacturing output subsidies. The analysis generates four main findings: (1) welfare falls in most regions raising industrial subsidies except for regions where pre-existing distortions fall sufficiently or where terms of trade rise in other sectors (services); (2) welfare in non-subsidizing regions rises for most regions with variation in these welfare cross-border spillover effects driven by the strength of four effects: an output competition effect, an input competition effects, a downstream effect, an upstream effect; (3) subsidy wars between two global stylized blocs of economies can result in excessively high subsidy rates that are globally inefficient, with outcomes depending on the weight placed on expanding their manufacturing sectors relative to real income; (4) raising industrial subsidies in all regions together has a positive impact on many regions and a negative impact on a relatively small set of regions with the highest initial share of output in manufacturing. However, in the long run welfare can be adversely affected in all regions if there would be positive externalities from specializing in sophisticated sectors, since the upstream effects pull resources out of the sophisticated sectors.