Why Do Countries Subsidize Investment and Not Employment?

26 Pages Posted: 4 Sep 1998 Last revised: 7 May 2000

See all articles by Clemens Fuest

Clemens Fuest

ifo Institute – Leibniz Institute for Economic Research at the University of Munich; Ludwig-Maximilians-University, Munich; Center for Economic Studies (CES)

Bernd Huber

Ludwig Maximilian University of Munich (LMU) - Staatswirtschaftliches Institut; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: August 1998

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.

Suggested Citation

Fuest, Clemens and Huber, Bernd, Why Do Countries Subsidize Investment and Not Employment? (August 1998). NBER Working Paper No. w6685. Available at SSRN: https://ssrn.com/abstract=122408

Clemens Fuest (Contact Author)

ifo Institute – Leibniz Institute for Economic Research at the University of Munich

Poschinger Str. 5
Munich, DE 81679
Germany
++89-9224-1430 (Phone)

Ludwig-Maximilians-University, Munich ( email )

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Germany

Center for Economic Studies (CES) ( email )

Schackstr. 4
Munich, DE 80539
Germany
++89 2180-2748 (Phone)
++89 2180-17845 (Fax)

Bernd Huber

Ludwig Maximilian University of Munich (LMU) - Staatswirtschaftliches Institut ( email )

Ludwigstrasse 28/III VG
D-80799 Munich
Germany
+49 89 2180-2874 (Phone)
+49 89 2180-3128 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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