Why Do Governments Subsidize Investment and Not Employment?

Journal of Public Economics, Vol. 78, Issue 1-2, October 2000

Posted: 19 Aug 2001

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)

Abstract

The governments of nearly all industrialized 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 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. It turns out that an investment subsidy dominates an employment subsidy in terms of welfare if there is bargaining over wages and employment on the firm level. If bargaining is over wages only, results are ambiguous but capital subsidies may still be preferable.

Keywords: Capital subsidies, Labor subsidies, Unemployment

Suggested Citation

Fuest, Clemens and Huber, Bernd, Why Do Governments Subsidize Investment and Not Employment?. Journal of Public Economics, Vol. 78, Issue 1-2, October 2000. Available at SSRN: https://ssrn.com/abstract=252533

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 )

Schackstrasse 4 / II
Munich, DE 80539
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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