AltInst: Employment vs. Investment Subsidies

"Why Do Countries Subsidize Investment and Not Employment?"

      BY: CLEMENS FUEST
              University of Munich
              Staatswirtschaftliches Institut
           BERND HUBER
              University of Munich
              Staatswirtschaftliches Institut

Paper ID: NBER Working Paper No. 6685
    Date: August 1, 1998

 Contact: CLEMENS FUEST
   Email: Mailto:clemens.fuest@lrz.uni-muenchen.de
  Postal: University of Munich
           Staatswirtschaftliches Institut
           Ludwigstr. 28 / III
           D-80799 Munich, GERMANY
   Phone: ++89 2180-6339
     Fax: ++89 2180-3128
 Co-Auth: BERND HUBER
   Email: Mailto:huber.office@lrz.uni-muenchen.de
  Postal: University of Munich
           Staatswirtschaftliches Institut
           Ludwigstrasse 28/III VG
           D-80799 Munich, GERMANY

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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.

JEL Classification: H20, J51

Robin Hanson
hanson@econ.berkeley.edu http://hanson.berkeley.edu/
RWJF Health Policy Scholar, Sch. of Public Health 510-643-1884
140 Warren Hall, UC Berkeley, CA 94720-7360 FAX: 510-643-8614

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Received on Fri Oct 16 20:28:57 1998