Why Do Countries Subsidize Investment and Not Employment?

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.