Subsidy competition and imperfect labor markets

• Author: Kazuhiro Yamamoto,Tadashi Morita,Yukiko Sawada
• DOI: http://doi.org/10.1111/jpet.12400
• Date: 01 June 2020
• Published date: 01 June 2020

J Public Econ Theory. 2020;22:698–728.wileyonlinelibrary.com/journal/jpet698

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© 2019 Wiley Periodicals, Inc.

Received: 27 August 2018

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Accepted: 14 August 2019

DOI: 10.1111/jpet.12400

ORIGINAL ARTICLE

Subsidy competition and imperfect labor

markets

Tadashi Morita

1

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Yukiko Sawada

2

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Kazuhiro Yamamoto

3

1

Faculty of Economics, Kindai

University, Kowakae, Higashiosaka,

Osaka, Japan

2

Faculty of Economics, Ryukoku

University, Kyoto, Japan

3

Graduate School of Economics, Osaka

University, Osaka, Japan

Correspondence

Tadashi Morita, Faculty of Economics,

Kindai University, Osaka 5778502, Japan.

Email: t-morita@kindai.ac.jp

Funding information

JSPS, Grant/Award Numbers:

JP15H03348, JP16H03615, JP25870925,

17K13741; RIETI

Abstract

This study presents a two‐country model of subsidy

competition for manufacturing firms under labor market

imperfections. Because subsidies affect the distribution

of firms, subsidies influence unemployment rates and

welfare in both countries. We show that when labor

market frictions are high, subsidy competition is bene-

ficial, although subsidies under subsidy competition are

inefficiently high. In the coordinated equilibrium, the

supranational authority provides a subsidy to firms that

equal the expected total search costs, which increases the

number of firms relative to laissez‐faire and improves

welfare relative to laissez‐faire and subsidy competition.

Finally, we find that a rise in a country’s labor market

frictions raises the equilibrium subsidy rate, affects

unemployment rates, and lowers welfare.

1

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INTRODUCTION

In recent years, active labor market policies involving subsidies to private sector employers have

been implemented in many European Union (EU; Kluve, 2010) and Organisation for Economic

Co‐operation and Development (OECD) countries (Card, Kluve, & Weber, 2010; Martin, 2015).

On the one hand, many governments provide subsidies to private firms to lower unemployment

rates, and these subsidies have been considered to have only indirect effects on foreign

countries.

1

On the other hand, the Subsidies and Countervailing Measures Agreement (SCM

Agreement) aims to control the subsidies granted by World Trade Organization (WTO)

members, which may be harmful for other countries.

2

In particular, the SCM Agreement

1

The OECD (2010) states that labor market interventions have an indirect bearing on international trade.

2

Mavroidis (2016) states that the SCM Agreement requires that WTO members avoid using two types of prohibited subsidies (i.e., local content and export

subsidies) as well as other subsidies that may adversely affect other WTO members. The SCM Agreement does not make the treatment of subsidies conditional

on their rationale. In other words, nowadays, subsidies can be counteracted regardless of their rationale.

prohibits an export subsidy or a subsidy contingent for the use of domestic over imported goods

or a subsidy seriously prejudicing the interests of another member. Indeed, a subsidy in one

country may result in another country experiencing a negative externality. In other words,

although active labor market policies aim to internalize the distortions generated by labor

market frictions, they may result in negative externalities to other countries. If the subsidy

policy in our study can be interpreted as seriously prejudicing the interests of another member,

it would be prohibited under Articles 5 and 6 of the SCM Agreement.

On the contrary, WTO and European state aid regulations permit a subsidy to firms that

offset a “proven”cost disadvantage relative to another competition location. In our model,

governments have an incentive to provide a subsidy to firms, since labor market frictions

worsen the profitability of firms and lower welfare. In that case, the WTO allows governments

to provide subsidies to firms, which lead them into subsidy competition.

Against the background of the WTO prohibiting subsidy policies that may harm other

countries, this study investigates whether the absence of such subsidy competition is beneficial

or harmful for two countries that trade manufactured goods and face labor market

imperfections. Our study points out that a subsidy that improves the labor market imperfections

in a country brings about a negative externality to the other country. Moreover, the subsidy

rates in these two countries are strategic complements, which means that the equilibrium

subsidy rate becomes inefficiently high. Therefore, the analysis presented in this study shows

that subsidy competition is more beneficial (wasteful) than laissez‐faire economics when labor

market frictions are large (small) relative to the negative externality brought about by subsidy

competition.

3,4

Thus, we show that the WTO’s policy of prohibiting subsidy competition is

harmful when labor market frictions are large, even when one country brings about a negative

externality to another country under subsidy competition. Moreover, our analysis shows that

trade liberalization enlarges the negative externality of subsidy competition as well as the

possibility that subsidy competition is harmful for both countries. Thus, we further show that

recent globalization increases the possibility that the WTO’s policy may be reasonable.

We construct a two‐country, two‐sector (manufacturing and agriculture) model in which the

markets for manufactured goods are segmented between the two countries. A specific feature of

our model is that the labor market in the manufacturing sector is assumed to be imperfect.

Firms entering the manufacturing sector search for workers to employ, and these search

activities are assumed to incur a positive search cost, which lowers the entry of operating firms

in the market. We show that in the laissez‐faire economy, a government provides a subsidy to

manufacturing firms, which increases the number of operating firms and improves welfare.

Thus, when there is a positive search cost, governments have an incentive to provide subsidies

to manufacturing firms to decrease the inefficiency induced by labor market frictions.

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Each government is assumed to provide a subsidy to maximize welfare in its own country. In

our model, an externality is generated by subsidy competition, following previous tax

competition studies, including Borck, Koh, and Pflüger (2012) and Pflüger and Suedekum

(2013). The increase in subsidies speeds up the entry of firms into the country, which intensifies

3

Andolfatto (1996), Shimer (2005), and Menzio and Shi (2011) find that the estimated values of labor market frictions (search costs for firms) in the United

States differ widely.

4

Boadway, Cuff, and Marceau (2002) show a case in which tax competition improves welfare in a model with labor market imperfections. Wilson (1999) and

Wilson and Wildasin (2004) introduce models in which tax competition improves efficiency in their comprehensive reviews of tax competition studies.

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Costinot (2009) constructs a small open economy in which there are search frictions in labor markets and positive search costs for vacancies create a rent

distributed to employed workers. This study focuses on the effect of protectionism on the unemployment rate, showing that an increase in international trade

tax (i.e., protection policy) by a government may increase aggregate rents in a country.

MORITA ET AL.

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