Subsidies as optimal fiscal stimuli

Abstract

Theoretical macroeconomic models typically take fiscal policy to mean tax-and-spend by a 'benevolent government' that exploits potential aggregate demand externalities inherent in the imperfectly competitive nature of goods markets. Whilst shown to raise aggregate output and employment, these policies crowd-out private consumption and typically reduce welfare. On account of their widespread use to stimulate economic activity, we consider the use of 'tax-and-subsidize' instead of 'tax-and-spend' policies. Within a static general equilibrium macro-model with imperfectly competitive goods markets, we examine the effects of wage and output subsidies and show that, for a small open economy, positive tax and subsidy rates exist which maximize welfare, rendering no intervention suboptimal. We also show that, within a two-country setting, a Nash non-cooperative symmetric equilibrium with positive tax and subsidy rates exists, and that cooperation between governments in setting these rates is more expansionary and leads to an improvement upon the non-cooperative solution. © 2012 The Authors. Bulletin of Economic Research © 2012 Blackwell Publishing Ltd and the Board of Trustees of the Bulletin of Economic Research.