Business Creation Subsidies in a Competitive Credit Market

Category: Macro Seminar
When: 18 April 2023
, 14:15
 - 15:30
Where: HoF E.01/Deutsche Bank
Speaker: Luigi Paciello (EIEF)

Title: Business Creation Subsidies in a Competitive Credit Market

(with V. Cuciniello (bank of Italy) and C. Michelacci (eief))

Abstract: We study the effects of business creation subsidies in an analytically tractable firm life cycle model with long-term debt, geographical variation in business idiosyncratic risk and worker mobility. Firms are initially financially constrained but after entry they have access to a perfectly competitive credit market, which gives them incentives to (over)borrow to dilute the value of past debt, at the cost of greater bankruptcy risk. This overborrowing externality leads to excessive entry, which is exacerbated by a business creation subsidy. In the short run, the subsidy also makes highly leveraged incumbent firms more likely to go bankrupt, since the bust in business creation makes the local labor market tighter. These welfare costs are more pronounced in periods of cheap credit (as in recent years) and in regions with greater idiosyncratic risk (as in the South). We use the model to study the effects of the recent “I Stay in the South” business creation subsidy, specifically targeted to stimulate aggregate activity in the South of Italy (through possible aggregate demand externalities) and to retain the labour force locally (to ameliorate possible congestion externalities). Given the financial frictions, we find that the subsidy was close to optimal. Absent financial frictions, the optimal subsidy would have been fifty percent larger.