The Political Advantage of Soft Budget Constraints

One of the enduring puzzles in transition economies is why incumbent politicians postpone reforms aimed at hardening budget constraints towards unproductive firms. We submit that voters prefer politicians capable of implementing reforms that promote job creation rather than policies that simply maintain high levels of employment by avoiding job destruction, but they cannot always tell the difference. To show this, we develop a voting model with incomplete information in which politicians who are unable to identify or implement productivity-enhancing reforms can hide their inability through firm subsidies that decreases the rate of job destruction. The model characterizes the equilibrium size and composition of subsidies - both through explicit budgetary support and through economically more detrimental implicit subsidies such as the accumulation of arrears to tax authorities, suppliers, creditors, or workers. The model generates a rich set of predictions, of which we highlight in particular two. An increase in government rents will increase the level of subsidies and shift them in favour of implicit subsidies, incurring a double cost to the economy. An increase in monitoring capacity of the voters will decrease the level of subsidies but also shift them towards implicit subsidies. It follows that democratization and increased freedom of the press may have the negative implication that it causes politicians to choose less efficient instruments for their subsidies