The political advantage of soft budget constraints

Abstract

Why do soft budget constraints persist in many post-socialist economies? We submit that the explanation may be to serve the political purpose of hiding the incumbent government's inability to promote job creation. We present a voting model with adverse selection in which politicians who are unable to implement productivity-enhancing reforms resort to firm subsides to decrease the rate of job destruction. We characterize the equilibrium size of subsidies and its composition into explicit and implicit subsidies. The equilibrium size and composition of subsides depend, among other things, on government rents, political transparency, political expectations, and firms' labour unit costs.