DP3797 Public Finance and the Optimal Speed of Transition

Author(s): Micael Castanheira
Publication Date: February 2003
Keyword(s): subsidies, transition
JEL(s): H20, P20
Programme Areas: Transition Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3797

We develop a general equilibrium model that jointly considers the influence of capital accumulation constraints and of labour market frictions on the process of transition. We endogenize the economic and budgetary costs of different government policies and show that, early in transition, governments ought to subsidize state firms. Provided that inter-temporal commitment is feasible, this policy limits the initial output fall, which relaxes capital accumulation constraints, accelerates transition, and increases welfare. Moreover, by resorting to indirect ? instead of direct ? taxes, governments can bring the path of transition closer to the first best. Yet, political pressures may induce a policy of excessive subsidization.