Subsidies to Poor Regions and Inequalities: Some Unpleasant Arithmetic

This paper analyses the effect of different types of regional subsidies to poor regions on industrial location, employment, income inequality - between and inside regions - and welfare. We show that the impact on location of such subsidies is stronger when trade costs are low. When firms are mobile, regional subsidies that take the form of tax breaks or subsidies to the fixed cost lead to higher profits for all firms, even those not located in the region that gives the subsidy. If financed at the national level, such subsidies, given to firms in the poor region increase regional income inequality as the rich region owns more capital. Hence, even though they constitute an official financial transfer from the rich to the poor region, they actually lead to an income transfer from the poor to the rich region. It also leads to higher inequality within regions. When financed at the local level, subsidies succeed in attracting firms. Besides, as regional subsidies to firms of the manufacturing sector in the poor region alter local competition and firm size, they may actually lead to a decrease of regional employment and production of that sector in the poor region. Finally, with relocation costs, such regional subsidies may hurt the poor region.