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Public Input Provision in Asymmetric Regions with Labor Market Imperfections

Abstract This paper examines efficiency in public input provision in two large regions with labor market imperfections. Because employment and pecuniary externalities are associated with public input provision, the provision level exceeds the optimal amount under the presence of wage rigidities in the capital-exporting jurisdiction if only head taxes are used to finance government expenditures. Efficiency in public input provision will remain ambiguous in the capital-importing jurisdiction unless a specific functional form is assumed for the production technology. The constrained efficient provision with public inputs can be restored with an additional tax (subsidy) on capital that is used to strategically influence the interest rate on the common capital market and to increase employment by attracting foreign capital.