The efficiency case for transit subsidies in the presence of a ‘soft’ budget constraint

Abstract

The main contribution of this paper is to discuss the implications of a ‘soft’ budget constraint on optimal transit fares and subsidies. We find that the e↵ect of productive ine"ciencies on optimal fares and subsidy levels depends critically on the way cost reducing e↵ort enters the cost function and on the institutional environment (as measured by the ‘tightness’ of the budget constraint faced by operators). In particular, recognizing that subsidies may have an adverse e↵ect on productive e"ciency does not necessarily imply that transit subsidies should be eliminated. Unsurprisingly, there will be a trade-o↵ between the negative cost e"ciency e↵ects of transit subsidies and the welfare enhancing allocative e"ciencies related to these subsidies. Under certain conditions optimal subsidies may be higher when operators face an intermediate budget constraint than when they face a ‘tight’ budget constraint. We illustrate this last result using a simple numerical example.