Compensations as signaling devices in the political economy of reforms*

We propose an explanation for why efficient reforms are not carried out when losers can block their implementation and compensations are feasible. In our model, a government tries to sequentially implement two efficient reforms by bargaining with interest groups. The organization of interest groups is endogenous. Compensations are distortionary and different governments care differently about distortions. Governments use low compensations to discourage losers who just want to receive transfers from organizing. This comes at the cost of reforms being blocked by interest groups with relatively high losses, resulting in a bias against payment of compensations and the implementation of reforms.