Journal Issue
Working Paper Summaries (WP/94/1 - WP/94/76)

Working Paper Summaries 94/46: Searching for the Virtues of the European Model

International Monetary Fund
Published Date:
August 1994
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Should Europe scrap its labor market regulations? Would doing so imply the adoption of a highly inegalitarian “American model”?

This paper argues that the redistributive goals that motivate labor market rigidities in Europe may be achieved at a much lower cost using more traditional tax and transfer instruments. This is true even when the distortionary impacts of these instruments are taken into account. Only for implausibly high values of these distortions can some redistributive virtues to labor market rigidities be found.

The institution on which the paper focuses is the minimum wage. Section II details the distortions it introduces, and argues that an increase in the minimum wage may well have adverse impacts on inequality. This is because although it redistributes income from skilled to unskilled workers, by creating unemployment it also redistributes income from the poorest to the lower middle class.

Section III develops a simple model to analyze the impact of two alternative systems. One is a minimum wage with associated unemployment benefits. The second is a simple system of taxes and transfers. It is shown that the second system typically can achieve the same level of income distribution with a higher level of output. Also, if the labor market is “rigid” (in the sense of lower turnover), then (i) it is more likely that raising the minimum wage actually increases inequality, and (ii) the gains from shifting to the “tax” system are larger. These results are supported by the model’s calibration developed in Section IV.

Section V discusses some political economy issues. While it is true that shifting to the tax system is more efficient in order to reach a global income distribution objective, it may well be the case that employed unskilled workers suffer from such a shift. If the balance of power is such that they can block a change which is detrimental to them, the reform will not be politically feasible. This is more likely to happen when there is low turnover, which is precisely the case when the tax system is much more egalitarian than the minimum wage system. The simulations, however, suggest that when the turnover rate is very low, a moderate rise of the tax rate, above the one which achieves the same equality level as the minimum wage system, is enough to induce the employed to favor the reform. Therefore, while political viability may have to be taken into account in the design of the new system, the conclusion that the tax and transfer system is more efficient than the minimum wage system is left unaltered.

Section VI discusses the effects of other types of labor market rigidities, such as unemployment benefits and job protection laws. It critiques the view that these provisions raise productivity because they increase on-the-job training and improve the probability that an unemployed worker will find a job that better matches his or her abilities.

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