Journal Issue

Policy Complementarities: The Case for Fundamental Labor Market Reform

International Monetary Fund. Research Dept.
Published Date:
January 1997
  • ShareShare
Show Summary Details

The message of this paper can be summarized in two simple points: (1) a wide range of labor market institutions—including unemployment benefits, job security legislation, and payroll taxes—have complementary effects on unemployment; and (2) thus, a correspondingly wide range of labor market policies aimed at reforming these institutions are also complementary. Our definition of unemployment policy complementarities is straightforward: a group of policies is complementary when the unemployment effect of each policy is greater when it is implemented in conjunction with the other policies than in isolation. More generally and formally, a set of policy instruments xi,i = 1,....n, has complementary effects on a policy objective y when (∂2y / ∂xj ∂xj) > 0 for ij.

The rigidities in many European labor markets spring from a variety of sources: unemployment benefits, job security legislation, workers’ bargaining power, welfare state entitlements, job search costs, barriers to entry of firms, barriers to mobility of labor, minimum wages, costs of human capital acquisition, and others. Our analysis investigates the channels whereby these rigidities are complementary to each other in their influence on unemployment. As we shall see, for example, when unemployment benefits discourage workers from seeking jobs and thereby reduce firms’ payoff from seeking job applicants, this gives firing costs more leverage in discouraging firms from creating new jobs.1 Not only do unemployment benefits magnify the unemployment effects of job security legislation, but the same is also true the other way around: when firing costs reduce firms’ incentives to search for new recruits, and thereby reduce unemployed workers’ payoff from seeking jobs, this magnifies the disincentives to job search stemming from unemployment benefits. Our analysis shows that such institutional complementarities apply to a broad range of labor market rigidities.

Furthermore, when labor market institutions are complementary, then policies to reform these institutions are complementary as well. This implies that partial labor market reform is unlikely to achieve significant reductions in unemployment rates. For example, active labor market policies (such as job counseling and retraining schemes) may not be very effective in the presence of substantial passive policies (such as generous unemployment benefits and stringent job security provisions). By the same token, a scaling down of passive income support may have little effect on unemployment in the absence of active labor market policies. We contend that this may be an important reason why the diverse, piecemeal labor market reforms implemented in many European countries over the past decade and a half have had so little success in reducing long-term unemployment.2 We argue that what is required, instead, is a thoroughgoing, many-handed approach: that is, reforms that are both “broad” (covering a wide range of complementary policies) and “deep” (of substantial magnitude). These reforms must be combined with measures that address the distributional objectives of the prereform policies more efficiently. This is our case for fundamental labor market reform.

The paper is organized as follows. Section I discusses some key features of European labor markets, focusing on how labor market rigidities may be interrelated and mutually reinforcing, thereby suggesting a role for complementary labor market policies. Section II presents a baseline forma) model of some major institutional rigidities in the labor market. Section III analyzes the associated policy complementarities. Section IV extends the model to distinguish between skilled and unskilled workers and to examine the role of training policies and minimum wages. Section V deals with redistributive policy. Section VI concludes.

I. Complementarities in European Labor Markets

It is widely recognized that there are many factors underlying the high European unemployment rates over the past two decades: aside from supply-side shocks and tight macroeconomic policies to reduce inflation and the accumulation of government debt, economists broadly agree that a variety of European labor market institutions have contributed to the unemployment problem.3 We will argue that these institutions are complementary and thus suggest the need for a strategy of complementary labor market reforms.

The institutions usually identified as contributors to high and persistent European unemployment include unemployment benefit systems and other welfare entitlement programs that discourage job search; high social insurance contributions that discourage employers from seeking employees (especially for low-paying jobs) and workers from seeking jobs; school systems that do a poor job of preparing students for entrance into the labor market and ineffective public sector training programs; insufficiently competitive product and housing markets that restrain the demand for workers and reduce mobility; job security legislation that insulates incumbent employees from the forces of demand and supply; and union power, collective bargaining arrangements, and minimum wage laws that make wages unresponsive to market forces, prevent wage differentials from reflecting productivity differentials, and encourage the substitution of capital for labor.

It is not hard to see how these institutional rigidities reinforce one another. For instance, when unemployment benefits discourage workers from seeking jobs and when employers’ social contributions discourage employers from seeking workers, these two effects augment one another, as the workers’ discouragement reinforces the employers’ discouragement and vice versa. This nexus of effects is further reinforced by ineffective education and training, which can prevent workers from acquiring skills appropriate for the available jobs. Furthermore, the effect of job security legislation on incumbent employees’ bargaining power may be reinforced by labor immobilities arising in the housing market.

We will argue that these institutional complementarities point to policy complementarities and that the latter have not been adequately exploited in dealing with the European unemployment problem. Our underlying hypothesis is that the unemployment effect of a reform package depends significantly on its breadth (the range of complementary policies included in the package) and its depth (the size of the policy change). This hypothesis provides a conceivable explanation for a famous policy puzzle: European unemployment is certainly not the product of policy inaction. Over the past decade and a half, most European countries have undertaken a large number of labor market policy initiatives. These have covered not only passive policies but have increasingly emphasized active labor market policies, so as to increase people’s incentives to find work and acquire skills.4 Nevertheless, these policies do not appear to have been particularly effective thus far. Why? Our analysis suggests one possible reason: the European policies initiatives have not been sufficiently “broad” and “deep.” This is clearly not the only reason for the observed policy ineffectiveness, but it is one that has been largely ignored in the literature thus far.5 and we will argue that it is potentially important.

European governments are now spending enormous amounts on labor market programs. In recent years, spending on these programs has been equivalent to 3½ percent of GDP in Europe on average, and to 5½-7 percent of GDP in Denmark, Finland, and Sweden.6 In most countries, only about one-third of total expenditures on labor market programs have been for active labor market policies, with the remainder providing passive income support. These large expenditures on labor market programs have been financed by high and rising taxes and, in many countries, by increasing government deficits. The resulting tax wedge—income taxes plus employees’ and employers’ social security contributions—is very high in Europe compared with other industrial countries (Figure 1). These high taxes restrain demand and increase labor costs, both of which reduce employment. Widening budget deficits further exacerbate the problem by putting upward pressure on interest rates and reducing confidence. This constellation of problems suggests that complementarities between labor market policies and the tax system have contributed to the European unemployment problem.

Figure 1.Marginal Tax Wedgesa

(In percent of total income)

Source: OECD (1994a, Part II, p. 241).

a The lax wedge includes employees’ and employers’ social security contributions, persona] income taxes, and consumption taxes.

It is not hard to find specific examples of isolated policy reforms, unaccompanied by complementary reforms in other areas, that have had little if any impact on unemployment. Spain, for instance, attempted to promote labor market flexibility by introducing fixed-term labor contracts with low firing costs in 1984. The rapid expansion of fixed-term contracts allowed Spanish firms, which face some of the strictest job security regulations among Organization for Economic Cooperation and Development (OECD) countries (Figure 2), to buffer fluctuations in demand by changing the number of fixed-term employees. Bentolila and Dolado (1994) argue that this policy reduced the risk of unemployment for workers with permanent contracts, which strengthened their bargaining position. Since wage bargaining agreements mainly reflect the interests of the insiders with permanent contracts, the result may have been less rather than more wage flexibility.7 Thus, the introduction of fixed-term contracts without changes to the stringent job security regulations for workers with permanent contracts may have had perverse effects in terms of labor market flexibility and may have contributed to higher rates of unemployment. Recently, Spain has reintroduced some restrictions on fixed-term contracts and has reduced firing costs for all workers.

Over the 1990s, France has implemented a very large number of labor market initiatives. Many of the labor market programs have been aimed at moderating the adverse employment effects of high minimum wages and payroll taxes—which remain among the highest of all OECD countries— through a variety of special programs, temporary exemptions, and other ad hoc measures (OECD, 1995a). Restrictions on part-time work have also been eased, and worksharing has been encouraged. However, very little has been done in complementary areas, such as improving training and education or reducing the stringency of job protection legislation and the power of insiders in the wage determination process.8

Over the 1980s, the United Kingdom introduced substantial reforms, including legislation restricting strikes and secondary picketing, decentralizing wage bargaining, liberalizing hiring and firing restrictions, and reducing the duration of unemployment benefits and tightening the associated eligibility criteria. The wage councils that had set minimum wages were abolished. Job search by unemployed people was promoted through the Restart interviews and related measures. Mayhew (1991), Ramaswamy and Prasad (1994), and Henry and Karanassou (1996) have argued that these reforms have contributed to a fall in the equilibrium unemployment rate and to a steady decline in unemployment rates from 10½ percent in mid-1993 to 6¾ percent at the end of 1996. The policy changes above, however, have not been accompanied by substantial reforms of other welfare-state entitlements, such as housing benefits, or by a thoroughgoing drive to improve education and training systems. Furthermore, the U.K. labor market reforms have not been accompanied by major changes in the tax and transfer system to address the distributional consequences of the reforms.

Figure 2.Maximum Notification and Severance Pax Periods

(In months)

Source: OECD (1994a. Part II. p. 73). except for the United States, which is from U.S. Department of Labor (1989).

The Swedish experience is also interesting from our perspective, since it focuses on a different subset of interrelated policies while still falling far short of major reform of the full set of complementarity policies. In Sweden, unemployment benefits are of comparatively short duration, and unemployed people have ready access to job counseling and training. However, the replacement ratios (the ratios of unemployment benefits to wages) are high, jobless people frequently have the opportunity of moving from unemployment benefits to training programs and back, and generous welfare state entitlements raise the attractiveness of inactivity relative to employment. Many observers have argued that these institutional factors help explain why Swedish unemployment grew so rapidly after the adverse shocks of the early 1990s, why it has remained high since then, and why the average working age in Sweden is so low relative to the United States and most other European countries.

Many recent European labor market reforms have attempted to reduce the generosity of unemployment benefit systems, either through reducing replacement ratios, tightening eligibility criteria, or shortening benefit periods. In general, however, only marginal changes have been made to existing benefit systems (OECD, 1996), which remain generous compared with those in the United States or Japan (Figure 3). Moreover, there have been few, if any, major reforms to other types of passive income support programs or disability programs. These programs and other welfare-state benefits often function as alternatives to, or extensions of, unemployment benefits; reforming only one program may not do much to encourage job search and reduce long-term dependency if alternative forms of income support are available. The potentially large impact of benefit programs can be seen in the Netherlands, which has one of the most generous unemployment and disability benefit systems among the OECD countries, and where fully 17 percent of the working age population was receiving unemployment, disability, early retirement, or social assistance in 1993 (OECD, 1994b).

Figure 3.Unemployed Benefit Replacement Ratiosa

(Benefits in percent of previous earnings, pretax)

Source: OECD (1994b, p. 87).

a In descending order, according to 1991 values.

It is clear that substantial reductions in benefit programs and, more generally, fundamental labor market reforms are politically difficult to implement. One of the main reasons is that reforms often have readily identifiable distributional consequences for specific groups of people who will organize to oppose the reforms. This suggests the importance of implementing broad-based labor market reform programs that address the full range of rigidities and disincentives and do not appear to place the burden of reform unfairly on a specific group. It also suggests the importance of addressing distributional consequences directly by incorporating measures to achieve distributional objectives in a more efficient manner.

In sum, European countries have not, on the whole, sought to reduce unemployment by implementing a coherent strategy of fundamental reforms across a broad range of complementary policies. In the main, these countries have adopted a number of ad hoc measures that attempt marginal corrections to the most egregious distortions stemming from existing labor market policies or regulations. We argue that, since only marginal, piecemeal changes have been implemented, existing restrictive institutions and regulations that are complementary to each other continue to interact, blocking the effectiveness of the recent reforms and prolonging unemployment.

In the next section, we present a simple, formal model that attempts to capture some of the major complementarities among labor market policies,

II. A Simple Model

We begin with a baseline model that covers a core set of institutional features that amplify each other’s influence on unemployment: unemployment benefits, job security legislation, workers’ bargaining power, costs of job search, and barriers to entry of firms. The interactions among these institutions will suggest complementarities among policies aimed at institutional reform.

The Search for Workers and Jobs

Consider an economy in which output is produced by means of labor input. Let each employee generate real revenue a {a positive constant) and receive real wage w, so that the profit per employee (a — w) is positive. Let L be the size of the aggregate labor force (a positive constant) and V be the aggregate number of job vacancies. For simplicity (but without any substantial loss of generality), we assume that each worker lives for a single period. Thus, in each period, L workers enter the labor market.

These workers are engaged in either “constructive” or “unconstructive” job search. The constructive searchers want to work and are able to generate a revenue of a per worker. The unconstructive searchers are not willing, to work; they are merely “pretending” to search in order to qualify for unemployment benefits (which are granted conditional on search). If they were hired, they would generate no revenue.

Employers are unable to distinguish a constructive from an unconstructive job searcher before making contact with the worker. At the beginning of each period of analysis, each employer searches for an employee by making a random drawing from the tabor force. After contact has been made, the employer learns whether the worker is a constructive searcher. Since constructive searchers are willing to work while unconstructive searchers are not, both groups have an incentive to signal to their potential employers whether they would generate revenue upon being hired. Thus only constructive workers are hired.

A proportion θ* (0 < θ* < 1) of the aggregate labor force searches constructively. The rate at which workers arrive at a vacancy and the rate at which vacancies arrive at a worker are given by Poisson processes. The probability that a vacancy is matched by a constructive searcher may be expressed as

where 0 ≤ ε ≤ l and έ > 0 for 0 < ε < 1. Similarly, the probability that a constructively searching worker finds a job is given by

where 0 ≤ ρ ≤ 1 and p' > 0 for 0 < ρ < I.

The proportion θ* of the workforce that searches constructively is determined as follows. Workers are assumed to be heterogeneous in terms of their constructive search costs. Let us order the workers in terms of these costs, from lowest to highest, and let θ stand for the proportion of the workforce ordered in this way. Then the marginal employee’s cost of searching constructively is given by e(θ), é > 0 for 0 < θ < 1, where the marginal employee is the last employee out of the proportion θ of the ordered workforce.9 Unconstructive search is assumed to have zero cost.

With probability ρ, a constructive searcher finds a job and receives wage income w(1-t), where t is the income tax rate (a positive constant):10 with probability (1 - ρ), she does not find a job and receives the unemployment benefit b. Thus the marginal worker’s return from constructive search is pw(l - t) + (] - ρ)b-e(θ). If, however, she does not search constructively, she is certain not to get a job offer and thus her return is simply b. In equilibrium (θ = θ*), the marginal searcher is indifferent between constructive and unconstructive search, so that

The unemployment benefit is assumed to be proportionately related to the wage

where β is the replacement ratio. Thus, by equations (3) and (4), the proportion of the workforce thai searches constructively is

The Supply of Vacancies

To supply a vacancy, the employer must pay a fixed cost K (a positive constant). Thus the profit π from searching for an employee is

The probability ε of finding a constructive job searcher, the revenue a, the wage w, and the entry cost k are all known to the employer when the vacancy supply decisions are made.

Under free entry, vacancies are supplied until the associated profit is driven to zero: π = 0. By equation (6), this implies that the aggregate level of vacancies V that emerges in response to the aggregate number of constructive job searchers θL is given by

Wage Determination

After an employer has found a constructive job searcher, they negotiate the wage, which is the outcome of a Nash bargain. Under bargaining agreement, the employee receives w(l - t),11 and the employer receives (a - w). The employee’s fallback position is assumed to be equal to her unemployment benefit b. The employer’s fallback position is assumed to depend on the firing costs in the following simple way. Under bargaining disagreement, the employee engages in industrial action that is costly to the employer but not to the employee. The greater is the level of industrial action, the lower will be the employer’s fallback position and thus the higher will be the wage that the employee can achieve, up to a limit, beyond which the employer has an incentive to fire the employee. The employer faces a fixed firing cost of f per employee. If the cost of the industrial action to the employer exceeds the firing cost f, the employee will be replaced by a new recruit. Consequently, the employee will set the level of industrial action so that its cost to the employer is exactly f, making the employer indifferent between retaining and replacing the employee.

In sum, the employee’s bargaining surplus is w(l - t) - b, and the employer’s bargaining surplus is a-w(-f). Let the firing cost f be proportional to the wage f =φw, where φ is a constant, 0 < φ < 1. Then the employer’s surplus becomes a — a -(1-<)w. Thus the Nash bargaining problem is

Maximize (w(1 - t) - b)μ (a - (1 - <)w)1-μ,

where μ (a constant, 0 < μ < 1) is the bargaining strength of the employee relative to the employer. Noting that the value of the unemployment benefit b is taken as exogenously given in the bargain but that, in equilibrium, the unemployment benefit is proportional to the wage (equation (4)), the equilibrium negotiated wage becomes


The Unemployment Rate

The unemployment rate is

Define the ratio of vacancies to constructive job searchers as our measure of labor market “tightness” (τ) as follows:

Then, by equations (7), (8a), and (8b), the equilibrium degree of tightness is

Thus, by equations (5), (7), (8a), (8b), and (9), the equilibrium unemployment rate is

The Government Budget Constraint

Our model of the labor market is closed through a government budget constraint, showing that the government’s spending on unemployment benefits is equal to its tax receipts

where the left-hand side stands for unemployment benefit payments (since (1 - θρ)L is the level of unemployment and βw is the unemployment benefit per person) and the right-hand side is tax receipts (since θρL is the level of employment. wθρL is aggregate income, and t is the income tax rate).

In equilibrium, the government budget constraint becomes

The Labor Market Equilibrium and the Tax-Benefit Multiplier

Equations (11), (12), and (13’) describe the complete labor market equilibrium. First, given the equilibrium wage (equation (8a)) and the free-entry condition (equation (7)), equation (11) yields the equilibrium degree of labor market tightness τ*. Second, this equilibrium degree of labor market tightness τ* determines the equilibrium probability of finding a job (ρ* = ρ(τ*), by equation (2)), and, given ρ*, equation (12) yields the equilibrium unemployment rate for any given tax rate t. And finally, given ρ*, equation (13’) yields the tax rate t* that balances the government’s budget.

Thus the labor market equilibrium may be represented as the solution of the following system

where the former may be interpreted as describing the equilibrium unemployment rate for any given tax rate, and the latter is a restatement of the government budget constraint, describing the tax rate that balances the budget for any given unemployment rate.

Figure 4 pictures this system. Here, the UE curve represents the “unemployment equilibrium” (equation (12)), and the GBC curve represents the “government budget constraint” (equation (13”)). The labor market equilibrium is given by the intersection of these two curves.12

Our model reveals a striking interrelation between the tax system and various institutional features of the labor market. The following example illustrates this point clearly. Suppose that the labor market is initially in equilibrium, denoted by point E0 in Figure 4. At this equilibrium, the unemployment rate is u0 and the tax rate is t0 Now suppose that the replacement ratio β is reduced. The chain reaction of resulting effects is illustrated in the figure. In this exercise we assume—as is usually the case in practice—that the elasticity of labor demand is less than minus 1: (∂ρ/∂w) (w/ρ)< -1. This assumption is needed because the wage has a direct, negative effect on the employment probability ρ*. but it also has two countervailing effects on the proportion ρ* of constructive job searchers, since it raises the return from constructive search by raising the wage and reduces that return by reducing the employment probability ρ*. If the elasticity of labor demand is less than minus 1, the latter of these countervailing effects dominates the former, and consequently a rise in the wage unambiguously raises the unemployment rate.

Figure 4.Labor Market Equilibrium and the Tax-Benejil Multiplier

The impact effect of a fall in the replacement ratio ρ is described by equation (12). For any given tax rate t. a fall in ρ has three effects on the unemployment rate: (1) it has a direct expansionary effect on the proportion θ* of the labor force engaged in constructive job search; (2) it puts downward pressure on the negotiated wage (via α), raising expected wage income and thereby stimulating ihe proportion θ* indirectly; and (3) it increases the degree of labor market tightness, via the wage. Through all three channels, the unemployment rate falls: (∂u*(t)/∂β) > 0. Thus the UE curve shifts downward from UE to UE’ in Figure 4. At the initial equilibrium tax rate to, the unemployment rate consequently falls from u0to u1, in the figure.

Furthermore, the government budget constraint shifts upward from GBC to GBC’ in the figure. The reason is given by equation (13”): at any given unemployment rate u, the lower is the replacement ratio β, the lower must be the tax rate t in order for government spending on unemployment benefits to remain equal to tax receipts.

The resulting sequence of unemployment multiplier effects is straightforward. The fall in the replacement ratio ρ and the consequent decline in the unemployment rate from u0 to u1 reduce the government’s unemployment benefit payments and broaden the tax base, and thereby lead to a fall in the equilibrium tax rate. By equation (13’), for a given unemployment rate (1 - θρ) and employment rate 9p, the fall in the tax rate induced by a fall in the replacement ratio is

This initial drop in the tax rate is illustrated by the movement from t0 to t1 in the figure.

The fall in the tax rate, in turn, raises the proportion θ* of constructive job searchers, which leads to a fall in the associated unemployment rate

by equation (12), and increases the employment rate by an equal amount. This calls for a further fall in the tax rate (by equation (13’)), and so on.

The upshot is a tax-benefit multiplier, whereby a reduction in the replacement ratio leads to a succession of tax cuts, in response to the induced employment and unemployment repercussions. By equation (13’), this multiplier is13

On account of the tax-benefit multiplier, the labor market equilibrium moves from E0 to E1, in Figure 4.

We now turn to the role of policy complementarities in this labor market.

III. Policy Complementarities

The model above describes a network of complementarities among various labor market institutions, such as unemployment benefits, firing costs, and barriers to job creation, which implies an analogous network of complementarities among labor market policies.

We will examine the complementary influences of the following policies on unemployment;

  • job creation policies to reduce barriers to job creation K, for example, through tax reform or relaxation of regulations governing the entry and exit of firms;
  • reform of job security legislation policies to reduce the firing cost ratio 0;
  • search-promoting policies to reduce labor market search costs, which we capture through shift parameters ε0. ρ0, and e0 of the functions ε, ρ, and e, respectively.14 These policies include job counseling, information provision to unemployed workers and firms with vacancies, and mobility-promoting measures such as relocation subsidies or travel grants;
  • unemployment benefit reform to reduce the replacement ratio β; and
  • reform of the wage bargaining system to reduce the bargaining strength of incumbent employees (μ).

Whereas some of these policies can be implemented through legislative changes, others—especially the search-promoting measures—require government spending to be put into effect. For simplicity, we reinterpret the replacement ratio ρ to include such government spending on the relevant unemployment policies.

Our main thesis regarding the effectiveness of the unemployment policies above may be summarized by the following proposition:

Proposition 1: For the labor market equilibrium described by equations (11), (12), and (13’), the labor market policies given above are complementary, that is, they have a greater effect on unemployment when implemented in conjunction than in isolation.

The policy complementaries are implicit in equations (11), (12), and (13’); some of the main ones are illustrated in Figure 5. For example, suppose that the labor market is initially in equilibrium, whereupon the unemployment benefit b is reduced, implying a fall in the replacement ratio β.

Figure 5.Policy Complementarities

This change has two effects on the unemployment rate: (1) a direct effect whereby a fall in the replacement ratio raises the proportion of constructive job searchers (pictured by the arrow from β to θ) and thereby reduces the unemployment rate; and (2) an indirect effect whereby the fall in the replacement ratio reduces the wage (pictured by the arrow from β to w) and thereby raises the employment rate and reduces the unemployment rate.15 Observe that, by equations (5) and (8), the direct effect can be amplified by a drop in the firing cost φ, through policies that reduce the market power of employees (thereby reducing μ),16 and through search-promoting measures that increase ρ0. By the government budget constraint (equation (13’)), this amplification permits a fall in the tax rate t, which (by equation (5)) further amplifies the unemployment effect of the fall in the replacement ratio. Finally, job creation measures that reduce k and search-promoting measures that raise ε0 both serve to increase the degree of labor market tightness θ (by equation (11)), thereby raising the employment probability ρ. which also amplifies the unemployment effect above.

Figure 4 offers another way of visualizing these complementarities. Specifically, consider the complementarities between unemployment benefit reform (reducing β) and the job creation measures (reducing k). As shown in Section II, a fall in the replacement ratio β shifts the UE curve downward and the GBC curve upward in the figure, giving rise to a tax-benefit multiplier. The size of this multiplier depends on the relative slopes of the UE and GBC curves. A fall in k leaves the GBC curve unchanged but increases the slope of the UE curve. To see this, observe that, for any given tax rate r, the effect of the replacement ratio on the unemployment rate is

by equation (12). Also note that (∂τ*/∂k) < 0, by equation (11); thus, (∂ρ(τ*)/(∂K) < 0. Furthermore, expected income ρ(τ*)αa/(1 — φ) is inversely related to k since the elasticity of demand is less than minus 1. Consequently, (∂2u*/∂ρ∂k)> 0.

In other words, a fall in barriers to job creation k makes the UE curve steeper and thereby increases the tax-benefit multiplier. This means that a fall in the replacement ratio P has a more powerful contractionary effect on unemployment when it is accompanied by reductions in barriers to job creation k than when it is implemented in isolation.

Analogous arguments can be made with regard to the complementarities among the other policies above.17 These complementarities are summarized as follows:18

Policy Complementarities

where γ i, = 1,2,3 is defined as γ1 = ε°, ε2 = ρ0. and γ1 = e0.

The following corollary of proposition 1 provides a different perspective on the policy complementarities:

Corollary 1: In the context of the model, a restrictive labor market policy—such as one leading to a high firing cost ratio φ, a high replacement ratio ρ. high labor market search costs (ε0, ρ0, and e0), or a high cost of job creation k—reduces the effectiveness of the other labor market policies.

In other words, a single severe institutional rigidity can sabotage all other efforts at labor market reform. This result is also evident from Figure 4. A high replacement ratio β. for instance, means that the slope of the UE curve will be flat. (In the extreme case in which P = I, the UE curve is horizontal.) Consequently, policies that reduce barriers to job creation tc will have little effect on the unemployment rate. Once again, the same may be said of other combinations of unemployment-reducing policies and restrictive labor market practices.

Proposition I has an important implication for the interaction between “active” and “passive” unemployment policies. According to the usual usage, active policies are those that provide the unemployed with incentives to find jobs, whereas passive policies are ones that provide income support for those who do not find jobs. For example, job counseling that reduces job search costs e0 is an active policy, whereas the unemployment benefit system that determines the replacement ratio P is a passive policy. The interdependence of active and passive policies may be summarized as follows:

Corollary 2: The more generous are passive unemployment policies, the less effective will be active unemployment policies.

In terms of the example above, the greater is the replacement ratio β, the smaller will be the effect of the job counseling (that reduces e0) on the unemployment rate. Corollary 2 provides a possible explanation for why many European countries with generous passive unemployment policies have had so little success with their active ones.

It is, however, important to note that a motivation for some existing institutional rigidities, such as unemployment benefits and firing costs, is to provide support for the unemployed and job security for the employed: thus policies that reduce these rigidities must be accompanied by further measures that address these distributional objectives. After all, reductions in unemployment are rarely if ever the only objective of labor market policymakers. The challenge of policy formulation is to find a set of complementary reforms that have a powerful joint effect on unemployment without creating a socially undesirable widening of the distribution of income. Before addressing the distributional issue (in Section V), the next section extends our analysis to consider complementarities between the policies discussed above and those affecting human capital acquisition.

IV. Extensions

Since high unemployment tends to be a problem concentrated particularly among unskilled workers, we now broaden the model to include the distinction between unskilled and skilled workers and the training process whereby the former turn into the latter. In this context, we show how the effect of human capital acquisition costs on the unemployment rate is magnified by each of the institutional rigidities considered above, implying that the unemployment-reducing policies discussed above are complementary with those that reduce the cost of acquiring skills. We will also examine the unemployment effect of minimum wages.

Complementarities with the Costs of Human Capital Acquisition

Let the exogenously given labor force L be divided into Ms skilled and Mn unskilled workers (where the subscript n stands for “not skilled”), and let the aggregate number of vacancies be divided into Vs skilled ones and Vn unskilled ones. Only skilled employees are capable of working at skilled jobs; in case of a match, each skilled employee generates a real revenue as. Both the unskilled and skilled employees are capable of working at the unskilled jobs, where the real revenue per person is an, with an < as. We assume that employers are able to distinguish between skilled and unskilled workers prior to making specific matches, so that employers search exclusively among skilled workers to fill their skilled vacancies. Let θs*

and θn*
be the proportion of the skilled and unskilled workforces (respectively) that are engaged in constructive job search. Then the ratio of constructive job searchers to vacancies in the skilled sector is θs*Ms/Vs;
but in the unskilled sector it is θs*(LMs)/Vn,
as those skilled workers who are unable to find skilled jobs are available for unskilled ones.19

Let εs, and εn be the probabilities that a skilled vacancy is matched by a skilled worker and that an unskilled vacancy is matched by an unskilled worker, respectively. These probabilities are

where 0 ≤ εi ≤ 1, and έi > 0 for 0 < εi < 1, for i = s, n. Furthermore, the probability ρs that a skilled worker finds a skilled job and the probability ρn than an unskilled worker finds an unskilled job are

where 0 ≤ ρi ≤ 1, and ρ’i > 0 for 0 < ρi < 1, for i = s, n. Moreover, in line with the analysis of Section II. the proportions of constructive job searchers are

for i = s, n.

Let ws and wn be the wage of the skilled and unskilled employees, respectively; and let ks and Kn be the costs of supplying a skilled and unskilled vacancy, respectively. Then the profit from searching for a skilled and unskilled employee is

We assume that the wage in each sector is set after a match has taken place; it is the outcome of the following Nash bargain in the skilled and unskilled sectors: (wi (1 - t) - bi)μ (ai-wi+fi)1-μ, for i = s, n, where f = φiwi. Thus the negotiated wages in these sectors are

for i = s, n, We assume, plausibly, that φs > φn.

As above, unemployment benefits are taken to be proportional to wages: bs= βws(1-t) and bn= βwn(1-t). Consequently, the wage determination equations may be expressed as

for i = s, n, where ai is given by equation (8b). Observe that since φs > φn it follows that as / an >(1 - φs)/(1-φn) and thus the skilled wage ws, exceeds the unskilled wage wn.

Substituting the wage equations (18’) into the profit equations (17). we obtain

Since these profits are driven down to zero under free entry, the degrees of labor market tightness in the skilled and unskilled sectors are

for i = s, n where τs* = θs* Vs/ Ms and τn* = Vn/ θn* (L - Ms).

The unemployment rates for the skilled and unskilled workers are

for i = s, n. In line with the unemployment experience in market economies over the past two decades, we assume that τs* > τn*, so that the unemployment rate among skilled workers is lower than that among the unskilled. The aggregate unemployment rate is

At the beginning of the period of analysis—before matching takes place— workers decide whether or not to acquire sufficient human capital to become skilled (and thereby capable of performing skilled jobs). Workers are assumed to be heterogeneous in terms of their costs of human capital acquisition. Ordering the workers in terms of these costs, from lowest to highest, we let the cumulative distribution of the costs be approximated by a continuum given by the function c(Ms), c’ > 0 for Ms > 0. For the marginal worker of a skilled workforce MS, the expected payoff from human capital acquisition is ρsws - c(Ms), whereas the expected payoff from remaining unskilled is ρnwn. Since the marginal worker is indifferent between acquiring human capital and remaining unskilled, the equilibrium size of the skilled workforce is

taking the wage equation (18’) into account. The associated size of the unskilled workforce is, of course, Mn*=L-Mn*.

The government budget constraint now becomes

where the left-hand side stands for the government’s unemployment benefit payments and the right-hand side is its tax receipts. Substituting equations (16). (18). (19), and (22) into (23), the government budget constraint becomes

The labor market equilibrium is described by equations (16), (19), (21), (22), and (23’). Substituting equations (16), (19), and (22) into equation (21), we obtain an unemployment equilibrium equation that yields an upward-sloping UE curve, as in Figure 4. In the same vein, substituting equations (16), (19), and (22) into equation (23’), we obtain a government budget constraint that yields an upward-sloping GBC curve, also as in Figure 4.

In the context of this model, we may conceive of a training policy directed at the unemployed (for example, retraining subsidies to unemployed people) as one that reduces these people’s cost of human capital acquisition. Letting c0 be a shift parameter that increases the cost (c) of human capital acquisition, these measures may be seen as reducing c°. As for search-promoting measures, we include government spending on training measures in the coefficient β and, for the purposes of the analysis to follow, we assume that their direct contractionary effect on unemployment outweighs their indirect expansionary effect via β.

It is straightforward to show that this training policy is complementary to the policies discussed above when applied to the skilled sector (for example, reducing the barriers to job creation in the skilled sector). For instance, a job creation policy that reduces ks will increase the equilibrium degree of tightness in the skilled labor market τs* and thereby reduce the equilibrium skilled unemployment rate us* by equations (19) and (20). This influence magnifies the contractionary effect of the training policy on the unemployment rate, for any given tax rate t, by equation (21). As a result, the equilibrium tax rate t* falls, which, in turn, further increases the skilled workforce, by equation (22), which reduces the aggregate unemployment rate even further, and so on. Consequently, the training policy and the job creation policy reinforce one another: ∂2u*/∂c0∂ks) > 0.

Along the same lines, it can be shown that the unemployment effect of the training policy is augmented by

  • reform of job security legislation:∂2u*/∂c0∂φs) > 0.
  • search-promoting measures: ∂2u*/∂c0∂εs) >0, ∂2u*/∂c0∂ρ0s) >0, and ∂2u*/∂c0∂e0s) >0,
  • unemployment benefit reform: (∂2u*/∂c0∂βs) > 0 and
  • policies to reduce the bargaining strength of incumbent employees: ∂2u*/∂c0∂μs) > 0.

In short, reforms that reduce the costs of human capital acquisition for unemployed people have a smaller effect when implemented in isolation than when implemented in conjunction with the other labor market reforms discussed above.

Complementarities with a Legislated Minimum Wage

Now consider the effects of a legislated minimum wage that is binding for the unskilled workers. In other words, letting ws and wn be the negotiated wages resulting from the Nash bargaining process, as described by equation (18), and wmin be the legislated minimum wage, we assume that wn < wmin < ws.

Consequently, while the degree of labor market tightness in the skilled sector remains unchanged from the previous section (as given by equation (19)). in the unskilled sector it now becomes

On account of the minimum wage, the unskilled labor market is less tight than it would otherwise have been. Thus unskilled unemployment is higher than in the absence of the minimum wage:

The aggregate unemployment rate is higher as well:

The equilibrium skilled workforce under the minimum wage is

If we assume, as above, that the elasticity of the demand for unskilled labor is less than minus 1((ρnmin/wnmin)(wnmin/ρnmin)<1),

equation (22’) implies that the introduction of the minimum wage reduces the expected income per unskilled worker, thereby raising the skilled-unskilled expected income differential and leading to an increase in the equilibrium size of the skilled workforce. The government budget constraint in equilibrium is

where tmin is the tax rate under the minimum wage.

The labor market equilibrium is described by equations (16), (19’), (21’), (22’), and (23”).

It is straightforward to show that a fall in the minimum wage reinforces the other unemployment policies above.20 For instance, job creation measures that reduce Ks will increase the equilibrium degree of tightness in the skilled sector τs* and thereby magnify the contractionary effect of a fall in the minimum wage on the unemployment rate, at any given tax rate t. by equation (21’). This complementarity is magnified by the tax effects working through the government budget constraint (23”). Specifically, the introduction of the minimum wage raises the aggregate unemployment rate, reducing the tax base and increasing the number of people needing unemployment support; consequently, the equilibrium tax rate rises. The rise in the tax rate reduces the returns to human capital acquisition, thereby leading to a fall in the size of the skilled workforce and a corresponding rise in the unskilled workforce. As equation (21’) indicates, these effects further magnify the adverse impact of the minimum wage on the unemployment rate. For these reasons, a fall in the minimum wage will have a more powerful effect on unemployment when implemented jointly with job creation measures: ∂2u*/∂wmin ∂ks)>0.

In the same vein, it can be shown that the unemployment-reducing effect of a fall in the minimum wage is magnified by

  • reform job security legislation: (∂2u*/∂wmin ∂fs)>0
  • search-promoting measures: (∂2u*/∂wmin ∂ε0s)>0, (∂2u*/∂wmin ∂ρ0s)>0, and (∂2u*/∂wmin ∂e0s)>0,
  • unemployment benefit reform: (∂2u*/∂wmin ∂β)>0, and
  • policies to reduce the bargaining strength of incumbent employees: (∂2u*/∂wmin ∂μs)>0.

V. Redistributive Policy

As noted, a package of fundamental labor market reforms, taking advantage of the wide variety of policy complementarities, is likely to be politically feasible in most countries only if accompanied by policy changes that address the government’s distributional objectives. After all. the rationale for many of the “passive” labor market policies that contribute to the unemployment problem is that they are meant to mitigate income disparities. Thus fundamental reform generates a need to pursue the government’s equity objectives through other, more efficient, policies.

In this section, we outline one such policy approach: a conditional negative income tax. People would qualify for the negative income tax under two conditions: they must either be (1) employed at low pay or (2) unemployed and able to give evidence of constructive job search, which is one of the prerequisites for claiming unemployment benefits.

The unemployment benefit system is an inefficient way of redistributing income since not all the poor are unemployed,21 and since unemployment benefits discourage the unemployed from constructive job search. The conditional negative income tax system clearly does not suffer from the first deficiency. It does give rise to the second inefficiency but not to the same degree, since it uses income, rather than employment status, as the criterion for redistribution. When a worker finds a job, she loses all her unemployment benefits but only a fraction of her negative income taxes. Consequently, negative income taxes do less to discourage constructive job search than unemployment benefits.

Consider the unemployment effect of a switch from unemployment benefits to negative income taxes in the context of the model in Section II. For simplicity, let the negative income tax schedule be linear:

where T is the total tax payment per person, T0 is a positive constant, t is the tax rate, and y is gross income (that is, income before taxes). Let θ = θ be the proportion of the workforce engaged in constructive job search under the negative income tax (equation (24)). If the marginal employee (for θ = θ) searches constructively, then with probability p she finds a job and gets T0+ w(1 —t); and with probability (1 — p) she does not find a job and gets T0. Consequently, her return from constructive search is ρ(T0 + w(l - t)) + (1 - ρ)T0 - e(θ). If, however, she does not search constructively, she remains jobless and gets T0. Since the marginal worker is indifferent between constructive and unconstructive search, we obtain

Thus the proportion of the workforce engaged in constructive search is

Comparing equations (5) and (5’), we observe that, for any given employment probability p, wage w, and tax rate r, the negative income tax (NIT) system generates more constructive job search than the unemployment benefit (UB) system.22

Let us assume that the negative income tax payment T0 is set so as to provide the same return to an unemployed person as the unemployment benefit:

Then the resulting wage vtwill be the same as the wage (equation (8a)) under the unemployment benefit system: ŵ = w*. Consequently, by equation (11), the degree of labor market tightness τ will be the same as well: τ = t*. Thus, as long as the tax rate under the NIT system is not greater than that under the UB system, this implies that, in the labor market equilibrium, a greater proportion of the workforce is engaged in constructive job search under the NIT system than under the UB system: θ> θ*.

However, by the government budget constraint (13”), when θ > θ*, we obtain

In other words, there is more constructive job search in the labor market equilibrium under the NIT system than under the UB system, and the equilibrium tax rate is lower under the NIT system as well.

Thus, for any given tax rate r, the unemployment rate must be lower under the NIT system than under the UB system:

Accordingly, in Figure 6 the unemployment equilibrium curve under the negative income tax system {UENIT) lies below that under the unemployment benefit system (UEUB). Meanwhile, by equation (13”), the government budget constraint curve GBC is the same under both systems. Consequently, the labor market equilibrium point EUB under the UB system is associated with a lower unemployment rate than the equilibrium point ENIT under the NIT system.23

Figure 6.Equilibrium Unemployment Under the Unemployment Benefit System and the Conditional Negative Income Tax System

The advantages of the conditional negative income tax relative to unemployment benefits come into particularly sharp focus in the one-sector model of Section II. The reason is that, in this context, only the unemployed earn low income and thus only this group qualifies for the negative income tax. Now, when the negative income tax can be targeted perfectly at the unemployed, it is clear that the negative income tax system must lead to lower unemployment than the unemployment benefit system, since the former offers stronger incentives for constructive job search than the latter. In practice, of course, it is generally impossible to target the conditional negative income tax in this way.

The two-sector model of Section IV could be used to illustrate the relevant trade-offs. Suppose that in this model unskilled workers receive sufficiently low pay relative to the skilled ones, so that they join the unemployed in receiving negative income taxes. Then, if the maximum negative income tax is sufficiently large so that the unemployed receive the equivalent of what was previously their unemployment benefit, then the tax rate on skilled workers would need to be higher under the NIT system than under the UB system. In these circumstances, it is conceivable that this tax rate might be sufficiently high so that the constructive search of skilled workers is discouraged by more than the constructive search of the unskilled and tinemployed workers is encouraged, thereby leading to higher unemployment under the NIT system than under the UB system. It is easy to show, however, that for plausible parameter values this does not happen in the two-sector model (although, for brevity, we do not do so here). In this sense, both models suggest that the conditional negative income tax is more efficient in redistributing income than the unemployment benefit system.

VI. Conclusions

Our analysis suggests that complementarities among labor market policies are potentially important, and that failure to take these complementarities into account may help explain why the proliferation of recent European policy initiatives aimed at lowering unemployment appears to have had such little effect. In the absence of complementarities, incremental and piecemeal reforms could, in principle, be effective. With complementarities, however, incremental reforms (comprising small changes in policy instruments) and partial reforms (covering only a subset of institutional rigidities) are ineffective in comparison to what we have called fundamental labor market reform, which is both broad and deep.24

Given the diversity of labor market institutions and policies across Europe, and the variety of reforms already implemented, it is clear that the set of policy measures comprising “fundamental” labor market reform will differ from country to country. In many instances, a broad outline of a program of fundamental reform might include the following:

  • replacing passive income support measures with a negative income tax conditional on employment or job search to achieve distributional objectives with fewer adverse effects on incentives and employment (Snower 1995b), coupled with a substantial scaling back or elimination of existing measures of passive income support;
  • reducing payroll taxes, particularly for low-wage workers;
  • liberalizing job security legislation;
  • reducing wage rigidities (such as those arising from minimum wages or broad coverage of union wage agreements) to allow wage differentials to better reflect productivity differences;
  • implementing measures to increase incentives for the acquisition and provision of training, including allowing unemployed workers to transfer benefits for training vouchers (Snower, 1995a);
  • introducing longer-run reforms to education systems to better prepare students for the transition to work; and
  • taking measures to lower search costs by increasing worker mobility, including reforms in the housing market and in the portability of pensions.

The foregoing is, of course, only illustrative. Some of the above measures are irrelevant to some countries and, in any case, the relevant range of policy complementarities depends crucially on a country’s institutional structure.

Why are examples of fundamental reform not more common? Although some countries have made progress in improving the functioning of labor markets,25 the majority of European countries have not carried out packages of “broad” and “deep” reforms. One reason why policymakers have not attempted to implement fundamental labor market reforms may simply be that they have not sufficiently appreciated the importance of complementarities among labor market policies. There are also political economy explanations (Saint-Paul, 1993), although broad-based labor market reform may not be as politically difficult as commonly supposed. A coherent reform program that emphasizes the complementarities among different policies and addresses distributional concerns more efficiently could help to generate a constituency in favor of labor market reforms. This might reflect, for example, that fundamental reform might be perceived as more likely to succeed than piecemeal reforms, or it might be less vulnerable to determined opposition from well-organized interest groups if the burden of reform was spread across a wider segment of the population.26

Complementarities among policies and institutions are also important in other areas, such as trade liberalization and the transition from central planning to a market economy. Although these complementarities have not been formally analyzed, they have been explicitly recognized as important in the design of reform strategies. Piecemeal reforms, such as marginally reducing tariffs without lowering nontariff barriers, or privatizing without ensuring competition and introducing the legal framework of a market economy, for example, are widely recognized as unlikely to be effective. As with labor market reform, these are also areas where political economy issues are important. Governments have had the most success in trade liberalization and in the transition process when they have fostered a constituency for fundamental reform across a broad range of policies. The same is likely to be true in the area of labor market reforms,


    AlogoskoufisGeorge and others1995Unemployment: Choices for Europe (London: Centre for Economic Policy Research).

    BentolilaSamuel and GiuseppeBertola1990‘Firing Costs and Labour Demand: How Bad is Eurosclerosis?”Review of Economic StudiesVol. 57 (July) pp. 381-402.

    • Crossref
    • Search Google Scholar
    • Export Citation

    BentolilaSamuel and Juan J.Dolado1994“Labour Flexibility and Wages: Lessons from Spain,”Economic PolicyVol. 18 (April) pp. 53-99.

    BentolilaSamuel andGillesSaint-Paul1994“A Model of Labour Demand with Linear Adjustment Costs,”Labour EconomicsVol. 1 (September) pp. 303-26.

    • Crossref
    • Search Google Scholar
    • Export Citation

    BertolaGiuseppe and AndreaIchino1995“Crossing the River: A Comparative Perspective on Italian Employment Dynamics,”Economic PolicyVol. 21 (October) pp. 361-420.

    • Search Google Scholar
    • Export Citation

    BlanchardOlivier and others1995Spanish Unemployment: Is There a Solution? (London: Centre for Economic Policy Research).

    CalmforsLars1994“Active Labor Market Policy and Unemployment— A Framework for the Analysis of Crucial Design Features,”OECD Economic Studies No. 22 (Spring) pp. 7-47.

    • Search Google Scholar
    • Export Citation

    CardDavid andAlan B.Krueger1995Myth and Measurement: The New Economics of the Minimum Wage (Princeton, New Jersey: Princeton University Press).

    • Search Google Scholar
    • Export Citation

    EvansLewis and others1996“Economic Reform in New Zealand, 1984-95: The Pursuit of Efficiency,”Journal of Economic LiteratureVol. 34 (December) pp. 1856-902.

    • Search Google Scholar
    • Export Citation

    HenryS.G.B. andMarikaKaranassou1996“The U.K. Labor Market: Analysis of Recent Reforms,”in Economic Policies and Unemployment Dynamics in Europeed. byS.G.B.Henry andDennis J.Snower (Washington: International Monetary Fund) pp. 150-74.

    • Search Google Scholar
    • Export Citation

    HousemanSusan N.1991Industrial Restructuring with Job Security: The Case of European Steel (Cambridge, Massachusetts and London: Harvard University Press).

    • Search Google Scholar
    • Export Citation

    International Monetary Fund1994World Economic OutlookMay1994:A Survey by the Staff World Economic and Financial Surveys (Washington).

    • Search Google Scholar
    • Export Citation

    International Monetary Fund1996World Economic Outlook October 1996: A Survey by the Staff World Economic and Financial Surveys (Washington).

    • Search Google Scholar
    • Export Citation

    KatzLawrence F. andBruce D.Meyer1990‘The Impact of the Potential Duration of Unemployment Benefits on the Duration of Unemployment,”Journal of Public EconomicsVol. 41 (February) pp. 45-72.

    • Crossref
    • Search Google Scholar
    • Export Citation

    LindbeckAssar1995“Hazardous Welfare-State Dynamics,”American Economic Review Papers and ProceedingsVol. 85 (May) pp. 9-15.

    LindbeckAssar1996“The West European Employment Problem,”Weltwirtschaftliches ArchivVol. 132 (No. 4) pp. 609-37.

    LjungqvistLars andThomas J.Sargent1995“The Swedish Unemployment Experience,”European Economic ReviewVol. 39 (May) pp. 1043-70.

    MayhewKen1991“The Assessment: The UK Labour Market in the 1980s,”Oxford Review of Economic PolicyVol. 7 (Spring) pp. 1-17.

    MoffittRobert1992“Incentive Effects of the U.S. Welfare System: A Review,”Journal of Economic LiteratureVol. 30 (March) pp. 161.

    • Search Google Scholar
    • Export Citation

    NeumarkDavid andWilliamWascher1995“The Effect of New Jersey’s Minimum Wage Increase on Fast-Food Employment: A Re-Evaluation Using Payroll Records,”NBER Working Paper No. 5224 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation

    Organization for Economic Cooperation and Development1994aJobs Study (Paris).

    Organization for Economic Cooperation and Development1994bOECD Economic Surveys Netherlands (Paris).

    Organization for Economic Cooperation and Development1995aOECD Economic Surveys France (Paris).

    Organization for Economic Cooperation and Development1995band1996OECD Employment Outlook (Paris).

    • Export Citation

    RamaswamyRamana and EswarPrasad1994“Shocks and Structural Breaks: Labor Market Reforms in the United Kingdom,”IMF Working Paper 94/152 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

    Saint-PaulGilles1993“On the Political Economy of Labor Market Flexibility,”in NBER Macroeconomics Annualed. byOlivier J.Blanchard andStanleyFischer (Cambridge, Massachusetts: MIT Press) pp. 151-95.

    • Crossref
    • Search Google Scholar
    • Export Citation

    Saint-PaulGilles1994“Do Labor Market Rigidities Fulfill Distributive Objectives? Searching for the Virtues of the European Model,”Staff PapersInternational Monetary FundVol. 41 (December) pp. 624-42.

    • Crossref
    • Search Google Scholar
    • Export Citation

    SnowerDennis J.1995a“The Simple Economics of Benefit Transfers,”IMF Working Paper 95/5 (Washington: International Monetary Fund).

    SnowerDennis J.1995b“Unemployment Benefits Versus Conditional Negative Income Taxes,”IMF Working Paper 95/65 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation

    SnowerDennis J. and Pilar DiazVazquez1996“Unemployment and Job Security” (unpublished).

    U.S. Department of Labor Employment and Training Administration1989“A Guide to Advance Notice of Closings and Layoffs: The Worker Adjustment and Retraining Notification Act (WARN)” (Washington: U.S. Government Printing Office).

    • Search Google Scholar
    • Export Citation
1It also gives insiders more leverage in pushing up wages—their own wages and those of new entrants—and thereby discourages job creation even further.
2This unsuccessful experience has been widely documented. See, for example, Katz and Meyer (1990), Houseman (1991). and Moffitt (1992).
3See, for example, Lindbeck (1996). Alogoskoufis and others (1995), IMF (1994), and OECD (1994a).
4This approach has been widely advocated; see, for example, IMF (1994) and OECD (1994a).
5There are some exceptions, such as Bertola and Ichino (1995) and Lindbeek (1996), although these do not provide a rigorous analysis of policy complementarities. See also Calmfors (1994).
6These estimates are from the OECD (1995b) and refer to 1994 or the most recent year for which data are available. To put these figures in perspective, general government fiscal deficits are estimated to have averaged 4’A percent of GDP in the European Union in 1996 (IMF, 1996), while the Maastricht deficit criteria is 3 percent of GDP.
8The sheer number of special labor market initiatives and programs may itself have adverse effects on incentives, increase moral hazard problems, and reduce the ability of the government to monitor compliance and effectively administer the various programs; see Ljungqvist and Sargent (1995).
9In other words, the cumulative distribution of constructive job search costs is approximated by a continuum given by the function elQ).
10For simplicity, we assume that employers are not taxed; including employers’ taxes would not affect the substance of our analysis.
11Since profits are reduced to zero through tree entry, each worker’s income is equal to her wage income.
12The relative slopes of these curves are determined by correspondence-principle considerations. Given the equilibrium at point E0, if the unemployment rate were above u0, the tax rate associated with this unemployment rate (on the UE line} would be greater than the lax rate that balances the government’s budget (on the GBC line), and thus it is possible to reduce the unemployment rate through a tax reduction. However, if the unemployment rale were below Up, the tax rate associated with this unemployment rate (on the UE line) would be less than the tax rate necessary to balance the government’s budget (on the GBC line), and thus such an unemployment rate is not feasible. If this condition were not satisfied in equilibrium, then it would be possible to reduce the unemployment rate to zero through a sufficiently large tax reduction.
13The multiplier is unambiguously positive since it can be shown that the denominator is positive when the labor demand elasticity is less than minus 1.
14Specifically, ε0 is a shift parameter that reduces the probability e that a vacancy is matched by a constructive searcher for any given degree of labor market tightness θ, and similarly for the shift parameters τ0 and e0.
15As discussed in the previous section, the effect of the wage on unemployment operates via τ, ρ, and θ.
16Recall that, under the assumption that the elasticity of labor demand is less than minus 1, the resulting fall in the wage will raise wage income ρw.
17Recall that the search-promoting measures involve government expenditures that, in the context of the analysis above, increase the coefficient p (reinterpreted to include these expenditures). We assume that the direct contractionary effect of these measures on unemployment outweighs their indirect expansionary effect via the increase in β.
18The policy complementarities associated with job security legislation arise because reductions in firing costs reduce unemployment in our model. However, the unemployment effect of firing costs is a matter of controversy in the literature. Bentolila and Bertola (1990) argue that, when the labor market faces permanent shocks, tiring costs tend to stimulate, rather than reduce, employment. Bentolila and Saint-Paul (1994) demonstrate that firing costs may reduce employment when the shocks are transient. Snower and Vazquez (1996) show that, when firing costs influence employment both directly (as in Bentolila and Bertola, 1990; and Bentolila and Saint-Paul, 1994) and indirectly via wage determination, their average effect on employment depends on how prolonged the shocks are. The model here does not include the possibility of firing, and thus the firing cost affects employment only indirectly via the wage. In this case, a rise in the firing cost unambiguously raises the unemployment rate.
19Skilled workers prefer skilled to unskilled jobs since—as shown below—the skilled wage ws exceeds the unskilled wage wa.
20It is important to note that, given our assumption that the labor demand elasticity is less than minus 1, a fall in the minimum wage unambiguously stimulates employment. This issue is subject to heated debate in the literature (see Card and Krueger, 1995; and Neumark and Wascher, 1995). In our model, a rise in the minimum wage reduces the probability of employment for a given number of constructive searchers, but it increases the number of such searchers. Our elasticity assumption ensures that the former effect on employment dominates the latter.
21This aspect lies beyond the scope of our formal analysis.
22Only when the replacement ratio is zero (β = 0) do both systems give rise to the same amount of constructive job search, for given ρ and w.
23See also Saint-Paul (1994), who presents a different model showing that it is more efficient to achieve distributive objectives through the lax and transfer system than through minimum wages and unemployment benefits. Snowcr (1995b) provides another analytical framework for evaluating the gains from replacing unemployment benefits by conditional negative income taxes.
24There is another argument for fundamental reform that lies beyond the scope of our analysis: Lindbeek (1995 and 1996) and others have argued that high levels of unemployment have become such a common feature of European economies that habits and social conventions have adjusted to them: to modify entrenched behaviors, therefore, a decisive, permanent break with past policies may be required to signal a change in regime.
25There were far-reaching reforms in the United Kingdom in the early 1980s. Although (as noted) these did not include major changes to the benefit system or corresponding income support initiatives or thoroughgoing changes in the public provision of education and training, there is some evidence that these reforms have lowered the long-run equilibrium rate of unemployment. Perhaps the best example of fundamental reform, one that incorporated many of the points highlighted above, is New Zealand (Evans and others. 1996). The unemployment rate in New Zealand fell a remarkable 5 percentage points from early 1992 to late 1995, with little evidence of heightened wage pressures.
26It is also clear that labor market reforms will be easier to implement in a growing economy.

Other Resources Citing This Publication