Abstract
The distributional effects of the minimum wage are analyzed in a model where skilled and unskilled labor enter the production function. It is argued that distributional goals are best achieved by letting the labor market clear and achieving redistribution through taxes and transfers.
I. Introduction
Europe is at a crossroad. With unemployment above 10 percent for more than 10 years and sharply rising, the issue of labor market flexibility is back in the political debate. Yet few measures have actually been undertaken; caution and sluggishness are the salient characteristics of most labor market reforms on the continent. Behind this paralysis lies the fear that labor market flexibility would require adopting the “American model,” with full employment being achieved at the cost of large, socially unacceptable income inequalities. This argument is present in recent policy proposals to reduce unemployment that focus primarily on reducing non-wage labor costs with considerably less emphasis on more fundamental reforms of labor market regulations and unemployment benefit regimes. According to this view, sticking to the status quo is justified by the fact that the current set of labor market rigidities achieves socially desirable redistributive goals. 2/
This paper is a critique of this view. The bottom line is that these goals may be achieved at a much lower cost using more traditional tax and transfer instruments. This, even taking into account the distortionary impact of these instruments. Only for implausibly high values of distortions can we find some redistributive virtues to labor market rigidities.
The institution on which we focus is the minimum wage. It is unimportant in some European countries such as Germany, but pervasive in others such as France. 3/ Section II details the distortions introduced by the minimum wage, and argues that even abstracting from alternative forms of redistribution, an increase in the minimum wage may well have adverse impacts on inequality. This is because while 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 on output and inequality of two alternative systems. One is a minimum wage associated with unemployment benefits. The second is a simple system of taxes and transfers. It is shown that the second system typically allows to achieve the same level of inequality 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/transfer” 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 inequality target, it may well be the case that the 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. It is shown that this is more likely to happen when there is low turnover, which is precisely the case where the tax system is much more egalitarian than the minimum wage system. This is because the employed enjoy so much job protection that they do not take into account the increased welfare of the unemployed when computing their gains from shifting to the new system. The analysis suggests that “politico-economic complementarities” may arise across labor market rigidities: there will be more political support for the minimum wage if turnover is lower. 4/ The simulations suggest, however, 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/transfer system dominates 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. Section VII contains concluding comments.
II. The Effects of Minimum Wages
In this section we enumerate various channels through which the minimum wage may have perverse effects. These effects arise either because it lowers the efficiency of the economy or because it does not achieve the redistributive role it is supposedly assigned. They are all present in the model developed below.
First, the minimum wage creates unemployment among the unskilled, thus reducing output. Whereas it raises the welfare of those who keep their jobs, it lowers the welfare of those who lose jobs. It is therefore not obvious whether it actually reduces inequality. This depends on the level of unemployment compensation (the replacement ratio is around 0.6-0.7 in Europe). It also depends on what is meant by inequality. If one takes the Atkinson (1970) measure of inequality as representative of the preferences of society, it is easy to see that for a high index of inequality aversion, the minimum wage will actually increase inequality. This is because such an index puts a lot of weight on the poorest, i.e., the unemployed. On the other hand, a moderate index of inequality aversion will imply that an increase in the minimum wage will reduce inequality.
Second, the minimum wage reduces the income of skilled workers. This is because, as long as there is (even a small amount of) complementarity between the skilled and the unskilled, a lowering of the unskilled input in production reduces the marginal product of the skilled.
Third, the minimum wage makes labor taxation more distortionary in the unskilled labor market. Figure 1 illustrates this point. In the absence of the minimum wage, equilibrium would be determined by the intersection of the labor supply and labor demand schedules. The labor supply schedule is likely to be quite inelastic, that is, not very far from vertical. Introducing a tax would only reduce employment by a small amount. The economy would move from point E to point A along the labor demand curve and point B along the labor supply curve, with taxes equal to the vertical distance AB. Wages would be determined by point B’s vertical coordinate, and would fall almost one for one to match the increase in the tax. Introducing a minimum wage is equivalent to replacing, from the employer’s viewpoint, the labor supply curve LS with a horizontal line MM. Employment then reacts to the tax wedge as if its supply were infinitely elastic at the minimum wage level. Introducing a tax would move the economy from E’ to A’, with a large decline in employment.
Minimum Wage Regulation and the Distortionary Impact of Taxation
Citation: IMF Working Papers 1994, 046; 10.5089/9781451973853.001.A001
Minimum Wage Regulation and the Distortionary Impact of Taxation
Citation: IMF Working Papers 1994, 046; 10.5089/9781451973853.001.A001
Minimum Wage Regulation and the Distortionary Impact of Taxation
Citation: IMF Working Papers 1994, 046; 10.5089/9781451973853.001.A001
Labor taxes such as social security contributions are often blamed as a culprit for unskilled unemployment. But they have this effect only because other rigidities are present in the labor market. In the model developed below, this magnifies the direct distortionary impact of the regulation. To prevent inequality from rising too much with unemployment, one must have unemployment benefits, which are financed by means of a labor tax. This tax further reduces output and employment because the very existence of the minimum wage makes it distortionary. 5/
Fourth, the redistributive properties of the minimum wage are affected by other forms of labor market rigidities. In particular, labor turnover, which depends on firing/hiring costs and job protection legislation, is crucially related to the distributional impact of the minimum wage. In a high turnover world, income is on average equally shared among members of the unskilled labor force. While the employed earn more than the unemployed, they will soon switch positions. Therefore, the minimum wage has a small impact on inequality among the unskilled. By contrast, if turnover is very low, the employed expect to keep their jobs for a long time and reap most of the benefits of an increase in the minimum wage. Those unlucky enough to join the larger pool of unemployed workers will lose, and stay in that pool for a long time. In that case the minimum wage is more likely to be unegalitarian.
The irony is that the minimum wage is often associated with high job protection and low mobility. This suggests that labor market rigidities may be associated with less philanthropic goals than income redistribution, a point to which we return in Section IV.
III. A Simple Model
In this section we develop a simple model to analyze the effect of the minimum wage on output, income distribution, unemployment, and welfare. There are two types of labor: skilled and unskilled. These are the only inputs into the production function. In the long run, there is no loss of generality associated with ignoring capital as long as the long-run capital stock is pinned down by the condition that its marginal product must be equal to some exogenous required return. 6/
The production function is assumed to be CES in both inputs:
where subscripts 1 and 2 denote skilled and unskilled labor, respectively, α ϵ ] -∞, 1] is an index of complementarity between the two types. If α=l then they are perfect substitutes and unskilled labor cannot artificially raise its price above market clearing levels. If α is less than 1, then unskilled labor can achieve welfare gains by increasing its price at the expense of skilled labor’s earnings. The more the two inputs are complementary, the less the demand for unskilled labor will fall when its price rises. We also typically assume that ρ is low enough to ensure that the skilled earn more than the unskilled. 7/ Total labor force is normalized to 1, with x skilled workers and (1-x) unskilled workers. Each worker is endowed with 1 unit of labor, which has no disutility.
We shall consider two systems. In system A, there is a minimum wage which is above the market clearing level for unskilled workers. Labor is taxed at a flat rate, and the proceeds are used to finance unemployment benefits. In system B, there is no minimum wage and both markets clear. Labor is taxed at a flat rate to finance a transfer to the unskilled. We shall compare both systems from three points of view: efficiency, income distribution, and political incentives.
If taxation were nondistortionary, then system B would clearly dominate system A, since full employment would prevail and a high enough tax rate would achieve whatever distributional goal is set by society. Therefore, it is only when taxation is distortionary that the comparison is not obvious.
We introduce tax distortions by assuming that a dollar of tax levied generates less than a dollar of transfers. More specifically, I assume that a dollar of taxes generates (1-ϕ(τ)) dollars of transfers, where τ is the tax rate, and ϕ is an increasing, convex function of τ. This loss can be thought of as a tax collection/processing cost. An alternative approach would be to introduce an elastic labor supply curve. The approach taken here gives an advantage to the minimum wage: it redistributes income directly without having to incur the collection cost. This advantage will, however, be insufficient.
1. World A
Let us first consider the outcome under system A. Let
The cost of employing an unskilled is equal to
Using (2), (3) can be inverted to compute L2:
The unemployment rate for unskilled workers u2 is then computed as:
The (pretax) skilled wage is determined as the marginal product of skilled labor at full employment:
This essentially closes the model. In order to make some welfare comparisons let us define the consumption level of each group. Concerning the skilled, it is simply equal to the post-tax income:
We now turn to the unskilled. Those who are employed have a net income of
There are several ways to convert these incomes into consumption levels for the unskilled. The way we do it allows to bring one interesting parameter into the discussion, namely the extent to which the labor market is “flexible”. At one extreme, one can assume that those employed consume
In practice, redistribution between the employed and the unemployed is achieved through labor market turnover. We thus specify the employed and unemployed consumption levels in a way which allows to take into account mobility between the two states. If mobility is very high, then the initial status of an unskilled worker (employed or not) will have very little impact on his/her permanent income, which will almost be bu2 +
The permanent income of an unemployed worker is, similarly:
In a steady state with unemployment u2, inflows must be equal to outflows, implying μ = σ(1-u2)/u2. Plugging this into (9) and (10), and assuming that consumption equals permanent income yields the following rules for computing the consumption levels of the employed and unemployed unskilled workers:
where s = σ/δ. (11) and (12) tell us that the consumption levels of the employed and unemployed unskilled workers are a weighted average of the minimum wage and unemployment benefits. The weight on w is decreasing in u 2and higher for the employed. When s increases, c2e falls and c2u rises. s may be thought of as an index of labor market “flexibility”. It will tend to be lower in economies with regulations that prevent labor reallocation and turnover, such as firing restrictions, rent controls, or subsidies to declining industries. When s goes to zero, c2e goes to
In order to compare income distributions, we will use an Atkinson (1970) measure of inequality (I) with parameter ϵ ϵ ]-∞, 1]. In system A, it is equal to:
where
2. World B
We now turn to system B. In system B wages are fully flexible, implying that both the skilled and unskilled are fully employed. One therefore has L1 = x and L2 = (1-x). Pretax wages are then equal to marginal products:
Taxes are used to finance a transfer to the unskilled. Let a be the amount of the transfer per unskilled worker. Then the budget balance equation implies that:
The skilled consumption level is then given by c1 = w1 (1-τ), while the unskilled consumption level is given by c2 = w2(l-τ)+a. The Atkinson inequality index is then given by:
where aggregate consumption is
The points made in the previous section are apparent from the above equations. An increase in
The net effect of the minimum wage on inequality is therefore ambiguous. At low levels of unemployment benefits, it will tend to increase inequality. At high levels of unemployment benefits, it will tend to reduce it.
That the minimum wage increases the distortionary impact of taxes is also clear if one compares (15)-(18) with (1)-(14). In system A, taxes have no effect on output since there is full employment in both markets. They reduce consumption, however, because of the collection cost. A 1 percent increase in the tax rate would be matched by a 1 percent drop in post tax wages so as to leave w1 and w2 unaffected (equation (15)-(16)). The economy would remain at full employment with the same level of output. Consumption would drop by -ϕ’(τ)/(l-ϕ(t)) percentage points. In system A, the unskilled’s post tax wage cannot drop, so a 1 percent increase in the tax rate has to be matched by an increase in u2 (equations (3)-(4)). This introduces an additional distortion, since output drops: everything works as if the unskilled’s labor supply, which was inelastic under system B, were infinitely elastic (cf. Figure 1). Furthermore, a 1 percent increase in τ generates a drop in the skilled after tax wage which is larger than 1 percent. This is because their pretax wage falls due to the fall in L 2 (equation (6)).
IV. Model Calibration
The preceding discussion suggests that the minimum wage is a powerful tool to redistribute income from the skilled to those unskilled workers who remain employed. In this section we calibrate the model and answer the following question: can system B achieve the same inequality level as system A at a lower cost in terms of distortions? Given the model’s simplicity, it is not easy to define what “realistic” parameter values should be. However, this is not very important because the results are robust to a wide range of variations in those values.
Table 1 presents the set of parameter values for the benchmark simulation. Concerning the proportion of skilled workers x, x=1/2 was chosen. 9/ The production function parameters α and ρ were calibrated so as to imply w1/w2 = 2 under system B, meaning that the average income of the 50 percent richest is two times the average income of the 50 percent lowest. This leaves one degree of freedom for α, which, given the moderate elasticities of labor demand implied by econometric studies, was not allowed to exceed 0.2. ϵ, the exponent in the inequality measure is fixed to -1, but results are very robust to wide variations in ϵ. Last, the index of labor mobility s is 1, which may seem on the low side. Recent work on labor turnover (Burda and Wyplosz (1993), Davis and Haltiwanger (1992), Blanchard and Diamond (1991)) suggests a job destruction rate of around 10 percent, which, with a real interest rate of 5 percent, would imply s=2. However, one has to take into account the fact that the labor market is very heterogeneous: a lot of this high turnover rate is probably due to a “secondary tier” of workers with very low job security and high turnover. Most of the people in employment probably have a transition probability to unemployment of less than 10 percent. s=1 therefore seems a better estimate. Concerning tax distortions, a linear specification ϕ(τ) = ϕτ was chosen. A wide range of values for ϕ was tried, with little change in results. ϕ=1 was retained in the benchmark simulations. It implies a Laffer curve peaking at τ=0.5 in the full employment case, less than that under system A. Higher values of ϕ therefore seem rather implausible.
Parameter Values of the “Benchmark Simulation”
Parameter Values of the “Benchmark Simulation”
| Index of complementarity | α | 0.2 |
| Unskilled labor productivity parameter | ρ | 0.03125 |
| Labor market flexibility | s | 1 |
| Income inequality parameter | ϵ | -1 |
| Proportion of skilled workers | x | 0.5 |
| Tax distortion | φ | 1 |
Parameter Values of the “Benchmark Simulation”
| Index of complementarity | α | 0.2 |
| Unskilled labor productivity parameter | ρ | 0.03125 |
| Labor market flexibility | s | 1 |
| Income inequality parameter | ϵ | -1 |
| Proportion of skilled workers | x | 0.5 |
| Tax distortion | φ | 1 |
Table 2 reports the basic results from the benchmark simulation. The minimum wage and tax rates under system A were picked so as to generate an unskilled unemployment rate of around 20 percent, with a replacement ratio b/
Impact of a Shift From a Minimum Wage System to a Transfer System
Notes: B1 is System B with τ=0. B2 is System B with τ computed so as to achieve same level of I as in System A. I is Atkinson’s inequality measure with ϵ=-1.
Impact of a Shift From a Minimum Wage System to a Transfer System
| System B | |||||
|---|---|---|---|---|---|
| System A | B1 | B2 | |||
| Minimum wage (post tax) | 2.75 | … | … | ||
| Unskilled labor wage (pre-tax) | w2 | … | 2.53 | 2.53 | |
| Tax rate | τ | 0.045 | 0 | 0.027 | |
| Unskilled unemployment rate | u2 | 0.213 | 0 | 0 | |
| Skilled labor wage (pre tax) | w1 | 4.75 | 5.06 | 5.06 | |
| Replacement ratio | b/ | 0.514 | … | … | |
| Transfer per unskilled worker | a | … | 0 | 0.202 | |
| Income inequality | I | 0.0887 | 0.111 | 0.0887 | |
| Output | y | 3.51 | 3.80 | 3.80 | |
| Aggregate consumption | 3.5 | 3.79 | 3.79 | ||
| YB/YA | 1.081 | ||||
| cB/cA | 1.084 | ||||
Notes: B1 is System B with τ=0. B2 is System B with τ computed so as to achieve same level of I as in System A. I is Atkinson’s inequality measure with ϵ=-1.
Impact of a Shift From a Minimum Wage System to a Transfer System
| System B | |||||
|---|---|---|---|---|---|
| System A | B1 | B2 | |||
| Minimum wage (post tax) | 2.75 | … | … | ||
| Unskilled labor wage (pre-tax) | w2 | … | 2.53 | 2.53 | |
| Tax rate | τ | 0.045 | 0 | 0.027 | |
| Unskilled unemployment rate | u2 | 0.213 | 0 | 0 | |
| Skilled labor wage (pre tax) | w1 | 4.75 | 5.06 | 5.06 | |
| Replacement ratio | b/ | 0.514 | … | … | |
| Transfer per unskilled worker | a | … | 0 | 0.202 | |
| Income inequality | I | 0.0887 | 0.111 | 0.0887 | |
| Output | y | 3.51 | 3.80 | 3.80 | |
| Aggregate consumption | 3.5 | 3.79 | 3.79 | ||
| YB/YA | 1.081 | ||||
| cB/cA | 1.084 | ||||
Notes: B1 is System B with τ=0. B2 is System B with τ computed so as to achieve same level of I as in System A. I is Atkinson’s inequality measure with ϵ=-1.
It is apparent from Table 2 that system B clearly dominates system A. While it is true that in the absence of taxes under system B, it would be more unequal than system A, the tax rate needed to achieve the same level of inequality is 2.7 percent, substantially smaller than under system A. The output gain from shifting to system B is more than 8 percent, a large number. What makes a lower tax rate possible under system B is that the same level of inequality can be achieved with a lower level of the unskilled/skilled wage ratio. This is because shifting to system B automatically removes the contribution of unemployment to inequality.
Given the wide margin by which system B dominates system A in the benchmark simulation, the results are quite robust to alterations in parameter values. For example, increasing labor market mobility would reduce inequality under system A, which should be matched by an increase in τ under system B. However, τ stays well below 4.5 percent even for implausibly large values of s, so that system B still unambiguously dominates. Similarly, an increase in ϵ, which would give less weight to the poorest under system A, has only a small impact on the value of τ which achieves the same level of inequality under system B. An increase in the level of distortion φ increases system B’s dominance over system A since the tax rate is lower under system B.
Table 3 presents a simulation which was cooked in such a way to be very favorable to system A. First, a high level of mobility was chosen under system A (s=2). Second, the value of α=-0.2 implies a low demand elasticity for unskilled workers, thus lowering the impact of the minimum wage on unemployment. These two assumptions tend to make τ larger under system B. To strengthen system A’s case even further, an implausibly high value of φ=5 is assumed. This implies that for a 10 percent tax rate, half of the proceeds are lost due to distortions. While it is true that the tax rate is now higher under system B, this is insufficient to make it superior to system A. For the same level of inequality, total consumption is still 5 percent higher under system B than under system A. It is however possible to cook even more extreme examples. For example, for α=-0.5, s=5, φ=5, and
Impact of a Shift from a Minimum Wage System to a Transfer System: Searching for the Virtues of System A
Notes: See notes to Table 2. In System B, τ is set in order to preserve I the same as in System A. Parameters as in the benchmark simulation except for s=2, ϕ=5 and α=-0.2.
Impact of a Shift from a Minimum Wage System to a Transfer System: Searching for the Virtues of System A
| System A | System B | |||
|---|---|---|---|---|
| Minimum wage (post tax) | 0.05 | … | ||
| Unskilled labor wage (pre-tax) | w2 | … | 0.044 | |
| Tax rate | τ | 0.045 | 0.079 | |
| Unskilled unemployment rate | u2 | 0.199 | 0 | |
| Skilled labor wage (pre tax) | w1 | 0.08 | 0.088 | |
| Replacement ratio | b/ | 0.428 | … | |
| Transfer per unskilled worker | a | … | 0.0063 | |
| Income inequality | I | 0.0717 | 0.0717 | |
| Output | y | 0.061 | 0.0638 | |
| Aggregate consumption | 0.06 | 0.066 | ||
| yB/yA | 1.078 | |||
| cB/cA | 1.053 |
Notes: See notes to Table 2. In System B, τ is set in order to preserve I the same as in System A. Parameters as in the benchmark simulation except for s=2, ϕ=5 and α=-0.2.
Impact of a Shift from a Minimum Wage System to a Transfer System: Searching for the Virtues of System A
| System A | System B | |||
|---|---|---|---|---|
| Minimum wage (post tax) | 0.05 | … | ||
| Unskilled labor wage (pre-tax) | w2 | … | 0.044 | |
| Tax rate | τ | 0.045 | 0.079 | |
| Unskilled unemployment rate | u2 | 0.199 | 0 | |
| Skilled labor wage (pre tax) | w1 | 0.08 | 0.088 | |
| Replacement ratio | b/ | 0.428 | … | |
| Transfer per unskilled worker | a | … | 0.0063 | |
| Income inequality | I | 0.0717 | 0.0717 | |
| Output | y | 0.061 | 0.0638 | |
| Aggregate consumption | 0.06 | 0.066 | ||
| yB/yA | 1.078 | |||
| cB/cA | 1.053 |
Notes: See notes to Table 2. In System B, τ is set in order to preserve I the same as in System A. Parameters as in the benchmark simulation except for s=2, ϕ=5 and α=-0.2.
The main conclusion of this section is therefore that it is very unlikely that distributional considerations could justify the kind of rigidities that plague European labor markets.
V. Political Aspects
So far, we have assumed the existence of a “benevolent” policymaker who only cared about output and some aggregate measure of inequality. In this section, a slightly more cynical view is adopted, i.e., that unskilled employed workers support the minimum wage simply because it increases their own welfare. We first consider what happens if they can block any reform from which they lose, and then ask the question under what conditions would a shift from system A to system B which achieves the same level of inequality be “politically viable”, i.e., not blocked by the unskilled employed workers? Even if a reform is politically viable, it may be the case that relative to the skilled, the unskilled are worse off. This does not imply that they would block the reform, but it does imply that once the reform is passed, they will have incentives to lobby for a higher tax rate. In principle, this could make system B less efficient than system A. To tackle this issue, we also consider what happens when in both systems, the tax rate is set so as to maximize the welfare of the unskilled employed workers.
1. Can Reform Be Blocked?
The unskilled employed workers may lose from the reforms if system A is very rigid (i.e., a very low value of s). In that case they are little exposed to unemployment, so that they do not value at all the increase in the unemployed’s welfare generated by the reform. The inequality-preserving tax rate will then not be high enough to compensate them. A higher tax rate is necessary. The question is then: can the excess distortions created by this higher tax rate be large enough to make the shift to system B undesirable from an efficiency point of view?
Table 4 presents some elements of an answer to this question. In the top panel of Table 4, the parameters are the same as for the benchmark simulation. For low values of s, the tax rate which equalizes inequality across systems is insufficient (column 3). The politically viable tax rate (column 5) is substantially higher, but distortions are not large enough to make the shift welfare reducing (column 6). The bottom panel of Table 4 presents similar simulation in a world where tax distortions are larger (ϕ=5), while distortions from the minimum wage are smaller (α=-0.2). In that case, for low values of s there exists no tax rate which compensates the employed for a shift to system B: the tax system is politically inviable. The value of s above which it becomes viable is however quite small (0.3). In that case the shift to system B is, again, welfare improving by a wide margin.
Political Viability of Reform
Notes: τ(I) = tax rate which matches inequality under system B. P.V. = political viability index equal to the relative gain to the unskilled employed of shifting from system A to system B with tax rate τ(I).
Political Viability of Reform
| (1) | (2) | (3) | (A) | (5) | (6) |
|---|---|---|---|---|---|
| s | τ(I) | P.V. | τ(P.V.) | ||
| A: Benchmark simulation | |||||
| 0.01 | 0* | -0.075 | 1.084 | 0.0435 | 1.082 |
| 0.1 | 0.0074 | -0.03 | 1.084 | 0.0264 | 1.083 |
| 0.2 | 0.0168 | 0.00 | 1.0837 | 0.0168 | 1.0837 |
| B: ϕ=5, α=-0.2 | |||||
| 0.01 | 0* | -0.12 | 1.09 | NN** | … |
| 0.1 | 0.021 | -0.05 | 1.086 | NN | … |
| 0.2 | 0.042 | -0.01 | 1.079 | NN | … |
| 0.3 | 0.053 | +0.01 | 1.077 | 0.047 | 1.078 |
Notes: τ(I) = tax rate which matches inequality under system B. P.V. = political viability index equal to the relative gain to the unskilled employed of shifting from system A to system B with tax rate τ(I).
Political Viability of Reform
| (1) | (2) | (3) | (A) | (5) | (6) |
|---|---|---|---|---|---|
| s | τ(I) | P.V. | τ(P.V.) | ||
| A: Benchmark simulation | |||||
| 0.01 | 0* | -0.075 | 1.084 | 0.0435 | 1.082 |
| 0.1 | 0.0074 | -0.03 | 1.084 | 0.0264 | 1.083 |
| 0.2 | 0.0168 | 0.00 | 1.0837 | 0.0168 | 1.0837 |
| B: ϕ=5, α=-0.2 | |||||
| 0.01 | 0* | -0.12 | 1.09 | NN** | … |
| 0.1 | 0.021 | -0.05 | 1.086 | NN | … |
| 0.2 | 0.042 | -0.01 | 1.079 | NN | … |
| 0.3 | 0.053 | +0.01 | 1.077 | 0.047 | 1.078 |
Notes: τ(I) = tax rate which matches inequality under system B. P.V. = political viability index equal to the relative gain to the unskilled employed of shifting from system A to system B with tax rate τ(I).
While these simulations convey the qualitative message that Europe’s low labor mobility may generate political opposition to system B, Table 4 nevertheless suggests that this will only arise for very low values of the mobility parameter. Furthermore, for the benchmark parameter values, which are more reasonable than those in panel B, an increase in the tax rate can compensate the unskilled employed and leave the ranking of the two systems in terms of welfare unaffected.
2. Can Reform Lead to Too Much Expropriation?
We now consider what happens if in both systems the tax rate is endogenously determined by the unskilled employed so as to maximize their welfare. This will typically lead to much higher tax rates than the ones considered above.
In system B, the tax rate which maximizes the unskilled employed is readily computed as the solution to:
Given that w1 and w2 are unaffected by τ, the first order condition with ɸ (τ)=ɸτ yields:
With w1=2w2 and x=0.5, this is equivalent to t = 1/(3φ), which for φ=1 yields a tax rate of 33 percent.
In system A, the tax rate benefits the employed only indirectly since it is used to finance unemployment insurance. As a result, the equilibrium tax rate which prevails under system A is much lower. However, taxes are much more distortionary under system A because they reduce employment. Simulations suggest that the second effect is likely to dominate. For the benchmark simulation, the equilibrium tax rate under system A is 17 percent, but this generates an unemployment rate among the unskilled of 40 percent. This large distortionary impact makes aggregate consumption lower under system A than under system B.
However, a new interesting problem arises: skilled workers now object to the reform! This is not too surprising, since they are taxed at a rate twice higher under system B. The fact that their gross marginal product is also higher is not strong enough to outweigh this tax effect. In principle, the skilled and unskilled could agree on a future tax rate before shifting to system B. Such Pareto-improving tax rate would exist for a wide range of parameter values, as suggested in Table 4. However, if there is no commitment device to enforce this agreement, then the skilled will block the reform.
Now, this result is in some sense “cooked” because under system A we have ruled out any transfers to the unskilled employed, who decide on the tax rate. For that reason it may be useful to run a more symmetrical experiment, for example, assuming that under system A, taxes are handed out as transfers to both the employed and unemployed unskilled workers. The simulations (not reported) suggest that the tax rate will only be slightly lower under system A, and that system B unambiguously dominates system A.
VI. Other Types of Rigidities
The above discussion has focused on a peculiar type of rigidity, namely the minimum wage. More generally it is applicable to any institution (such as unemployment benefits) that allows unskilled workers to raise their compensation beyond the market clearing level. However, it may be argued that the “European Model” consists of a wide array of interventions in the labor market and that some of them may have beneficial effects. It is of course impossible to review this in detail here. Let us however discuss two common arguments about possible justifications for job protection and unemployment insurance.
The first argument is that job protection may be good for productivity and long-run growth because long-term jobs are associated with more job specific human capital than short-term jobs. Several criticisms can be made about this argument. First, there is no reason to believe that the market cannot internalize the effect of tenure on productivity. Nothing prevents firms from voluntarily providing implicit or explicit job protection, and it is indeed what is observed. As pointed out by Hall (1982), in the U.S. where no job protection is granted by the state, most jobs last a long time. Second, these supposed productivity effects of firing costs are likely to prevail in declining sectors where they are not much needed. At the same time firing costs slow reallocation toward new productive sectors. If one takes the Schumpeterian view that growth essentially comes from new goods rendering old goods obsolete, then the latter effect is likely to dominate the former. 10/ Indeed, while the latter effect is likely to be a growth effect, the former is only a level effect: a higher mean tenure is associated with a higher productivity level. Third, the productivity gains from higher job protection have to be weighted against the productivity losses from higher unemployment duration. The symmetrical idea that higher unemployment duration generates skill loss is as plausible as the idea that higher job duration generates skill gains. Fourth, the empirical evidence on the effect of tenure on wages is not very strong, particularly so given that there may be a bias since a positive association between the two variables may just be due to “good news” about match quality rather than an effect of tenure per se. 11/
The second common argument is that unemployment benefits allow workers to search longer for a better match, thus improving aggregate productivity through the distribution of matches in society. This argument is not likely to be very relevant, for the following reasons. First, unemployment does not seem to be a very productive activity in order to find a job. As Tobin (1972) argued, the employed presumably get better information about jobs than the unemployed. Moylan et al. (1982), cited by Layard et al. (1989), report that in the U.K., more than half the unemployed spend less than five hours a week looking for a job! Similarly, the mean rate of job application by the unemployed is, in the U.K., of the order of magnitude of 1 per month! 12/ Second, if waiting for better matches was that important, one would not observe the monotonously decreasing profile of exit rates from unemployment as unemployment duration increases.
VII. Conclusion
We have developed a model which allows to analyze the effect of alternative labor market regulations on the welfare of individuals according to their skill level and employment status. The model allows to discuss the desirability of labor market from the point of view of efficiency, income distribution and political feasibility. It also allows to relate this discussion to other characteristics of the economy such as labor mobility or the distortionary impact of taxation.
The model could be adapted to analyze other sorts of regulations that have a similar impact on the demand for unskilled labor, for example an unemployment benefit system which raises the workers’ reservation wage.
The general message is that there is little justification to the set of labor market regulations which now prevail in Europe. Alternative instruments such as direct taxes and transfers would be more efficient in order to achieve distributional goals. While there may be some political resistance to the reform, a properly designed package should be able to overcome this problem while still increasing the economy’s efficiency.
Why reform has been so timid therefore remains a puzzle. One may incriminate irrationality or shortsightedness, failure to recognize gains from general equilibrium effects, or uncertainty about the pace of events once reform has been passed. Analyzing these factors is a useful direction for future research.
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The author is a Researcher at DELTA (a joint research unit ENS-CNRS-EHESS), with a joint appointment with CERAS and ENPC, and is a Fellow of the Centre for Economic Policy Research. This paper was written while the author was visiting the International Monetary Fund Research Department. Its main theme was suggested by David T. Coe and Robert P. Ford, and it has benefitted from discussions with José De Gregorio. The views expressed in this paper are those of the author and do not necessarily reflect those of the Fund.
See the European Commission (1993) White Paper for recent policy proposals and Emerson (1989) for a cautious discussion on the welfare state and labor market reform.
Although there is also a minimum wage in the United States, as a percent of average wages it is relatively small by European standards and is now less than it was in 1950.
For an analysis of the political issues in increasing labor market flexibility, with an emphasis on complementarities, see Saint-Paul (1993).
Although, in principle, the problem could be alleviated by raising the tax rate on skilled labor, in accordance with the prescriptions of optimal second-best taxation. Another option is to specify the minimum wage as a pre-tax wage. France is trying to gradually shift toward such a system by replacing payroll taxes (which act as in Figure 1) with so-called “Contribution Sociale Généralisée” (CSSG)) which is levied upon all incomes, including the minimum wage and unemployment benefits.
This would be the case in an open economy with capital mobility where the marginal product of capital would be equal to the world rate of interest.
As emphasized by Ortega (1994), there is no canonical way of labeling workers as “skilled” or “unskilled” as long as they are not perfect substitutes.
Note that the model exhibits “fiscal increasing returns” as analyzed in Blanchard and Summers (1987): an increase in the unemployment rate lowers the tax base, which for a given target for unemployment benefits, calls for an increase in taxes, which leads to further increases in unemployment.
Given that there are only two skill levels in the economy, there is no clear-cut way to calibrate x. If one takes the number of people earning the minimum wage as a guideline, then 0.5 is too low for x, since the minimum wage will then be binding for 50 percent of the labor force. However, if one takes the proportion of workers with higher education as an alternative criterion, then 0.5 is too high.
See Bertola (1991).
See for example Jovanovic (1979); Abraham and Farber (1987).
