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Research Department, and Birkbeck College (University of London) and CEPR, respectively. This paper, which was written while Dennis Snower was a visiting scholar in the Research Department, was presented at the conference on “Unemployment and Policies Towards It” at the European University Institute, Florence, Italy, 12-13 April 1996. We thank conference participants, Pierre-Richard Agenor, and Hemming Larsen for comments, and Claire Adams and Toh Kuan for research assistance.
It also gives insiders more leverage in pushing up wages - their own wages and those of new entrants - and thereby discourages job creation even further.
These 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 expected to average 4 percent of GDP in the European Union in 1996 (IMF, 1995), while the Maastricht deficit criteria is 3 percent of GDP.
The 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).
In other words, the cumulative distribution of constructive job search costs is approximated by a continuum given by the function e(θ).
For simplicity, we assume that employers are not taxed. Including employers’ taxes would not affect the substance of our analysis.
Since profits are reduced to zero through free entry, each worker’s income is equal to her wage income.
The relative slopes of these curves is 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 tax 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. On the other hand, if the unemployment rate were below u0, 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. (Clearly, 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.)
The multiplier is unambiguously positive since it can be shown that the denominator is positive when the labor demand elasticity is less than -1.
Specifically, ε° is a shift parameter that reduces the probability (ε) that a vacancy is matched by a constructive searcher for any given degree of labor market tightness (τ), and similarly for the shift parameters ρ° and e°.
As discussed in the previous section, the effect of the wage on unemployment operates via τ, ρ, and θ.
Recall that, under the assumption that the elasticity of labor demand is less than -1, the resulting fall in the wage will raise wage income ρw.
Recall that the search-promoting measures involve government expenditures which, in the context of the analysis above, increase the coefficient β (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.
It is important to note that the 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, firing costs tend to stimulate, rather than reduce, employment. Bentolila and Saint-Paul (1994) show 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. Then a rise in the firing cost unambiguously raises the unemployment rate.
Skilled workers prefer skilled to unskilled jobs, since - as shown below - the skilled wage ws, exceeds the unskilled wage wn.
It is important to note that, given our assumption that the labor demand elasticity is less than -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 later.
This aspect lies beyond the scope of our formal analysis.
Only when the replacement rate β = 0 do both systems give rise to the same amount of constructive job search, for given ρ and w.
See also Saint-Paul (1994), containing a different model showing that it is more efficient to achieve distributive objectives through the tax and transfer system than through minimum wages and unemployment benefits. Snower (1995b) provides another analytical framework for evaluating the gains from replacing unemployment benefits by conditional negative income taxes.
There is another argument for fundamental reform that lies beyond the scope of our analysis: Lindbeck (1995, 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 adjust to them; to modify entrenched behaviors, therefore, a decisive, permanent break with past policies may be required to signal a change in regime.
There 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 (Kasper, 1995). 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.
It is also clear that labor market reforms will be easier to implement in a growing economy.