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Gilles Saint-Paul is a researcher with CERAS and DELTA and a fellow of the Center for Economic Policy Research. DELTA is a joint research unit of ENS-CNRS-EHESS. This paper was written while he was a visiting scholar at the IMF’s Research Department. Its main theme was suggested by David Coe and Robert Ford, and it has benefited from discussions with José De Gregorio.
For an analysis of the political issues in increasing labor market flexibility with an emphasis on complementarities, see Saint-Paul (1993).
In principle, the problem could be alleviated by raising the tax rate in the skilled market, in accordance with the prescriptions of optimal second-best taxation.
This would be the case in an open economy with capital mobility. The marginal product of capital would then be equal to the world rate of interest.
As emphasized by Ortega (1993), 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.