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.

Marginal Tax Wedges^a

(In percent of total income)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994a, Part II, p. 241).^a The lax wedge includes employees’ and employers’ social security contributions, persona] income taxes, and consumption taxes.

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Marginal Tax Wedges^a

(In percent of total income)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994a, Part II, p. 241).^a The lax wedge includes employees’ and employers’ social security contributions, persona] income taxes, and consumption taxes.

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Marginal Tax Wedges^a

(In percent of total income)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994a, Part II, p. 241).^a The lax wedge includes employees’ and employers’ social security contributions, persona] income taxes, and consumption taxes.

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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.

Maximum Notification and Severance Pax Periods

(In months)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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

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Maximum Notification and Severance Pax Periods

(In months)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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

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Maximum Notification and Severance Pax Periods

(In months)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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

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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).

Unemployed Benefit Replacement Ratios^a

(Benefits in percent of previous earnings, pretax)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994b, p. 87).^a In descending order, according to 1991 values.

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Unemployed Benefit Replacement Ratios^a

(Benefits in percent of previous earnings, pretax)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994b, p. 87).^a In descending order, according to 1991 values.

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Unemployed Benefit Replacement Ratios^a

(Benefits in percent of previous earnings, pretax)

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

Source: OECD (1994b, p. 87).^a In descending order, according to 1991 values.

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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 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

$\begin{array}{cc}u*=1-\rho (\tau *)e^{-1}\left[\rho (\tau *)\alpha \frac{a}{1-\phi }(1-t)(1-\beta )\right]\mathrm{.}& \left(12\right)\end{array}$

$\begin{array}{cc}u*=1-\theta *\rho (\tau *)=\frac{t}{\beta +t}\mathrm{.}& \left(\begin{array}{c}13\prime \prime \end{array}\right)\end{array}$

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.

Labor Market Equilibrium and the Tax-Benejil Multiplier

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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Labor Market Equilibrium and the Tax-Benejil Multiplier

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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Labor Market Equilibrium and the Tax-Benejil Multiplier

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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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

$\frac{\partial t}{\partial \beta }=\frac{1-\theta \rho }{\theta \rho }>0.$

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

$\frac{\partial u*}{\partial t}=\rho (\tau *)\left(e^{-1}\right)\rho (\tau *)\alpha \frac{\alpha }{1-\phi }(1-\beta )>0,$

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

$\begin{array}{cc}\frac{dt}{d\beta }=\frac{t+\rho (\tau *)\left(e^{-1}\right)\prime \alpha (a/(1-\phi )){(b+t)}^2(1-t)}{t-\rho (\tau *)\left(e^{-1}\right)\prime \alpha (a/(1-\phi )){(b+t)}^2(1-\beta )}>0.& \left(14\right)\end{array}$

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.

Policy Complementarities

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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Policy Complementarities

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Policy Complementarities

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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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 M_s skilled and M_n unskilled workers (where the subscript n stands for “not skilled”), and let the aggregate number of vacancies be divided into V_s skilled ones and V_n unskilled ones. Only skilled employees are capable of working at skilled jobs; in case of a match, each skilled employee generates a real revenue a_s. Both the unskilled and skilled employees are capable of working at the unskilled jobs, where the real revenue per person is a_n, with a_n < a_s. 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 ${\theta }_s^{*}$

View Expanded

and ${\theta }_n^{*}$

View Expanded

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 ${\theta }_s^{*}{M}_s/V_s;$

View Expanded

but in the unskilled sector it is ${\theta }_s^{*}(L-M_s)/V_n,$

View Expanded

as those skilled workers who are unable to find skilled jobs are available for unskilled ones.¹⁹

Let ε_s, and ε_n 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

$\begin{array}{cc}{\varepsilon }_s={\varepsilon }_s\left(\frac{{\theta }_s^{*}}{V_s}\right)\prime {\varepsilon }_n={\varepsilon }_n\left(\frac{{\theta }_n^{*}(L-M_s)}{V_n}\right)\prime & \left(15a\right)\end{array}$

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

$\begin{array}{cc}{\rho }_s={\rho }_s\left(\frac{V_s}{{\theta }_s^{*}{M}_s}\right)\prime {\rho }_n={\rho }_n\left(\frac{V_n}{{\theta }_n^{*}(L-M_s)}\right)\prime & \left(15b\right)\end{array}$

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

$\begin{array}{cc}{\theta }_i^{*}=e^{-1}\left[{\rho }_i{W}_i(1-t)(1-\beta )\right],& \left(16\right)\end{array}$

for i = s, n.

Let w_s and w_n be the wage of the skilled and unskilled employees, respectively; and let k^s 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

${\pi }_s={\varepsilon }_s\left(\frac{{\theta }_s^{*}{M}_s}{V_s}\right)(a_s-w_s)-k_s,$

$\begin{array}{cc}{\pi }_n={\varepsilon }_n\left(\frac{{\theta }_n^{*}{M}_n}{V_n}\right)(a_n-w_n)-k_n,& \left(17\right)\end{array}$

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: (w_i (1 - t) - b_i)^μ (a_i-w_i+f_i)_1-μ, for i = s, n, where f = φ_iw_i. Thus the negotiated wages in these sectors are

$\begin{array}{cc}{w}_i=\mu \frac{a_i}{1-{\phi }_i}+\frac{1+\mu }{1-t}{b}_i,& \left(18\right)\end{array}$

for i = s, n, We assume, plausibly, that φ_s > φ_n.

As above, unemployment benefits are taken to be proportional to wages: b_s= βw_s(1-t) and b_n= βw_n(1-t). Consequently, the wage determination equations may be expressed as

$w_i=\alpha \frac{a_i}{1-{\phi }_i}$

for i = s, n, where a_i is given by equation (8b). Observe that since φ_s > φ_n it follows that a_s / a_n >(1 - φ_s)/(1-φ_n) and thus the skilled wage w_s, exceeds the unskilled wage w_n.

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

${\pi }_s={\varepsilon }_s\left(\frac{{\theta }_s^{*}{M}_s}{V_s}\right)\left[a_s(1-\frac{\alpha }{1-{\phi }_s})\right]-k_s,$

$\begin{array}{cc}{\pi }_n={\varepsilon }_n\left(\frac{{\theta }_n^{*}\left({L-M}_s\right)}{V_n}\right)\left[a_n(1-\frac{\alpha }{1-{\phi }_n})\right]-k_n,& \left({17}^{\prime }\right)\end{array}$

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

$\begin{array}{cc}{\tau }_i^{*}={\left[{{\varepsilon }_i}^{-1}\left(\frac{k_i}{a_i(1-\alpha /(1-{\phi }_i))}\right)\right]}^{-1},& \left(19\right)\end{array}$

for i = s, n where τ_s* = θ_s* V_s/ M_s and τ_n* = V_n/ θ_n* (L - M_s).

The unemployment rates for the skilled and unskilled workers are

$\begin{array}{cc}{u}_i=1-{\theta }_i^{*}\rho \left({\tau }_i^{*}\right),& \left(20\right)\end{array}$

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

$\begin{array}{cc}{u}_i=(1-{\theta }_s^{*}\rho \left({\tau }_s^{*}\right))\frac{M_s}{L}+(1+{\theta }_n^{*}{\rho }_n\left({\tau }_n^{*}\right))\frac{L-M_s}{L}\mathrm{.}& \left(21\right)\end{array}$

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(M_s), c’ > 0 for M_s > 0. For the marginal worker of a skilled workforce M_S, the expected payoff from human capital acquisition is ρ_sw_s - c(M_s), whereas the expected payoff from remaining unskilled is ρ_nw_n. Since the marginal worker is indifferent between acquiring human capital and remaining unskilled, the equilibrium size of the skilled workforce is

$\begin{array}{cc}{M}_s^{*}=C^{-1}\left[\left({\rho }_s\left({\tau }_s^{*}\right)\alpha \frac{{\alpha }_s}{1-{\phi }_s}-{\rho }_n\left({\tau }_n^{*}\right)\alpha \frac{{\alpha }_n}{1-{\phi }_n}\right)(1-t)\right],& \left(22\right)\end{array}$

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

The government budget constraint now becomes

$\begin{array}{cc}(1-{\theta }_s^{*}{\rho }_s)M_s{\beta w}_s+(1-{\theta }_n^{*}{\rho }_n)M_n{\beta w}_n=t{w}_s{\theta }_s^{*}{\rho }_s{M}_s+{tw}_n{\theta }_n^{*}{\rho }_n{M}_n,& \left(23\right)\end{array}$

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

$(1-{\theta }_s^{*}{\rho }_s\left({\tau }_s^{*}\right))M_s^{*}\beta \alpha \frac{a_s}{1-{\phi }_s}+(1-{\theta }_n^{*}{\rho }_n\left({\tau }_n^{*}\right))(L-M_s^{*})\beta \alpha \frac{a_n}{1-{\phi }_n}$$=t\alpha \frac{a_s}{1-{\phi }_s}{\theta }_s^{*}{\rho }_s\left({\tau }_s^{*}\right)M_s^{*}$$\begin{array}{cc}+t\alpha \frac{a_n}{1-{\phi }_n}{\theta }_n^{*}{\rho }_n\left({\tau }_n^{*}\right)(L-M_s^{*})\mathrm{.}& \left({23}^{\prime }\right)\end{array}$

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 k_s will increase the equilibrium degree of tightness in the skilled labor market τ_s^* and thereby reduce the equilibrium skilled unemployment rate u_s^* 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∂k_s) > 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∂φ_s) > 0.

• search-promoting measures: ∂²u^*/∂c⁰∂ε_s) >0, ∂²u^*/∂c⁰∂ρ⁰_s) >0, and ∂²u^*/∂c⁰∂e⁰_s) >0,

• unemployment benefit reform: (∂²u^*/∂c⁰∂β_s) > 0 and

• policies to reduce the bargaining strength of incumbent employees: ∂²u^*/∂c⁰∂μ_s) > 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 w_s and wⁿ be the negotiated wages resulting from the Nash bargaining process, as described by equation (18), and w^min be the legislated minimum wage, we assume that w_n < w^min < w_s.

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

$\begin{array}{cc}{\tau }_n^{\min }={\left[{\varepsilon }_n^{-1}\left(\frac{k_n}{a_n-w^{\min }}\right)\right]}^{-1}\mathrm{.}& \left({19}^{\prime }\right)\end{array}$

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:

$\begin{array}{cc}{u}_n^{\min }=1-\rho \left({\tau }_n^{\min }\right)>u_n\mathrm{.}& \left({20}^{\prime }\right)\end{array}$

The aggregate unemployment rate is higher as well:

$\begin{array}{cc}{u}^{\min }=[1-{\rho }_s\left({\tau }_s^{*}\right)]\frac{M_s}{L}+[1-{\rho }_n\left({\tau }_n^{\min }\right)]\frac{L-M_s}{L}>u\mathrm{.}& \left({21}^{\prime }\right)\end{array}$

The equilibrium skilled workforce under the minimum wage is

$\begin{array}{cc}{M}_s^{\min }=c^{-1}\left[\left({\rho }_s\left({\tau }_s^{*}\right)\alpha \frac{a_s}{1-{\phi }_s}-{\rho }_n\left({\tau }_n^{\min }\right)w^{\min }\right)(1-t)\right]\mathrm{.}& \left({22}^{\prime }\right)\end{array}$

If we assume, as above, that the elasticity of the demand for unskilled labor is less than minus $1\left((\partial {\rho }_n^{\min }/\partial w_n^{\min })(w_n^{\min }/{\rho }_n^{\min })<-1\right),$

View Expanded

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

$[1-{\rho }_s\left({\tau }_s^{*}\right)M_s^{\min }\beta \alpha \frac{a_s}{1-{\phi }_s}+[1-{\rho }_n\left({\tau }_n^{\min }\right)](L-M_s^{\min })\beta \alpha \frac{a_n}{1-{\phi }_n}]$

$=t^{\min }\alpha \frac{a_s}{1-{\phi }_s}{\rho }_s\left({\tau }_s^{*}\right)M_s^{\min }$

$\begin{array}{cc}+t^{\min }\alpha \frac{a_n}{1-{\phi }_n}{\rho }_n\left({\tau }_n^{*}\right)(L-M_s^{\min }),& \left({23}^{\prime \prime }\right)\end{array}$

where t^min 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 K^s will increase the equilibrium degree of tightness in the skilled sector τ_s* 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*/∂w^min ∂k_s)>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*/∂w^min ∂f_s)>0

• search-promoting measures: (∂²u*/∂w^min ∂ε⁰_s)>0, (∂²u*/∂w^min ∂ρ⁰_s)>0, and (∂²u*/∂w^min ∂e⁰_s)>0,

• unemployment benefit reform: (∂²u*/∂w^min ∂β)>0, and

• policies to reduce the bargaining strength of incumbent employees: (∂²u*/∂w^min ∂μ_s)>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 {UE_NIT) lies below that under the unemployment benefit system (UE_UB). Meanwhile, by equation (13”), the government budget constraint curve GBC is the same under both systems. Consequently, the labor market equilibrium point E_UB under the UB system is associated with a lower unemployment rate than the equilibrium point E_NIT under the NIT system.²³

Equilibrium Unemployment Under the Unemployment Benefit System and the Conditional Negative Income Tax System

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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Equilibrium Unemployment Under the Unemployment Benefit System and the Conditional Negative Income Tax System

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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Equilibrium Unemployment Under the Unemployment Benefit System and the Conditional Negative Income Tax System

Citation: IMF Staff Papers 1997, 001; 10.5089/9781451957112.024.A001

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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:

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,