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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 estimated to have averaged 4’A percent of GDP in the European Union in 1996 (IMF, 1996), while the Maastricht deficit criteria is 3 percent of GDP.
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 elQ).
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 tree entry, each worker’s income is equal to her wage income.
The relative slopes of these curves are determined by correspondence-principle considerations. Given the equilibrium at point E0, if the unemployment rate were above u0, the tax rate associated with this unemployment rate (on the UE line} would be greater than the lax rate that balances the government’s budget (on the GBC line), and thus it is possible to reduce the unemployment rate through a tax reduction. However, if the unemployment rale were below Up, the tax rate associated with this unemployment rate (on the UE line) would be less than the tax rate necessary to balance the government’s budget (on the GBC line), and thus such an unemployment rate is not feasible. If this condition were not satisfied in equilibrium, then it would be possible to reduce the unemployment rate to zero through a sufficiently large tax reduction.
The multiplier is unambiguously positive since it can be shown that the denominator is positive when the labor demand elasticity is less than minus 1.
Specifically, ε0 is a shift parameter that reduces the probability e that a vacancy is matched by a constructive searcher for any given degree of labor market tightness θ, and similarly for the shift parameters τ0 and e0.
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 minus 1, the resulting fall in the wage will raise wage income ρw.
Recall that the search-promoting measures involve government expenditures that, in the context of the analysis above, increase the coefficient p (reinterpreted to include these expenditures). We assume that the direct contractionary effect of these measures on unemployment outweighs their indirect expansionary effect via the increase in β.
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, tiring costs tend to stimulate, rather than reduce, employment. Bentolila and Saint-Paul (1994) demonstrate that firing costs may reduce employment when the shocks are transient. Snower and Vazquez (1996) show that, when firing costs influence employment both directly (as in Bentolila and Bertola, 1990; and Bentolila and Saint-Paul, 1994) and indirectly via wage determination, their average effect on employment depends on how prolonged the shocks are. The model here does not include the possibility of firing, and thus the firing cost affects employment only indirectly via the wage. In this case, a rise in the firing cost unambiguously raises the unemployment rate.
Skilled workers prefer skilled to unskilled jobs since—as shown below—the skilled wage ws exceeds the unskilled wage wa.
It is important to note that, given our assumption that the labor demand elasticity is less than minus 1, a fall in the minimum wage unambiguously stimulates employment. This issue is subject to heated debate in the literature (see Card and Krueger, 1995; and Neumark and Wascher, 1995). In our model, a rise in the minimum wage reduces the probability of employment for a given number of constructive searchers, but it increases the number of such searchers. Our elasticity assumption ensures that the former effect on employment dominates the latter.
This aspect lies beyond the scope of our formal analysis.
Only when the replacement ratio is zero (β = 0) do both systems give rise to the same amount of constructive job search, for given ρ and w.
See also Saint-Paul (1994), who presents a different model showing that it is more efficient to achieve distributive objectives through the lax and transfer system than through minimum wages and unemployment benefits. Snowcr (1995b) provides another analytical framework for evaluating the gains from replacing unemployment benefits by conditional negative income taxes.
There is another argument for fundamental reform that lies beyond the scope of our analysis: Lindbeek (1995 and 1996) and others have argued that high levels of unemployment have become such a common feature of European economies that habits and social conventions have adjusted to them: to modify entrenched behaviors, therefore, a decisive, permanent break with past policies may be required to signal a change in regime.
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 (Evans and others. 1996). The unemployment rate in New Zealand fell a remarkable 5 percentage points from early 1992 to late 1995, with little evidence of heightened wage pressures.
It is also clear that labor market reforms will be easier to implement in a growing economy.