Ebook Labor market policy instruments and the role of economic turbulence
Times of high unemployment always inspire debates on the role of labor market policy and most of the time lead to a variety of policy advice. The motivation of this work stems from the on-going controversy about optimal policy instruments for Germany that experienced a dramatic increase in unemployment during the years 2000 to 2005. While people agree that especially the rate of low-skilled unemployment is excessively high and current policy is suboptimal and leaves room for improvement, opinions on what should be done are mostly at odds with each other. Take as an example debate the Sinn et al. (2006) versus Brown et al. (2007). While the former prefer wage subsidies targeted at persons with low abilities, the latter favor hiring subsidies for long-term unemployed workers with low skills. Other empirical studies suggest that the effectiveness of both subsidies is limited. Bonin et al. (2002) find that wage subsidies for low-skilled workers in order to decrease disincentives do not appear to work very effectively and that such a policy is likely to be too costly. Boockmann et al. (2007) draw their conclusions from legal changes in the eligibility of German workers to EGZ which they use as natural experiments. They find that eligibility to this subsidy did not change the transition rates from unemployment to employment significantly. However, named empirical studies provide limited conclusion concerning the macroeconomic effects of hiring and wage subsidies as they cannot directly measure the effect of the subsidies in question, because they have never been implemented Germany-wide.
Cahuc and Le Barbanchon (2010), in their study on counseling, very well notice that micro evaluations neglecting crowding out, adverse spill over effects on non-targeted persons, and other equilibrium effects can lead to misguided policy advice. A similar point is made by Van der Linden (2005) who endogenizes job search effort and wages in his evaluation. In addition, the sort of studies mentioned above tends to lack a thorough evaluation of the cost side. Therefore, we base our analysis on a model of equilibrium unemployment and our conclusions rely on theoretical reasoning and numerical simulations.
Dynamic search and matching models have been widely used to evaluate employment subsidies ever since the influential paper of Mortensen and Pissarides (1994). However, the conclusions so far are mixed. While Bovenberg et al. (2000) and Cardullo and Van der Linden (2006) argue that wage subsidies can substantially reduce unemployment, Boone and van Ours (2004) find no such effect. The majority of these simulation studies focuses on the effect of wage subsidies or in-work benefits on unemployment. One exception is Yashiv (2004) who compares wage versus hiring subsidies in a partial equilibrium approach with endogenous job finding but constant separation rates. The results of his empirical simulations using Israeli data suggest that hiring subsidies should be preferred. A more theoretical treatment - probably most closely related to this paper - is provided by Mortensen and Pissarides (2003) (henceforth MP). First, they derive conditions on the policy instruments for the implementation of the welfare optimizing first-best solution. In an extension of the model they find evidence that a wage subsidy for low-skilled workers cross-financed by high-skilled workers is an effective measure to reduce overall unemployment.
We will contribute to those two findings. First, MP do not allow for a revenue generating firing tax as modeled in Blanchard and Tirole (2008) (henceforth BT), who - in a static setup - find that the distortions of unemployment benefits can be exactly offset by a firing tax. We will allow for this policy instrument in our dynamic framework where job acceptance and destruction margins are explicitly modeled and might be distorted by such a tax. It will be shown that taking job acceptance into account - which is not done in MP will alter the first-best implementation by requiring an additional policy instrument. In this extended MP-style intragroup model, we characterize two possible implementations of the social optimum, one utilizing hiring and the other wage subsidies. Both schemes are limited: the first, which involves redistribution from firing to hiring firms, is limited if firms are liquidity constrained. The wage subsidy implementation of the first-best cannot work if the replacement ratio is too large.
Building on the intragroup model we introduce a second skill class to allow for intergroup redistribution. We will characterize optimal policy with and without the presence of economic turbulence. We will argue that in a world of economic turbulence a cross-financed wage subsidy scheme as suggested by MP might be considerably less efficient2. They assume skill classes to operate in complete juxtaposition, except for the connection via the government’s budget constraint, which underestimates the adverse effect on high-skilled workers. In order to model the interaction of different skill groups we will follow the idea of economic turbulence proposed by Ljungqvist and Sargent (1998), where unemployed workers will lose their skills in the course of time.
The outline of the paper is as follows. First a simple intragroup model is developed to analytically derive the effects of the considered subsidies and different forms of taxes on the equilibrium variables. The next part deals with efficiency aspects where the optimal policy mix, implementing the social planner’s solution, is derived. Section 3 extends the intragroup to an intergroup model and introduces economic turbulence in form of state dependent transitions between skill classes. We will derive analytic results as far as possible and then also discuss some simulation results.
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