Scialà & TilliXiamen - LABOR 20061 Taxation and Unemployment Benefits with Imperfect Goods and Labor Markets Antonio Scialà Riccardo Tilli University of.

Scialà & Tilli Xiamen - LABOR 2006 1

Taxation and Unemployment Benefits with Imperfect Goods and Labor

Markets

Antonio Scialà Riccardo Tilli

University of Padua Sapienza University of Rome

2006 Symposium on Contemporay Labor Economics

Xiamen, december 16-18


Motivations• The 90s have been years of flexibilisation of the labor market

in the main European countries, in order to reduce unemployment.

• In Italy, there is a lack of unemployment benefit programs able to adverse the effects of the higher labor turnover generated by flexibility; however…

• …public financing of such programs has to take into account EU-SGP constraints on Government budget

• In the last few years, there is a large debate about the needs to liberalize some strategic markets such as public utilities, services and so on

• We show that the fiscal effects of liberalization policies could contribute to finance unemployment benefit programs


Goal of the Paper• The aim of the paper is to study the interactions

between wage taxation, unemployment benefits, and goods market competition in a theoretical framework where:

– the labor market is characterized by frictions (Pissarides, 2000)

– there is monopolistic competition in the goods market (Dixit-Stiglitz, 1977)

– Government is subject to a balanced-budget constraint.

• We evaluate the effects of both more competition in the goods market and higher unemployment benefits on labor market equilibrium and equilibrium tax rate.


Main Results

• More competition on goods market has a positive effect on equilibrium unemployment and on the Government budget.

• The increase of per capita unemployment benefits can be financed in two ways:

– increasing tax rate – increasing competition in the goods market

• The first way can introduce in the economic system further distortions, with an additional negative effect on unemployment.

• Alternatively, reforms in the goods market towards a higher degree of competition can maintain the same level of tax rate and offset the negative effects on unemployment brought about by the raise of unemployment benefit.


• Unemployment effects (Koeniger 2002, Ebell and Haefke 2003, Kugler and Pica 2005, Ziesemer 2005, Xie 2006)

• Rent redistribution effects (Blanchard and Giavazzi 2003)

• Optimal tax progressivity (Sorensen 1999)

• Our model: interactions between goods and labor market reforms and their effects on PBC

Related Literature


The Labor Market• Search and matching model (labor market with

frictions).

• Total labor force normalized to 1.

• The matching process is summarized by a well behaved matching function: ,h h u v

increasing in both arguments (vacancies and unemployed) and homogeneous of degree one.


The coverage rate of a vacant job is given by:

,h u vm

v

The exit rate from unemployment is given by:

is the ratio between vacant jobs and unemployed workers

and represents a convenient measure of the tightness of

the labor market.

• Exogenous job destruction: idiosyncratic shock on productivity arrive at constant rate s.

,h u vm

u


The Beveridge Curve

• The dynamic of unemployment is given by the difference between the inflows into and outflows from unemployment:

• In steady state the Beveridge curve is given by:

1u s u m u

s

us m


Consumer Preferences

Consumers allocate their consumption according to Dixit-Stiglitz preferences

Constant elasticity () demand function


is a measure of the degree of product market competition that we use as a policy instrument

“To interpret an increase in as the result of deregulation, one should think of our specification of utility as a reduced form reflecting higher substitutability among products for whatever reason” (Blanchard-Giavazzi, QJE 2003, p. 885)


Profit Maximization

• Multiple workers firm;• CRS technology, with labor as the unique

input;• Entry cost k;• Each firm faces the constant elasticity

demand function of the unique good it produces (monopolistic competition);

»Price rule: mark up on marginal cost.


Job Creation• Profit maximization and symmetric equilibrium

determine a job creation condition:

(JC)

• JC represents the level of wage that firms are willing to pay, and is a decreasing function of , since higher reduces m() with an increase in the expected search costs.

• The wage is lower than productivity because of both the finite value of the demand elasticity of product and the search externality.

; ,w JC c


Nash Bargaining• The economic activity yields a surplus that is

shared between the two parties by a Nash bargaining.

• The maximization of the geometric average of the surplus of workers (SW) and firms (SF) weighted with the relative bargaining power determines the following sharing rule:

where is the bargaining power of the worker and t is the tax rate on wages.

1

1W F

tS S


Wage Equation

• Given the sharing rule, the optimal behavior of the economic agents yields the following wage equation:

(WE)

• When θ is high the expected recruiting cost faced by firms is high, while, conversely, the cost for workers to wait for the next job offer is low. This implies that workers can bargain better wages.

• With a higher t, the worker will claim a higher wage in order to preserve the level of the net wage.

, ; , , , ,w WE t b c


Government Budget Constraint

• No public deficits are allowed, hence Government faces the following budget constraint:

• we can express the budget constraint as:

• As θm(θ) is an increasing function of θ, equation PB states a decreasing relationship between the tax rate t and the labor market tightness.

• Higher θ decreases the unemployment rate; as a consequence we have a reduction of the expenditure for unemployment benefits and, given t, an increase of the public revenue. Hence, the public budget balance requires a lower level of t.

st=s + m( )

1 1t u w t u w

(PB)


• Equilibrium is described by the following equations:

• The wage equation, which is a pseudo labor supply deriving from the Nash bargaining;

• The job creation, which is a pseudo labor demand deriving from the profit maximization;

• The government budget constraint;

• The Beveridge curve, which expresses the flows equilibrium in the labor market.

The Equilibrium


; ,w JC c

, ; , , , ,w WE t b c

s

ts m

* * *, ,w t

Beveridge Curve

*u

Zero Profit Condition

*y*n **** 1 uynY


t

(JC=WE)

PB

The Equilibrium Tightness and Tax Rate


t

(JC=WE)

(JC=WE)'

PB

AC

B

Increasing Product Market Competition


• Consider the effect of an increase in the demand elasticity. The (JC=WE) curve moves up to the right:– Given t, we have that both the wage that firms are willing to

pay and the one required by the workers increase; the latter increase is proportionally lower than the former: hence, given t, the "demand side" wage is higher than the "supply side" one.

– Firms will open a higher number of vacancies, that in turn implies a higher θ: that implies a lower u (shift from A to B)

• In B, the labor market is in equilibrium (we are on the (JC=WE) curve) but the public budget is in surplus

• Given , lower tax rate t is required in order to balance the Government budget.– The reduction of the tax rate produces a feedback on the

bargained wage because workers will perceive a higher net wage and they will claim a lower gross wage, with a further positive effect on θ (given the wage offered by the firm).

• The final result of this process will be a higher equilibrium value of θ and a lower equilibrium value of t (point C in figure).


t

(JC=WE)'

(JC=WE)

PBA

B

PB'

Increasing Unemployment Benefit


• Consider now an increase in the replacement ratio ρ. This implies a shift down to the left of the (JC=WE) curve and up to the right of the PB curve.

• The former effect stands from the fact that, given t, an increase in ρ enhances the option value of the worker which will claim for a higher gross wage.

• Consequently, because of the negative effect on profit, firms reduce vacancies. This leads to a higher level of wage w and a lower level of tightness θ.

• The shift of the PB curve is due to the fact that, given θ, an increase in ρ requires a higher tax rate t in order to balance the public budget.

• A specular process with respect to the one discussed above with regard to an increase in σ, leads to a lower equilibrium value of θ and a higher equilibrium tax rate t.

• Looking at the figure, we move from equilibrium A to equilibrium B.


t

(JC=WE)

PB

A

B

C

D


• Suppose that, after the 90s labor market flexibilization, we are now in point A

• As shown above, an increase in u.b. leads to the equilibrium B: i.e. we would pay a cost in terms of higher unemployment

• Liberalization policies could permit – to avoid an increase in unemployment if we

allow some rise in the tax rate (point C);– to decrease unemployment if liberalization

policies are incisive enough to keep the tax rate unchanged (point D)


Main Conclusions• Unemployment can be reduced increasing

competition in goods market; however…

• …such reforms may claim for an increase of welfare state expenditure; then…

• …an appropriate combination of the two policy is required


Extensions

• Demand elasticity depending on the number of firms (Hotelling)

• Tax function with coefficient of residual income progression (Musgrave and Thin, 1948)

• Workers heterogeneity and ridistibutive effects

Scialà & TilliXiamen - LABOR 20061 Taxation and Unemployment Benefits with Imperfect Goods and Labor Markets Antonio Scialà Riccardo Tilli University of.

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