Alternative Subsidies for Low-Wage Employment

Abstract

Traditional business cycle theory makes a distinction between shocks and propagation mechanisms which lead to a prolonged effect of a shock in economic time series. In the past two decades, the negative effects of shocks seem to have had an ever-longer impact on real magnitudes such as (un)employment and output. One such propagation mechanism of adverse shocks is the disincentive to supply labour at low wages in the presence of relatively generous benefit systems. In this paper, we try to address the issue of financial incentives for low-productivity workers which are today widely recognised as an indispensable ingredient in tackling the (European) unemployment problem (e.g. PHELPS, 1994; SNOWER, 1994a; OECD 1996). The proposal of a targeted negative income tax offered in this paper is fully in line with the recent recommendation of the OECD (1996) that the tax and transfer system (TTS) should be designed such that work pays. In the parlance of modern employment theory, we are in search of a (partial) remedy for the high levels of equilibrium unemployment which apparently accompany high actual unemployment rates (ELMESKOV and MACFARLANE, 1993).²

We are grateful for comments on an earlier draft and related work from participants of the 1995 International Congress of the Hanns Martin Schleyer-Stiftung in Innsbruck, the 1995 Annual Meeting of the International Institute of Public Finance in Lisbon, and the 1996 Annual Meetings of the Royal Economic Society in Swansea, the Econometric Society in Istanbul, and the Verein für Socialpolitik in Kassel as well as workshop participants at the Universities of Aachen, Freiburg, Potsdam, Tübingen, Cologne and Munich. The usual disclaimer applies.