Taxation and Unemployment Benefits with Imperfect Goods and Labor Markets

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
2
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

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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.

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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.

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Related Literature

• 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

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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

increasing in both arguments (vacancies and
unemployed) and homogeneous of degree one.
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• The exit rate from unemployment is given by

• The coverage rate of a vacant job is given by

• q 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.

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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

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Consumer Preferences

• Consumers allocate their consumption according to
  Dixit-Stiglitz preferences
• Constant elasticity (s) demand function

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• s is a measure of the degree of product market
  competition that we use as a policy instrument
• To interpret an increase in s 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)

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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.

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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
  q, since higher q reduces m(q) 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.

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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 b is the bargaining power of the worker and
t is the tax rate on wages.
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Wage Equation

• Given the sharing rule, the optimal behavior of
  the economic agents yields the following wage
  equation
• (WE)
• When ? 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.

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Government Budget Constraint

• No public deficits are allowed, hence Government
  faces the following budget constraint
• we can express the budget constraint as
• As ?m(?) is an increasing function of ?, equation
  PB states a decreasing relationship between the
  tax rate t and the labor market tightness.
• Higher ? 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.

(PB)
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The Equilibrium

• 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.

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Beveridge Curve
Zero Profit Condition
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The Equilibrium Tightness and Tax Rate
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Increasing Product Market Competition
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• Consider the effect of an increase in the demand
  elasticity. The (JCWE) 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 ? that implies a
  lower u (shift from A to B)
• In B, the labor market is in equilibrium (we are
  on the (JCWE) curve) but the public budget is in
  surplus
• Given r, 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 ? (given the wage offered by the firm).
• The final result of this process will be a higher
  equilibrium value of ? and a lower equilibrium
  value of t (point C in figure).

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Increasing Unemployment Benefit
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• Consider now an increase in the replacement ratio
  ?. This implies a shift down to the left of the
  (JCWE) curve and up to the right of the PB
  curve.
• The former effect stands from the fact that,
  given t, an increase in ? 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 ?.
• The shift of the PB curve is due to the fact
  that, given ?, an increase in ? 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 s,
  leads to a lower equilibrium value of ? and a
  higher equilibrium tax rate t.
• Looking at the figure, we move from equilibrium A
  to equilibrium B.

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t
B
C
D
A
PB
(JCWE)
q

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• 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)

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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

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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