Many argue that the rigidities that characterize Europe's labour markets reflect the greater emphasis on equity, social insurance and protection of individuals in European societies relative to the US. In Discussion Paper No. 949, Research Fellow Gilles Saint-Paul maintains instead that they may simply benefit politically powerful and organized groups at the expense of the rest of society. He considers three examples of `politico-economic complementarities' in which an economic problem induces voters and lobbyists to make political (non-) decisions that will exacerbate the problem may lead to a vicious circle of high unemployment and perverse decision-making.

First, if a labour market exhibits high firing costs which the government then tries to reduce, firings will tend to increase. Hirings will also rise, however, so the unemployed will become better-off, and a well-designed reform may also benefit the employed. This is more likely to happen if the latter are vulnerable to unemployment. If firing costs are very high, however, the lack of support for the reduction in firing costs will make reform impossible. Second, while the long-term unemployed can invest resources to raise their probabilities of finding jobs, but they cannot borrow against future income to finance such expenses. Cash transfers may therefore be needed to enable the unemployed to search harder and thus reduce unemployment. Such transfers are likely to be lower when unemployment is already high: the tax base is lower and the tax rate may also shrink if the growth of an underclass enhances the fiscal conservatism of the median voter. Third, if high unemployment reduces the scope for workers in declining industries to find jobs elsewhere, incentives to vote or lobby for subsidies will rise to the detriment of new, growing sectors; this reduces labour demand and raises unemployment.

In Discussion Paper No. 950, Saint-Paul argues that the redistributive goals that motivate restrictions on labour market flexibility in European countries may be achieved at much lower cost by taxes and transfers. Saint-Paul develops a simple model with inputs of skilled and unskilled labour to compare the effects on efficiency, equality and political incentives of two alternative packages. The first entails imposing a minimum wage above the market-clearing level for the unskilled together with a flat rate of taxation whose proceeds finance unemployment benefits. The second entails no minimum wage; both markets clear and a flat tax rate finances a transfer to the unskilled. Saint-Paul shows that the second package can produce the same level of equality with a higher level of output. Also, if labour market `rigidity' takes the form of lower turnover, raising the minimum wage is more likely to increase inequality, and the gains from shifting to the tax-and-transfer system will be correspondingly larger.

Shifting to the tax system may provide a more efficient means of reaching a global inequality target, but the reform will not be politically feasible if employed unskilled workers are likely to suffer from such a shift and can block such a change. Saint-Paul shows that this is more likely to happen when turnover is low, which is when the tax-and-transfer system is most egalitarian relative to the minimum wage system. His simulations suggest, however, that a moderate rise of the tax rate above that which achieves the same level of equality as the minimum wage is then sufficient to induce the employed to favour the reform. Political viability must be taken into account in the design of the new system, but the conclusion that taxes and transfers outperform the minimum wage remains robust. Finally, Saint-Paul discusses other types of labour market rigidity such as unemployment benefits and job protection legislation. He demonstrates that arguments that these provisions increase productivity by raising on-the-job training and match quality are implausible.

Some Political Aspects of Unemployment
Searching for the Virtues of the European Model
Gilles Saint-Paul

Discussion Papers Nos. 949-50, May 1994 (HR/IM)