Labor market regulation under self‐enforcing contracts

This paper examines the effects of various labor market institutions (policies) on the welfare of workers and employers. We consider self‐enforcing contracts between risk‐averse workers and risk‐neutral employers in a labor market with search frictions. Employers promise to smooth out shocks to wages while workers promise long‐term commitment to employers. In this environment, regulatory policies can make it easier or harder for employers to keep their promise of wage smoothing, thus influencing the benefit accruing to each party. In our approach, we analyze the joint effect of policies by distinguishing between the financing and spending of funds used in the regulation of the labor market. With regard to financing, layoff tax strictly dominates hiring and payroll taxes on efficiency grounds, whereas the relative ranking of hiring and payroll taxes depend on the type of equilibrium that realizes. On the spending side, while unemployment payment increases workers' welfare at the expense of employers, in‐work benefit in the form of a one‐off wage subsidy leaves workers' welfare intact but may increase the welfare of employers.