Wage Subsidies for the Long Term Unemployed: A Search Theoretic Analysis

The persistence of mass unemployment in many OECD countries in the 1980s and 1990s has led to renewed interest in active labour market policies. We examine one such policy, a wage subsidy for employers hiring the long-term unemployed, using a search-theoretic framework. We assume that long-term unemployment leads to a loss of human capital, and that a subsidy can offset the consequent training costs faced by employers hiring the long-term unemployed. We argue that unemployment would be unambiguously reduced by such a policy. Furthermore, the often-made criticism of wage subsidies that they mainly lead to substitution, merely churning the unemployed, is misplaced. There are positive externalities to substitution that lead firms to open more vacancies, many of which in turn will be filled by the short-term unemployed.