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Labour Market Institutions and the Effectiveness of Tax and Benefit Policies in Enchancing Employment: A General Equilibrium Analysis

  • Alho, Kari O. E.
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    The paper aims to shed light on the relationships between labour market institutions with respect to wage formation and the effectiveness of economic and labour market policies in enhancing employment and overall economic performance. We evaluate tax and benefit policies under four alternative specifications of wage formation : fixed, market determined, and bargained wages. In the latter, we also distinguish between the short- and long-run effects, and between uncoordinated and coordinated (nation-wide) bargaining. To this end, we build a computable general equilibrium model which is calibrated using data on the Finnish economy and labour market, distinguishing workers of three skill categories by the level of their education. Evaluating policies under various possible labour market institutions, the paper also seeks relevance in a wider EU perspective. Overall, the model simulations show that labour market institutions with respect to wage formation influence to a large extent the effectiveness of many policies aiming at enhancing employment. When wages are allowed to react, policies expanding the demand for labour, which work well under fixed wages, turn out to be quite inefficient in the short run. The reverse emerges with supply side policies such as reducing benefits so that wage reactions reinforce the positive effects of these policies. The reduction of marginal taxes interacts with labour market institutions in quite a sensitive way. Under wage bargaining, tax reductions should be channelled to low-income earners, while the reverse holds under flexible wage formation. Policies directed at raising labour demand for a targeted group, typically the low skilled, are able, on the other hand, to lower unemployment amongst this group of workers also under coordinated wage bargaining. However, if the group concerned enters in a new wage bargaining round unilaterally, the effect of this policy can even be quite negative in terms of its impact on employment due to the rise of compensatory wage claims through the wage-wage links. We also consider a hypothetical, fully flexible labour market and find the extent of the widening of the wage distribution, but also the magnitude of clear economic gains, related to a low rate of unemployment reached through the assumed wage adjustment process. The most effective policy in terms of employment, labour supply and unemployment is the curtailment of social security benefits while out of work. Also a neutral policy of compensating the cut in unemployment benefits by a tax reduction leads, under bargaining, to an expansion in the economy. The results call for coordination in tax and benefit policy measures, so that incentives to work and to stay out of work are not created simultaneously

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    Paper provided by The Research Institute of the Finnish Economy in its series Discussion Papers with number 1008.

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    Length: 43 pages
    Date of creation: 2006
    Date of revision:
    Handle: RePEc:rif:dpaper:1008
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    1. Christoph Boehringer & Stefan Boeters & Michael Feil, 2004. "Taxation and Unemployment: An Applied General Equilibrium Approach," CESifo Working Paper Series 1272, CESifo Group Munich.
    2. Emmanuel Saez, 2000. "Optimal Income Transfer Programs: Intensive Versus Extensive Labor Supply Responses," NBER Working Papers 7708, National Bureau of Economic Research, Inc.
    3. Giuseppe Carone & Aino Salomaki, 2004. "Reforms In Tax-Benefit Systems In Order To Increase Employment Incentives In The Eu," Labor and Demography 0410005, EconWPA.
    4. Bean, Charles R., 1994. "European unemployment: A retrospective," European Economic Review, Elsevier, vol. 38(3-4), pages 523-534, April.
    5. Bovenberg, A. Lans & Graafland, Johan J. & de Mooij, Ruud A., 2000. "Tax reform and the Dutch labor market: an applied general equilibrium approach," Journal of Public Economics, Elsevier, vol. 78(1-2), pages 193-214, October.
    6. Lassila, Jukka & Valkonen, Tarmo, 2001. "Ageing, Demographic Risks, and Pension Reform," Discussion Papers 765, The Research Institute of the Finnish Economy.
    7. Marit Hinnosaar, 2004. "The Impact Of Benefit And Tax Reforms On Estonian Labor Market In A General Equilibrium Framework," University of Tartu - Faculty of Economics and Business Administration Working Paper Series 31, Faculty of Economics and Business Administration, University of Tartu (Estonia).
    8. Holmlund, Bertil & Lundborg, Per, 1999. "Wage bargaining, union membership, and the organization of unemployment insurance," Labour Economics, Elsevier, vol. 6(3), pages 397-415, September.
    9. Alho, Kari, 2004. "The Finnish EMU Buffers and the Labour Market under Asymmetric Shocks," Discussion Papers 914, The Research Institute of the Finnish Economy.
    10. Pekka Sinko & Pasi Holm & Pekka Tossavainen, 1999. "Labour Market Policy and Unemployment - A Job Flow Model of Finland," Discussion Papers 210, Government Institute for Economic Research Finland (VATT).
    11. Alho, Kari, 2002. "The Equilibrium Rate of Unemployment and Policies to Lower It: The Case of Finland," Discussion Papers 839, The Research Institute of the Finnish Economy.
    12. Giuseppe Carone & Aino Salom�ki & Herwig Immervoll & Dominique Paturot, 2003. "Indicators of unemployment and low-wage traps (marginal effective tax rates on labour)," European Economy - Economic Papers 197, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission.
    13. Petri Böckerman & Roope Uusitalo, 2005. "Union membership and the erosion of the Ghent system: Lessons from Finland," Labor and Demography 0508008, EconWPA.
    14. Arntz, Melanie & Boeters, Stefan & Gürtzgen, Nicole, 2005. "Alternative Approaches to Discrete Working Time Choice in an AGE Framework," ZEW Discussion Papers 05-62, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
    15. Pekka Sinko, 2004. "Progressive Taxation Under Centralised Wage Setting," Discussion Papers 349, Government Institute for Economic Research Finland (VATT).
    16. John C. Driscoll & Steinar Holden, 2004. "Fairness and Inflation Persistence," Journal of the European Economic Association, MIT Press, vol. 2(2-3), pages 240-251, 04/05.
    17. Koskela , Erkki, 2001. "Labour taxation and employment in trade union models: A partial survey," Research Discussion Papers 19/2001, Bank of Finland.
    18. Thomas Aronsson & Karl-Gustaf L–fgren & Tomas Sj–gren, 2002. "Wage setting and tax progressivity in dynamic general equilibrium," Oxford Economic Papers, Oxford University Press, vol. 54(3), pages 490-504, July.
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