International Political Spillovers: the case of labor market regulation

This paper explores how the political support for Labour Market Regulation (LMR) is affected by economic and political integration in a two country OLG model. We model LMR as wage regulation and analyse three institutional settings: Autarchy, Economic Union and Political Union. In Autarchy capital cannot flow across borders and each country sets its most preferred level of regulation. In the Economic Union capital markets are integrated, while political decisions are not. In the Political Union a common level of LMR is set at a centralized level. In Autarchy, LMR may endogenously arise if the economy is dynamically efficient. In this case, despite the distortions generated in the labour market, LMR increases the welfare of the young, because it raises their permanent income, their savings and the steady state capital stock. In the Economic Union, capital outflows make the implementation of LMR more costly and provide incentives for each country to undercut the rival in order to attract capital.Thus, a race-to-the-bottom takes place and the steady state level of LMR decreases, harming the young individuals. The Political Union restores, under symmetry, the autarchic outcome and welfare levels. The asymmetric case is also analysed.