Cross-country differences in unemployment: fiscal policy,unions and household preferences in general equilibrium

We develop and parameterize an overlapping generations model that explains hours worked, education, and unemployment within one coherent framework. We extend previous work in this tradition by introducing individuals with heterogeneous ability and a unionized labour market for lower ability workers. Unemployment is due to above market-clearing wages for these workers. Our calibrated model's predictions match the facts remarkably well in a sample of continental European, Nordic and Anglo-Saxon countries. We then use the model to explain the cross-country variation in unemployment. A Shapley decomposition reveals an almost equal role for differences in fiscal policy variables and in union preferences. Both account for about half of the explained variation in unemployment rates. While it is the above market-clearing wage chosen by the unions that directly leads to unemployment, the fiscal policy variables determine most of its magnitude. As to specific fiscal variables, differences in unemployment benefit generosity play a much more important role than tax differences. Controlling for fiscal variables and union preferences, any differences in the taste for leisure of the households have no role to play in determining cross-country variation in unemployment.