Raising Employment: Fiscal Policy, Wage Formation, And Their Impact On Welfare, Inequality And Poverty – A General Equilibrium Analysis

Raising employment, especially among low skilled workers, stands high on the agenda of policy makers in many OECD countries. They can rely on a huge body of literature that has studied the impact of fiscal policy and wage formation on employment. We contribute to this literature by studying within one coherent framework not only the employment effects of (targeted) changes in tax rates, unemployment benefits and wage setting, but also their effects on inequality and poverty. Our methodological framework is a fourperiod overlapping generations model that portrays two key characteristics: households differ by innate ability and there is an imperfect labor market (union wage floor) for individuals of low ability, causing unemployment. The model explains employment, per capita income and welfare at the aggregate level, as well as for specific ability and age groups. Our main findings are as follows. Unilateral fiscal actions, such as a reduction of labor taxes financed by lower unemployment benefits, can have clear positive effects on employment of (mainly) low ability individuals, but they raise poverty among those who remain unemployed. Achieving higher employment without increasing inequality and poverty, requires combined efforts of fiscal policy makers (labor tax cuts) and unions (wage moderation). Depending on the policy maker’s priority for either employment or lower inequality, a reduction of labor taxes on employers or on employees is preferable. If more progress is to be made in ameliorating inequality and poverty, union wage moderation may be supplemented by a transfer to all individuals below the poverty line, conditional on their active participation on the labor market. All our results assume employability of the unemployed, and are therefore to be seen as long-run effects, which may require complementary policies.