Scialà & TilliXiamen - LABOR Taxation and Unemployment Benefits with Imperfect Goods and Labor Markets Antonio Scialà Riccardo Tilli University of Padua Sapienza University of Rome 2006 Symposium on Contemporay Labor Economics Xiamen, december 16-18

Scialà & TilliXiamen - LABOR Motivations The 90s have been years of flexibilisation of the labor market in the main European countries, in order to reduce unemployment. In Italy, there is a lack of unemployment benefit programs able to adverse the effects of the higher labor turnover generated by flexibility; however… …public financing of such programs has to take into account EU-SGP constraints on Government budget In the last few years, there is a large debate about the needs to liberalize some strategic markets such as public utilities, services and so on We show that the fiscal effects of liberalization policies could contribute to finance unemployment benefit programs

Scialà & TilliXiamen - LABOR Goal of the Paper The aim of the paper is to study the interactions between wage taxation, unemployment benefits, and goods market competition in a theoretical framework where: –the labor market is characterized by frictions (Pissarides, 2000) –there is monopolistic competition in the goods market (Dixit-Stiglitz, 1977) –Government is subject to a balanced-budget constraint. We evaluate the effects of both more competition in the goods market and higher unemployment benefits on labor market equilibrium and equilibrium tax rate.

Scialà & TilliXiamen - LABOR Main Results More competition on goods market has a positive effect on equilibrium unemployment and on the Government budget. The increase of per capita unemployment benefits can be financed in two ways: –increasing tax rate –increasing competition in the goods market The first way can introduce in the economic system further distortions, with an additional negative effect on unemployment. Alternatively, reforms in the goods market towards a higher degree of competition can maintain the same level of tax rate and offset the negative effects on unemployment brought about by the raise of unemployment benefit.

Scialà & TilliXiamen - LABOR Unemployment effects (Koeniger 2002, Ebell and Haefke 2003, Kugler and Pica 2005, Ziesemer 2005, Xie 2006) Rent redistribution effects (Blanchard and Giavazzi 2003) Optimal tax progressivity (Sorensen 1999) Our model: interactions between goods and labor market reforms and their effects on PBC Related Literature

Scialà & TilliXiamen - LABOR The Labor Market Search and matching model (labor market with frictions). Total labor force normalized to 1. The matching process is summarized by a well behaved matching function: increasing in both arguments (vacancies and unemployed) and homogeneous of degree one.

Scialà & TilliXiamen - LABOR  The coverage rate of a vacant job is given by:  The exit rate from unemployment is given by:   is the ratio between vacant jobs and unemployed workers and represents a convenient measure of the tightness of the labor market. Exogenous job destruction: idiosyncratic shock on productivity arrive at constant rate s.

Scialà & TilliXiamen - LABOR The Beveridge Curve The dynamic of unemployment is given by the difference between the inflows into and outflows from unemployment: In steady state the Beveridge curve is given by:

Scialà & TilliXiamen - LABOR Consumer Preferences Consumers allocate their consumption according to Dixit-Stiglitz preferences Constant elasticity (  ) demand function

Scialà & TilliXiamen - LABOR  is a measure of the degree of product market competition that we use as a policy instrument “To interpret an increase in  as the result of deregulation, one should think of our specification of utility as a reduced form reflecting higher substitutability among products for whatever reason” (Blanchard-Giavazzi, QJE 2003, p. 885)

Scialà & TilliXiamen - LABOR Profit Maximization Multiple workers firm; CRS technology, with labor as the unique input; Entry cost k; Each firm faces the constant elasticity demand function of the unique good it produces (monopolistic competition); »Price rule: mark up on marginal cost.

Scialà & TilliXiamen - LABOR Job Creation Profit maximization and symmetric equilibrium determine a job creation condition: (JC) JC represents the level of wage that firms are willing to pay, and is a decreasing function of , since higher  reduces m(  ) with an increase in the expected search costs. The wage is lower than productivity because of both the finite value of the demand elasticity of product and the search externality.

Scialà & TilliXiamen - LABOR Nash Bargaining The economic activity yields a surplus that is shared between the two parties by a Nash bargaining. The maximization of the geometric average of the surplus of workers (S W ) and firms (S F ) weighted with the relative bargaining power determines the following sharing rule: where  is the bargaining power of the worker and t is the tax rate on wages.

Scialà & TilliXiamen - LABOR Wage Equation Given the sharing rule, the optimal behavior of the economic agents yields the following wage equation: (WE) When θ is high the expected recruiting cost faced by firms is high, while, conversely, the cost for workers to wait for the next job offer is low. This implies that workers can bargain better wages. With a higher t, the worker will claim a higher wage in order to preserve the level of the net wage.

Scialà & TilliXiamen - LABOR Government Budget Constraint No public deficits are allowed, hence Government faces the following budget constraint: we can express the budget constraint as: As θm(θ) is an increasing function of θ, equation PB states a decreasing relationship between the tax rate t and the labor market tightness. Higher θ decreases the unemployment rate; as a consequence we have a reduction of the expenditure for unemployment benefits and, given t, an increase of the public revenue. Hence, the public budget balance requires a lower level of t. (PB)

Scialà & TilliXiamen - LABOR Equilibrium is described by the following equations: The wage equation, which is a pseudo labor supply deriving from the Nash bargaining; The job creation, which is a pseudo labor demand deriving from the profit maximization; The government budget constraint; The Beveridge curve, which expresses the flows equilibrium in the labor market. The Equilibrium

Scialà & TilliXiamen - LABOR Beveridge Curve Zero Profit Condition

Scialà & TilliXiamen - LABOR The Equilibrium Tightness and Tax Rate

Scialà & TilliXiamen - LABOR Increasing Product Market Competition

Scialà & TilliXiamen - LABOR Consider the effect of an increase in the demand elasticity. The (JC=WE) curve moves up to the right: –Given t, we have that both the wage that firms are willing to pay and the one required by the workers increase; the latter increase is proportionally lower than the former: hence, given t, the "demand side" wage is higher than the "supply side" one. –Firms will open a higher number of vacancies, that in turn implies a higher θ: that implies a lower u (shift from A to B) In B, the labor market is in equilibrium (we are on the (JC=WE) curve) but the public budget is in surplus Given , lower tax rate t is required in order to balance the Government budget. –The reduction of the tax rate produces a feedback on the bargained wage because workers will perceive a higher net wage and they will claim a lower gross wage, with a further positive effect on θ (given the wage offered by the firm). The final result of this process will be a higher equilibrium value of θ and a lower equilibrium value of t (point C in figure).

Scialà & TilliXiamen - LABOR Increasing Unemployment Benefit

Scialà & TilliXiamen - LABOR Consider now an increase in the replacement ratio ρ. This implies a shift down to the left of the (JC=WE) curve and up to the right of the PB curve. The former effect stands from the fact that, given t, an increase in ρ enhances the option value of the worker which will claim for a higher gross wage. Consequently, because of the negative effect on profit, firms reduce vacancies. This leads to a higher level of wage w and a lower level of tightness θ. The shift of the PB curve is due to the fact that, given θ, an increase in ρ requires a higher tax rate t in order to balance the public budget. A specular process with respect to the one discussed above with regard to an increase in σ, leads to a lower equilibrium value of θ and a higher equilibrium tax rate t. Looking at the figure, we move from equilibrium A to equilibrium B.

Scialà & TilliXiamen - LABOR t  (JC=WE) PB A B C D

Scialà & TilliXiamen - LABOR Suppose that, after the 90s labor market flexibilization, we are now in point A As shown above, an increase in u.b. leads to the equilibrium B: i.e. we would pay a cost in terms of higher unemployment Liberalization policies could permit –to avoid an increase in unemployment if we allow some rise in the tax rate (point C); –to decrease unemployment if liberalization policies are incisive enough to keep the tax rate unchanged (point D)

Scialà & TilliXiamen - LABOR Main Conclusions Unemployment can be reduced increasing competition in goods market; however… …such reforms may claim for an increase of welfare state expenditure; then… …an appropriate combination of the two policy is required

Scialà & TilliXiamen - LABOR Extensions Demand elasticity depending on the number of firms (Hotelling) Tax function with coefficient of residual income progression (Musgrave and Thin, 1948) Workers heterogeneity and ridistibutive effects