Labor market regulation under self‐enforcing contracts

• Published date: 01 December 2020
• Author: Sahin Avcioglu,Bilgehan Karabay
• Date: 01 December 2020
• DOI: http://doi.org/10.1111/jpet.12481

J Public Econ Theory. 2020;22:1965–2018.wileyonlinelibrary.com/journal/jpet© 2020 Wiley Periodicals LLC

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1965

Received: 12 July 2019

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Accepted: 20 September 2020

DOI: 10.1111/jpet.12481

ORIGINAL ARTICLE

Labor market regulation under self‐enforcing

contracts

Sahin Avcioglu

1

|Bilgehan Karabay

2

1

Accident Compensation Corporation,

Wellington, New Zealand

2

School of Economics, Finance and

Marketing, RMIT University, Melbourne,

Victoria, Australia

Correspondence

Bilgehan Karabay, School of Economics,

Finance and Marketing, RMIT University,

Building 80, Level 11, 445 Swanston Street,

Melbourne, VIC 3000, Australia.

Email: bilgehan.karabay@gmail.com

Abstract

This paper examines the effects of various labor

market institutions (policies) on the welfare of

workers and employers. We consider self‐enforcing

contracts between risk‐averse workers and risk‐

neutral employers in a labor market with search

frictions. Employers promise to smooth out shocks to

wages while workers promise long‐term commitment

to employers. In this environment, regulatory policies

can make it easier or harder for employers to keep

their promise of wage smoothing, thus influencing

the benefit accruing to each party. In our approach,

we analyze the joint effect of policies by distin-

guishing between the financing and spending of

funds used in the regulation of the labor market.

With regard to financing, layoff tax strictly dominates

hiring and payroll taxes on efficiency grounds,

whereas the relative ranking of hiring and payroll

taxes depend on the type of equilibrium that realizes.

On the spending side, while unemployment payment

increases workers' welfare at the expense of em-

ployers, in‐work benefit in the form of a one‐off wage

subsidy leaves workers' welfare intact but may

increase the welfare of employers.

1|INTRODUCTION

The design of labor market policies (institutions) is an important yet a controversial topic. It is

important since the well‐being of workers and employers depends on specific policies that are

in place. It is controversial since there is a trade‐off between the flexibility of labor markets and

the economic security of workers and there is no consensus on the choice of optimal policy mix

among economists and policymakers.

Today, labor market reforms constitute a priority in the policy agenda of many countries.

There are three important components of these reforms. The first one is ‘Employment Pro-

tection Legislation (EPL)’. EPL consists of laws adopted by many countries to reduce layoffs and

raise job security for employed workers. The second one is ‘Unemployment Benefits (UBs)’,

which provide income in case of unemployment. The final component is ‘Active Labor Market

Policies (ALMPs)’. These are policies that are designed to facilitate the movement of workers

from unemployment to employment.

1

We believe, as in Heckman (2005), that causal effects cannot be defined outside theory.

2

Hence we construct a theoretical model, in which we study the joint effect of labor market

institutions, that is, both the financing and spending sides, on the welfare of workers and

employers.

3

This is essential since when we look at different country experiences, we see that

reforms in the labor market do not take place in isolation. On the financing side, we consider

payroll tax, layoff tax,

4

and hiring tax. Both layoff tax and hiring tax are elements of EPL such

that they make it costly to fire an existing worker or hire a new worker. On the other hand,

payroll tax is a component of ‘tax wedge’, which is a measure of the difference between labor

costs to employers and the corresponding net payment workers receive. In practice, un-

employment payment is usually financed by payroll tax paid by employers or employees, and by

government contributions (Holmlund, 1998). Therefore for comparison, we also consider

payroll tax as an alternative to hiring and layoff taxes. On the spending side, we consider

unemployment payment and in‐work benefit in the form of a one‐off wage subsidy. While

unemployment payment is part of UBs, in‐work benefit is part of ALMPs.

5

In our setup, risk‐averse workers and risk‐neutral employers must search for one another

until they match and form a ‘firm’. There are idiosyncratic output shocks (good and bad) that

can be observed only by agents within the firm. As a result, written contracts are not en-

forceable. The only way to maintain a relationship is via self‐enforcing contracts, in which

employers promise to smooth out shocks to wages in return for long‐run commitment by

workers. Since employers are risk‐neutral whereas workers are risk‐averse, equilibrium is ef-

ficient when wage payments are constant. However, when the firm is in difficulty, employers

may not keep their promise of full‐wage insurance (constant wage) and inefficient equilibrium

with fluctuating wages results. Put differently, when a negative shock occurs, it is harder for the

employer's incentive compatibility constraint to be satisfied.

1

There are different categories of ALMPs, such as public employment services, training schemes, employment subsidies,

and so forth. More on this can be found in Lehmann and Kluve (2010).

2

One major point made by Eichhorst et al. (2008) is that future work should be devoted to construct theoretical

underpinnings of interactions between different institutions that affect the labor market, and also between institutions

and economic environment to guide empirical work.

3

It is also possible to consider these institutions as part of a taxation problem, consisting of taxes and accompanying

transfers. For example, see Boadway and Cuff (2018) for a joint design of income taxation and unemployment

insurance.

4

As will be clear, due to the information structure of our model, regulators cannot know the exact cause of a termi-

nation of a given employment relationship. As a result, there is no clear‐cut distinction between layoff tax and firing tax

in our framework. For consistency, we will use the term ‘layoff tax’throughout the paper.

5

In‐work benefits are assistance provided to workers by governments conditional on work. These benefits can take

various forms, such as earned income tax credit, working family tax credit, wage subsidy, and so forth. In this paper, our

focus is on a one‐off wage subsidy directly given to workers at the start of employment.

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AVCIOGLU AND KARABAY

We analyze how different labor market institutions can affect the efficiency of equilibrium by

making it easier or harder for employers to keep their wage promise. In other words, we look at the

wage effects of these institutions on the welfare of workers and employers. With regard to

the financing, we find that layoff tax strictly dominates other taxes on efficiency grounds, while the

relative ranking of hiring and payroll taxes depends on the type of equilibrium that realizes. Moreover,

this result is in line with the literature on experience rating: it is better to finance any benefits

provided to unemployed workers with layoff tax. Our reasoning is different, however. While the

literature justifies the use of layoff tax on the basis of productive efficiency (see, e.g.,Blanchard&

Tirole, 2008), in our framework, it is preferred on account of allocative efficiency.

6

On the spending side,

while unemployment payment increases workers' welfare at the expense of employers, one‐off wage

subsidy leaves workers' welfare intact but may increase the welfare of employers.

7

Related literature: Although a rich literature studies the effects of labor market institutions, a

vast majority of these studies examine core labor market institutions in isolation from one

another. There are some notable exceptions, in which the effect of experience rating on em-

ployment and welfare is analyzed.

8

,

9

A large body of literature utilizes some version of the

Diamond–Mortensen–Pissarides equilibrium search model for this purpose: see, among others,

Millard and Mortensen (1997), Cahuc and Malherbet (2004), Baumann and Stähler (2006),

L'Haridon and Malherbet (2009), and Michau (2015). There are also studies that use other

modeling choices. For example, while Albrecht and Vroman (1999) and Fath and Fuest (2005)

employ the efficiency wage model of Shapiro and Stiglitz (1984), Mongrain and Roberts (2005),

Blanchard and Tirole (2008), and Cahuc and Zylberberg (2008) employ static models.

Our paper is different than these papers. First, our focus is not merely on experience rating,

namely, the choice between payroll tax and layoff tax. We also consider other labor market

policies and their interactions. For example, on the spending side, we consider the interaction

between unemployment payment and in‐work benefit in the form of a one‐off wage subsidy

given to workers. Second, many of these studies mainly focus on the effects of labor market

institutions on aggregate economic outcomes.

10

However, the impact of labor market institu-

tions on aggregate economic outcomes, such as unemployment and output, is unclear.

11

The

only robust finding is that they affect the distribution of income (see Betcherman, 2012;

Freeman, 2008). For example in a recent study, Dolado et al. (2018) analyze, within a com-

putationally tractable model, the effect of replacing a dual EPL system with a unified EPL

scheme and show that a unified EPL scheme reduces unemployment and worker turnover at

6

Blanchard and Tirole (2008) find that, absent any further limitations, full experience rating, in which firms cover the

whole cost of UBs through layoff tax, is optimal. This helps employers to internalize the cost of layoffs and leads to an

efficient layoff decision. This argument was first put forth by Feldstein (1976).

7

When there are incentive problems between agents in a team, generally a budget breaker, such as an insurance

company (private insurance) or the government (public insurance), is needed (see Holmström, 1982). Following the

majority of the literature, we assume that the government is the sole provider for these policies and thus exclude

market‐based solutions. For examples of such policies between private parties, see Fella and Tyson (2013). See also

Chetty and Saez (2010) for the coexistence of public and private insurance. In their paper, they also list reasons why

government insurance is still needed in the presence of private insurance.

8

Earlier papers on experience rating focus on temporary layoffs. These include Feldstein (1976), Burdett and Wright

(1989a,b), and Marceau (1993).

9

Holmlund (1998) provides a survey of the effects of experience rating on unemployment and welfare.

10

These studies use different modeling approaches, which potentially affect the change in aggregate outcomes. For

example, Baydur (2017) compares the standard Diamond–Mortensen–Pissarides model with the worker‐selection

model and concludes that the response of unemployment to changes in policies is much larger in the worker‐selection

model.

11

See Freeman (2005) and Heckman (2007) on the fragility of evidence on the role of labor market institutions.

AVCIOGLU AND KARABAY

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