Labor market regulation under self‐enforcing contracts

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 riskneutral 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 distinguishing 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 employers, 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 Protection 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, unemployment payment is usually financed by payroll tax paid by emp...

Introduction to the thematic issue on “Regulation in health, environmental and innovation sectors”

“…Nowadays, labor market reforms constitute a priority in the policy agenda of many countries, aiming to fine-tune the trade-off between the flexibility of labor markets and the economic security of workers. The paper by Avcioglu and Karabay (2020) examines the effects of various labor market institutions (or regulatory policies) on the welfare of workers and employers, in the tradition of Actras et al (2006). The authors consider self-enforcing contracts between riskaverse workers and risk-neutral employers in a labor market with search frictions.…”