Should wages be subsidized in a pandemic?

Abstract

We use a labor search model with heterogenous households and firms to study the efficacy of a wage subsidy during a pandemic, relative to enhancing unemployment benefits. A large proportion of the economy is forced to shut down, and firms in that sector choose whether to lay off workers or keep them on payroll. A wage subsidy encourages firms to keep workers on payroll, which speeds up labor market recovery after the pandemic ends. However, a wage subsidy can be costlier than enhancing unemployment benefits. If the shutdown is long or profit margins are low, then a wage subsidy is preferable and vice versa. The optimal mixture of policies includes a wage subsidy that covers 90 $\%$ of the first $200/week of earnings and expands unemployment benefits to cover all salary up to $275/week. Low-income workers, as well as those in less productive jobs, benefit the most from a wage subsidy.

How well-targeted are payroll tax cuts as a response to COVID-19? evidence from China

“…However, while we have made empirical statements about the liquidity-targeting properties of payroll tax cuts, the broader welfare effect of wage subsidies is more complicated. Birinci et al (2021) and Abbott and Van Phan (2021) use calibrated labor market search models to demonstrate that wage subsidies are an optimal fiscal response to a pandemic shock in labor markets with frictions, especially, though not exclusively, when unemployment insurance is limited (as in China). In these models, a welfare benefit arises because wage subsidies preserve employee-firm matches which provides direct income smoothing and speeds up the recovery once the initial shock subsides.…”

“…Yet labor market informality raises additional considerations that neither Birinci et al (2021) nor Abbott and Van Phan (2021) incorporate. For instance, formal employment may reflect better-quality matches, increasing the social value of retention of formal matches relative to informal ones.…”