Institut C.D. Howe Communiqué · The study, A Job-Creation Strategy for Governments with No Money, by William Scarth, Professor of Economics at McMaster University in Hamilton, Ont.,

C.D. Howe InstituteInstitut C.D. Howe Communiqué

Embargo: For release Wednesday, April 23, 1997

Changes in payroll taxneeded to spur job creation,

says C.D. Howe Institute study

Employer contributions to the employment insurance (EI) program need to be restructured,concludes a C.D. Howe Institute Commentary released today. Specifically, the study suggestsreducing the payroll tax employers pay for hiring low-wage workers and increasing the taxthey pay for hiring high-wage workers.

The study, A Job-Creation Strategy for Governments with No Money, by William Scarth,Professor of Economics at McMaster University in Hamilton, Ont., and an Adjunct Scholar ofthe C.D. Howe Institute, was prompted by dual concerns: Canada’s continuing high unem-ployment rate, and necessary fiscal constraints.

Scarth notes that, since the payroll tax is seen as a “tax on jobs” and is regularly referredto as a “job killer,” there have been widespread calls for large cuts in EI contributions. Ottawaoffered a small reduction in its most recent budget and has promised larger cuts in the future.But both the current and anticipated payroll tax cuts are across the board, the wisdom of whichScarth questions, for three reasons.

First, government funds are limited, so job-creation initiatives must be concentrated inareas where they have the biggest impact on unemployment. Second, inequality of marketearnings between high- and low-wage workers has increased over the past 20 years; as a result,equity objectives need to be emphasized when promoting jobs. Third, Scarth argues, there isa fundamental difference in the way that markets for skilled and unskilled workers operate.

In skilled labor markets, the employer payroll tax affects both demand and supply. Onthe demand side, it reduces firms’ ability to pay for workers. But since employees base wageclaims on their employer’s ability to pay, this tax also decreases the wage claims workers make.Empirical studies confirm that the net result is lower wages, not lower employment. Inunskilled labor markets, on the other hand, institutions such as minimum-wage laws keepwages from falling, so there is nothing to counteract the depressing effect of the employerpayroll tax on employment. As a result, Scarth says, while the payroll tax imposed on theemployers of skilled labor is not a job killer, the tax imposed on the employers of unskilledlabor does qualify for this discouraging label.

Scarth’s job-creation strategy is based on this basic insight. The idea is to cut a tax that isa job killer, and to make up for the lost government revenue by raising a tax that is not a jobkiller.

The proposal is self-financing — that is, revenue neutral — an important considerationsince the “fiscal dividend” that will emerge gradually as deficit reduction proceeds has not yetarrived. Scarth addresses concerns critics may raise about its effect on capital investment andthe wages of skilled workers. After all, when firms hire more of one input (unskilled labor) toproduce a fixed level of output, they need less of the other inputs (capital and skilled labor).Such a decreased demand for these other inputs, if it accompanies the proposed restructuringof EI contributions, would lead to the undesirable effects critics fear. Scarth argues, however,that this concern overlooks the fact that firms have no reason to feel constrained to producethe same level of output. Since the overall effect of the proposal is expansionary, the demandfor all inputs should rise.

Scarth points out an interesting parallel between his proposal and personal income taxprovisions that exempt interest earnings from tax (such as Registered Retirement Savings Plans— RRSPs). While it is mostly high-income individuals who benefit directly from these provi-sions, the fact that they lead to unskilled labor’s having more complementary factors ofproduction with which to work means that benefits “trickle down” to these other individuals.Scarth says that the same spreading of higher productivity benefits occurs with his proposal— only in this case, the direct benefits go to the unskilled and the indirect benefits “percolateup” to others. Given this parallel, defenders of RRSPs should have no difficulty with hisproposal, Scarth argues. His analysis shows that it raises both the general level of wages andinvestment, while reducing unemployment.

Scarth argues that his proposal is an appealing option for any government that wants tomaintain a hard head (by living within its fiscal means, respecting the principle that the privateeconomy is the basic creator of jobs, and fostering capital accumulation), while reasserting itsreputation for a soft heart (by actively supporting the disadvantaged).

* * * * *

The C.D. Howe Institute is Canada’s leading independent, nonpartisan, nonprofit economic policy researchinstitution. Its individual and corporate members are drawn from business, labor, agriculture, universities,and the professions.

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For further information, contact: Bill Scarth, (905) 525-9140, ext. 23807Susan Knapp (media relations),

C.D. Howe Institutephone: (416) 865-1904; fax: (416) 865-1866;

e-mail: [email protected];Internet: www.cdhowe.org/eng/pr/new.html

A Job-Creation Strategy for Governments with No Money, C.D. Howe Institute Commentary 92, by William Scarth(C.D. Howe Institute, Toronto, April 1997). 20 pp.; $6.00 (prepaid, plus postage & handling and GST — pleasecontact the Institute for details). ISBN 0-88806-410-1.

Copies are available from: Renouf Publishing Company Limited, 5369 Canotek Road, Ottawa, OntarioK1J 9J3 (stores: 71 1/2Sparks Street, Ottawa, Ontario, phone 613-238-8985; 12 Adelaide Street West, Toronto,Ontario, phone 416-363-3171); or directly from the C.D. Howe Institute, 125 Adelaide Street East, Toronto,Ontario M5C 1L7.

C.D. Howe Institute / Institut C.D. Howe Communiqué / 2

C.D. Howe InstituteInstitut C.D. Howe Communiqué

Embargo : à diffuser le mercredi 23 avril 1997

Il faudrait modifier les cotisations socialespour encourager la création d’emplois,

affirme une étude de l’Institut C.D. Howe

Il importe de restructurer les cotisations patronales au programme d’assurance-emploi, conclutun Commentaire de l’Institut C.D. Howe publié aujourd’hui. L’étude recommande plus particu-lièrement que l’on réduise les charges sociales des employeurs pour les gagne-petit et que l’onaugmente celles-ci pour les employeurs qui engagent des travailleurs à salaire élevé.

L’étude, intitulée A Job-Creation Strategy for Governments with No Money (Une stratégie decréation d’emplois pour les gouvernements à court d’argent) et rédigée par William Scarth, pro-fesseur d’économique à l’Université McMaster de Hamilton (Ontario) et attaché de rechercheà l’Institut C.D. Howe, est animée par une double préoccupation : le taux de chômage élevéqui persiste au Canada et les restrictions financières en vigueur.

Selon M. Scarth, on réclame de manière générale d’importantes réductions des cotisationsd’assurance-emploi; en effet, on perçoit celles-ci comme un « impôt sur l’emploi » et y on faitsouvent allusion en les appelant des « tueuses d’emplois ». Dans son récent budget, Ottawaproposait une modeste réduction, tout en promettant des coupures plus importantes dansl’avenir. Cependant, ces réductions, tant actuelles que prévues, sont générales, et c’est ce pointque M. Scarth remet en question, pour trois raisons.

En premier lieu, le gouvernement dispose de fonds limités; il faut donc diriger lesinitiatives de créations d’emplois vers des domaines où elles exerceront les répercussions lesplus importantes sur le chômage. En second lieu, l’inégalité des revenus entre les travailleursà salaire élevé et ceux à salaire modeste s’est accrue au cours des 20 dernières années; enconséquence, il importe de mettre l’accent sur les objectifs d’équité dans la promotion d’em-plois. Troisièmement, soutient M. Scarth, il existe une différence fondamentale dans la façondont les marchés fonctionnent pour les travailleurs qualifiés et ceux qui ne le sont pas.

Dans le cas du marché de l’emploi pour les travailleurs qualifiés, les charges sociales del’employeur influent tant sur l’offre que sur la demande. Du côté de la demande, ellesrestreignent la capacité des entreprises à payer pour des employés. Mais étant donné que lesemployés fondent leurs prétentions salariales sur la capacité de paiement de leur employeur,cette taxe réduit du même coup les revendications salariales des employés. Selon des étudesconcrètes, il en résulte une réduction des salaires et non une réduction des emplois. Par contre,

dans le marché de l’emploi pour les travailleurs non qualifiés, des institutions comme les loissur le salaire minimum empêchent cette baisse des salaires de se produire, et il n’y a donc pasmoyen d’obvier aux effets négatifs des charges sociales de l’employeur sur l’emploi. Enconséquence, explique M. Scarth, alors que les charges sociales perçues auprès des employeursde main-d’œuvre qualifiée ne sont pas des tueuses d’emplois, les charges sociales que l’onimpose aux employeurs de main-d’œuvre non qualifiée, elles, peuvent être cataloguées commetelles.

M. Scarth propose une stratégie de création d’emplois qui découle de cette théorie. Sonidée consiste donc à éliminer les charges sociales qui nuisent à l’emploi, et de récupérer lemanque à gagner par le biais d’une hausse des charges sociales qui elles, n’y nuisent pas.

Cette proposition est autofinancée — donc sans incidence sur les recettes — et il s’agit làd’une considération importante, puisque le « dividende fiscal » qui devrait faire son apparitiongraduellement avec la réduction du déficit ne s’est pas encore manifesté. M. Scarth aborde lespréoccupations que pourraient soulever les détracteurs vis-à-vis des répercussions sur l’inves-tissement des capitaux et les salaires des travailleurs qualifiés. Après tout, lorsque les entre-prises engagent plus d’intrants (soit de main-d’œuvre non qualifiée) pour produire un niveaudonné d’extrants, leur besoin des autres intrants (soit le capital et la main-d’œuvre qualifiée)diminue. Si la restructuration proposée des cotisations d’assurance-emploi s’assortit d’une tellebaisse de la demande pour les autres intrants, elle produira les effets indésirables que redoutentles détracteurs. Toutefois, soutient M. Scarth, cette préoccupation ne tient pas compte du faitque les entreprises n’ont aucun raison de s’en tenir au même niveau d’extrants. Étant donnéque l’effet global de cette proposition est expansionniste, il devrait en fait s’ensuivre une haussede la demande de tous les intrants.

M. Scarth souligne un intéressant parallèle entre sa proposition et les dispositions relativesà l’impôt sur les particuliers qui exemptent de l’impôt certains intérêts créditeurs (comme ceuxdes régimes enregistrés d’épargne-retraite — les REER). Bien que ces dispositions profitentsurtout directement aux individus à revenus élevés, elles entraînent aussi une hausse desfacteurs complémentaires de production chez la main-d’œuvre non qualifiée, et elles démon-trent ainsi que ces gains ont des retombées sur ces individus. M. Scarth indique que saproposition entraîne un étalement similaire des gains de productivité plus élevée — sauf quedans ce cas, c’est la main-d’œuvre non qualifiée qui perçoit les gains directs et les autres quien profitent indirectement. Compte tenu de ce parallèle, les défenseurs des REER ne devraientdonc pas éprouver de difficultés avec cette proposition, soutient M. Scarth. Son analysedémontre qu’elle hausse le niveau général des salaires et des investissements, tout en réduisantle chômage.

M. Scarth ajoute que sa proposition constitue une option attrayante pour tout gouverne-ment qui veut prouver qu’il garde la tête sur les épaules (en vivant selon ses moyens financiers,en respectant le principe selon lequel le secteur privé est le principal créateur d’emplois et enfavorisant l’accumulation de capitaux), tout en montrant qu’il a le cœur tendre (en soutenantactivement les groupes défavorisés).

* * * * *

L’Institut C.D. Howe est un organisme indépendant, non-partisan et à but non lucratif, qui joue un rôleprépondérant au Canada en matière de recherche sur la politique économique. Ses membres, individuels etsociétaires, proviennent du milieu des affaires, syndical, agricole, universitaire et professionnel.


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Renseignements : Bill Scarth, 905 525-9140, poste 23807Susan Knapp (relations avec les médias)

Institut C.D. Howetéléphone : 416 865-1904; télécopieur : 416 865-1866

c. électr. : [email protected] : http://www.cdhowe.org/fr/index.html

AJob-Creation Strategy for Governments with No Money, Commentaire no 92 de l’Institut C.D. Howe, par WilliamScarth, Toronto, Institut C.D. Howe, avril 1997, 20 p., 6,00 $ (les commandes sont payables d’avance, etdoivent comprendre les frais d’envoi, ainsi que la TPS — prière de communiquer avec l’Institut à cet effet).ISBN 0-88806-410-1.

On peut se procurer des exemplaires de cet ouvrage auprès des : Éditions Renouf ltée, 5369, chemin Canotek,Ottawa ON K1J 9J3 (librairies : 711/2, rue Sparks, Ottawa ON, tél. 613 238-8985 et 12, rue Adelaide ouest,Toronto ON, tél. 416 363-3171), ou encore en s’adressant directement à l’Institut C. D. Howe, 125, rueAdelaide est, Toronto ON M5C 1L7.


EmploymentPolicy

A Job-Creation Strategy forGovernments with No Money

by

William Scarth

With the national unemployment rate hoveringnear double digits and a federal election on thehorizon, Canadians are recalling the 1993election promise of “jobs, jobs, jobs.” SinceOttawa’s deficit-reduction targets are beingmet, many commentators argue that it is timeto spend some of its fiscal dividend. Those onthe right call for a tax cut — particularly in thepayroll tax, a levy regularly called a job killer.Those who favor more active government callfor retraining programs or wage andemployment subsidies.

The best option is a wage subsidy forlow-income workers, one provided as a payrolltax cut for employers, but only for theirlow-wage workers.

The main benefit would be lowerunemployment, but other outcomes should bea rise in both wages and investment, so theproposal should meet no political resistancefrom those interested in protecting the wages

of the already employed or the level of newcapital investment. Moreover, no newbureaucracy would be needed.

All this can be accomplished withoutabandoning deficit reduction. No significantfiscal dividend will appear until the ratio ofgovernment debt to gross domestic productfalls, an event that will not occur before 2000.The recommendation here, however, does notrequire a fiscal dividend. Rather, the payroll taxcut for low-wage workers can be financed by apayroll tax increase for higher-wage workerswithout jeopardizing any of the benefits.

All in all, this policy seems an appealingoption for a government that wants to maintaina hard head (by living within its fiscal means,respecting the principle that the privateeconomy is the basic creator of jobs, and byfostering capital accumulation) whilereasserting its reputation for a soft heart (byactively supporting the disadvantaged).

Main Findings of the Commentary

• In recent years, skills-based technological change has led to both higher unem-ployment, especially in Europe, and increased income inequality, especially in theUnited States. Canada needs a policy initiative that helps to limit similar out-comes. This initiative must respect the ongoing need for fiscal retrenchment andthe fact that the private sector is the economy’s basic generator of jobs.

• Employment insurance (EI) contributions are a form of payroll tax often called ajob killer. These contributions have four components: taxes paid by (1) firms foremploying high-wage individuals; (2) firms for employing low-wage individuals;(3) high-wage employees; and (4) low-wage employees. The analysis in this Com-mentary indicates that only (2) and (3) are job killers.

• If policy is to stimulate employment and lessen income inequality, only a cut intax (2) is warranted. A one percentage point cut in the employer payroll tax onlow-wage employees can reduce the unemployment rate of unskilled workers byfour-fifths of a percentage point.

• For additional job creation, the employer contribution to EI for low-wage employeesmay have to become negative. In that case, the tax should be relabeled a generalwage subsidy paid to firms for all low-wage employees. Given that the Commen-tary‘s recommendation is for both a tax cut (favored by the right) and a low-wagesubsidy (favored by the left), it may draw widespread political support.

• Some argue against wage subsidies on the grounds that they might lead todownward pressure on the wages of those already employed and on firms’ incentiveto invest in new capital equipment. But the analysis here shows that wages andinvestment can be expected to rise, not fall, when the recommended policy isimplemented.

• Any responsible proposal for government policy must be accompanied by anexplanation of how it can be financed.

• The federal government’s set of deficit-ratio targets was based on the assumptionthat funds saved through EI reform would be kept within the employmentenvelope. If Ottawa maintains this commitment, some $4 billion is now available,an amount more than enough to finance elimination of the employer EI contribu-tions for all employees earning less than $30,000 annually.

• If, instead, the government now intends to put all of these funds toward deficitreduction, some other tax must be increased to finance the recommended initia-tive. The analysis shows that a small increase in the employer payroll tax onhigh-wage employees would be sufficient to pay for the proposed initiative, leavingpositive effects on employment, wages, and investment.

Canada’s recent macroeconomic policyhas been based on three objectives: toreduce inflation (and thereby achievea corresponding reduction in nominal

interest rates); to eliminate the deficit (and there-by achieve higher future living standards); andto facilitate higher levels of employment.

The federal government has adopted ex-plicit numerical targets for both the inflationrate and the budget deficit. Has employmentreally been an objective? Critics question thispoint, and demand an explicit target for reduc-ing the unemployment rate, which would putsome flesh on the 1993 election promise of“jobs, jobs, jobs.”

Ottawa has set no specific unemploymenttarget, however, perhaps in part because itfeels it has insufficient policy instruments atits disposal. After all, government has just twoaggregate instruments — fiscal and monetarypolicy — and with these earmarked for deficitreduction and inflation control, nothing seemsavailable left in the short term for the employ-ment objective.

Is this sense of impotence justified? I be-lieve it is not, given that unemployment can bedivided into cyclical and structural compo-nents (see the box on p. 4), which have quitedifferent causes and respond differently tovarious government policies, and given thatthe federal government has some freedom inchoosing the specific details of monetary andfiscal policy.

On the monetary policy front, for example,more than one implementation strategy is avail-able for controlling the average inflation rate.The Bank of Canada should choose the strat-egy that is also best for limiting fluctuations incyclical unemployment, which, as I argue else-where,1 may involve using a target for the nomi-nal gross domestic product (GDP), an approachthat could help to stabilize employment withoutfostering inflationary expectations.2

As for the use of fiscal policy, deficit reduc-tion simply requires limiting the differencebetween the overall levels of spending andtaxation; the government can still alter therelative sizes of individual expenditure pro-

grams and particular taxes with a view toreducing structural unemployment. Ottawa’sinitial plan of reducing employment insurance(EI) benefits and using the savings to spendmore on retraining is just one of many possiblerevenue-neutral switches.

I applaud this general strategy, but I arguethat there is a preferred revenue-neutral policypackage — one that focuses on altering thestructure of the employer payroll tax withoutaffecting its overall yield. The fundamentaladvantage of this alternative is that it couldreduce structural unemployment without theintroduction any new government program.

Another advantage is that this initiativewould simultaneously raise the general level ofwage incomes and the level of investment innew capital. As Saint-Paul argues,3 proposalsto lower unemployment that would hurt others(such as the employed who suffer if wages arereduced) are of limited interest, given the po-litical constraint that the employed outnum-ber the unemployed. Also, future prosperity isthreatened if capital investment is pusheddown. Thus, the increases in both real wagesand investment are significant parts of theproposal recommended here.

Popular debate on payroll taxation seemsrestricted to whether or not Canada can afforda cut in the overall payroll tax rate. Yet thepayroll tax system has four components —levies on employers and on employees and forhigh-wage and for low-wage workers — andtheir economic effects differ substantially. Myanalysis supports cutting the employer payrolltax levied on low-wage workers and financingthis tax cut by increasing the employer payrolltax on high-wage individuals. This initiativewould be equivalent to providing a wage sub-sidy for low-wage individuals. I consider otherinitiatives, but conclude that these options aredominated by the suggested change in thepayroll tax system.

Outline of the Commentary

The paper proceeds as follows. In the firstsection, I present the standard, graphical analy-sis of payroll taxation. Then, I move to a general-

C.D. Howe Institute Commentary / 3

level discussion of a more involved but morerealistic labor market setting, and I defend myproposal in that setting.

In the following section, I sharpen the analy-sis of the extended labor market setting byreturning to the use of simple supply anddemand graphs. I then turn to considerationof alternative policies for reducing unemploy-ment and show that mine is both the mostequitable and the most immediately practical.A brief conclusion reinforces the argument.

Readers who want a more rigorous defenseof the proposal can consult the appendix, whichoffers a mathematical treatment of the issues.

Supply and Demand

Figures 1 and 2 illustrate the traditional eco-nomic analysis of wages, employment, and

payroll taxes. They describe a competitive la-bor market: firms, which demand labor, like alow wage, while households, which supplylabor, like a high wage. These competing de-sires are incorporated in figures by having thedemand curve negatively sloped and the sup-ply curve positively sloped.

Point A in Figure 1 is the equilibrium point.It is the market outcome since it is the onlycombination of wages and employment thatsatisfies the desires of both sides of the mar-ket. Payroll taxes are analyzed by determininghow their imposition changes the location ofthis point.

If the tax is a levy on employers, firms’willingness to pay for labor is reduced, achange shown in Figure 2 as a downward shiftin the labor demand curve (by the amount ofthe perunit tax). The new equilibrium is point B.

Cyclical and Structural UnemploymentAnalysts divide unemployment into two catego-ries, cyclical and structural unemployment, whichhave quite different underlying causes.

Cyclical unemployment is caused by the factthat all market-oriented economies experiencebusiness cycles. The conventional analysis ofcycles relies on sticky prices and wages. Forexample, when the demand for goods and servicesfalls, firms and workers are slow to adjust theirprices to lower levels. When the pre-existing levelof prices is too high to clear markets, firms reduceoutput and lay off some workers. Thus, cyclicalunemployment emerges as the economy movesinto recession.

Eventually, a recession induces workers tolower their wage claims. As a result, employersfind it profitable to rehire workers, and cyclicalunemployment is gradually eliminated.

Structural unemployment exists even whenwages and prices adjust completely to demand. Theoverall level of demand may be adequate to createenough job vacancies, but the skills of job aspirantsmay be poorly matched with these opportunities.Even without misalignments in skills, industries, orlocations, structural unemployment can still occuras a result of imperfect competition and incompleteinformation.

Competition can be limited both by govern-ment policy (through such initiatives as mini-mum wage laws) and by private market power.Either form of departure from competition can

leave wages at such a level that it is not in firms’profit interest to employ all those who would likework.

Incomplete information can also lead to un-employment. In many industries, upper-levelmanagers cannot measure the differential effortexpended by each individual employee. Thesemanagers may turn to indirectly inducing work-ers to limit shirking on the job by making theprospect of losing a job particularly unappealing.One way to do so is to pay a wage higher thanwould otherwise be profitable, so that the gapbetween what is received on the job and what isreceived if the worker is fired becomes a signifi-cant magnitude. But when many firms follow thisstrategy, the overall level of wages settles at toohigh a value to generate full employment. Readerscan think of this component of structural unem-ployment as existing because wages cannot per-form two market-clearing tasks at the same time.If wages are set to clear the market in workereffort, they cannot also be set to clear the marketfor all the individuals who want work. This incom-plete-information rationale for structural unem-ployment is known as the efficiency-wage theory(since it focuses on the proposition that employ-ers use high wages to elicit a higher level ofefficiency and effort from workers). It is a modern,more formal version of the Marxian notion thatfirms use a hoard of unemployed at the factorygate to keep workers on their toes.

4 / C.D. Howe Institute Commentary

By comparing points A and B, the analyst cansee that the tax causes employment to fall.

If, on the other hand, the payroll tax is alevy on employees, their wage claims increase,so the supply curve shifts up by the amountof the tax. The new equilibrium in this case ispoint C; once again, employment is reduced.

From this standard analysis, two funda-mental points follow:

• the effects of the payroll tax do not dependon which side of the market it is levied;

• the loss of jobs that accompanies the pay-roll tax is small when the supply and de-mand curves are inelastic and large whenthese curves are elastic.

The first proposition follows from the factthat points B and C lie along the same verticalline in Figure 2. The total revenue collectedfrom the tax is the shaded rectangle, whetherit is the employers or the employees who actu-ally transfer these funds to the government.The drop in employment is the same in eachcase as well.

The second proposition can be appreciatedby comparing Figures 2 and 3. In Figure 2,labor supply and demand are both rather un-responsive to wage changes, and the drop inemployment caused by payroll taxation is small.In Figure 3, however, labor supply and demand

respond dramatically to wage changes; the samevertical shift in either of these flatter curvescauses a much bigger drop in employment.

What does the empirical evidence suggestabout the wage elasticity of labor supply anddemand? Looking at the labor force as a whole,most analysts are comfortable with the propo-sition that labor supply is almost completelyinelastic (vertical).4 The implication is that pay-roll taxes have only a very small effect onemployment; employees bear most of the bur-den of such taxes, whether they are nominallylevied on employers or employees. Thus, thestandard analysis does not support the propo-sition that payroll taxes are the job killers theyare sometimes called.

The picture changes, however, when thismethod of investigation is applied specificallyto the unskilled labor market, a setting inwhich both the supply and demand curves aremuch more elastic. On the supply side, theavailability of welfare for these individuals is atempting alternative, so wage cuts evoke asignificant withdrawal of labor supply. On thedemand side, most production processes caninvolve readily available substitutes for un-skilled labor, so wage increases generate asignificant reduction in labor demand. Thus,for low-wage workers, the impact of payrolltaxes is much more like that of Figure 3 —large employment effects.

Number ofworkersDrop in

employment

Wage

Supply

Demand

Wage Supply

A

Demand

Number ofworkers

A

C

B

Wage Supply

Demand

A

Number ofworkers

C

B

Tax revenue

Drop inemployment

Figure 2: A Payroll Tax’sEffect on theLabor Market

Figure 1: The Labor Market Figure 3: A Payroll Tax’sEffect When WageElasticities Are High


The analyses of the last two paragraphscombine to demonstrate that a cut in thepayroll tax levied on low-wage workers can beexpected to raise employment by more than anincrease in the payroll tax on high-wage work-ers that involved the same revenue would re-duce employment. Thus, if the structure of the(EI) contribution system were changed in thisway, Canada could have a self-financing initia-tive that raised employment. This policy pack-age is exactly what I advocate in thisCommentary.

The defense of my proposal could be verybrief if the simple supply and demand analysisabove were completely convincing. However, itinvolves several controversial assumptions:that labor markets are competitive, that work-ers and employers have access to the sameinformation, and (perhaps most alarming) thatthere is no unemployment.

As I clarify in later sections of the paper,some of the key propositions that follow fromthe simplified analysis do not carry over to anextended model of the labor market. For exam-ple, it does matter whether it is employers oremployees who are taxed. But other proposi-tions continue to hold. In particular, the coreproposal of this Commentary receives furthersupport. And because this support is general,I we have confidence in advancing it at thepolicy level.

Unemployment andWage Inequality

The debate about alternative forms of capital-ism is currently drawing much interest.5 Overthe past two decades, technological changehas been decidedly skills based, with the result(in developed countries) that the demand forskilled workers has risen while that for theunskilled has fallen.

Standard supply and demand analysis sug-gests that this development can be expected tobid up wages for skilled individuals and tolower the payments firms can profitably maketo unskilled workers. In other words, withoutgovernment intervention, wage inequality mustrise following skills-based technological change.

The United States and Europe are oftencited as illustrations of the rather differentoutcomes that are possible. The United Stateshas only a limited welfare state, so there is littleto stop increased wage inequality from emerg-ing, as indeed it has over the past 20 years.

Europe, on the other hand, has much moredeveloped welfare states that maintain floorsbelow which the wages of the unskilled cannotbe pushed. Workers can simply opt for statesupport if it exceeds what they can generatefrom market employment. When technologicalchange decreases the demand for unskilledlabor, firms have no freedom to do anythingbut sharply reduce their employment of un-skilled individuals. Thus, Europe has avoidedbig increases in wage inequality, but the un-employment rate has been very high there formany years now.

The policy initiative I advocate in this Com-mentary is a compromise, an attempt to haveless wage inequality than in the United Statesand lower unemployment than in Europe.

Payroll Taxes

As already noted, payroll taxes can be leviedon both employers and employees and on bothskilled (high-wage) and unskilled (low-wage)workers. How do each of these components ofCanada’s payroll tax system affect the level ofemployment of high-wage and low-wage indi-viduals? I consider each category in turn.

An Employer Tax forHigh-Wage Workers

A payroll tax levied on employers for hiringhigh-wage individuals decreases firms’ will-ingness to pay for skilled labor. Workers rec-ognize this fact and so generally reduce theirwage claims in line with firms’ decreased abil-ity to pay. As a result, most empirical studiesfind that this tax is, for all intents and pur-poses, fully passed on to employees in the formof lower wages,6 so this payroll tax is a wagekiller, not a job killer.


To put the point in reverse, a cut in thistax would not raise employment in Canada’sskilled-worker sector; it would only raise thewages of those who already have jobs.

As far as overall employment is concerned,such a tax cut would actually be worse thanuseless since it would have an indirect down-ward effect on the level of employment forunskilled individuals. As noted previously,much of the unemployment among the un-skilled stems from the fact that the welfarestate blocks the downward adjustment of theirwages. Think of a minimum wage law. Thevalue of the minimum wage is customarily tiedto the general level of wages being earned inthe economy. Since a payroll tax cut for skilledworkers would raise their wages, it would pushup the minimum wage. As a result, moreunskilled workers would lose their jobs, andthe overall unemployment rate rise.

This kind of payroll tax cutwould thus provea job-reduction measure, and so must be re-jected.

An Employer Tax forLow-Wage Workers

A payroll tax levied on employers for their low-wage workers decreases firms’ willingness topay for unskilled labor. Unskilled workers rec-ognize this fact, but minimum-wage laws pre-clude their decreasing their wage claims in linewith firms’ decreased ability to pay. Thus, thisparticular payroll tax is a job killer.

This fact is the basic reason that I call fora cut in just this component of the payroll tax.If the tax were cut overall — without distin-guishing between high-wage and low-wageemployees — the level of employment amongthe unskilled would suffer competing effects.Firms’ willingness to hire would be bolsteredby the reduction in the tax itself, but lessenedby the rise in the wage firms must pay theunskilled (which, recall, would be pulled up bythe fact that a general employer tax cut raisesthe level of wages paid to skilled workers, andby the fact that state support levels rise inphase in any society that defines the low-in-come problem in relative terms).

In the specific model of this process dis-cussed more fully in the appendix, these com-peting effects exactly cancel each other out. Asa result, I do not recommend a general payrolltax cut. Indeed, I recommend a cut in the taxlevied for hiring low-wage individuals and (ifnecessary to finance the incentive) an increasein the tax levied for hiring high-wage workers.

An Employee Tax onHigh-Income Workers

A payroll tax levied on employees who arehigh-income workers raises their wage claims.As the wage employers must pay rises, firmsreact by hiring fewer skilled workers. Eventu-ally, since the increase in wages is reflected ina higher minimum wage, firms also hire fewerunskilled workers.

Clearly, cutting this component of the pay-roll tax would be good for Canadian employ-ment. But such an initiative would be un-appealing in equity terms. Moreover, cutting alevy that had been falling on higher-incomeindividuals would mean a loss of revenue.

An Employee Tax onLow-Income Workers

A payroll tax levied on employees who arelow-income workers raises their wage claims.But these claims are not the factor that islimiting employment in the unskilled sector;rather, it is the availability of the welfare state,which imposes the floor on wages and, there-fore, a ceiling on employment. Since the taxdoes not affect this constraint, a cut has noeffect on employment. Thus, while the em-ployee payroll tax levied on high-income indi-viduals is a job killer, that levied on low-incomeindividuals is not.

Yet, if the employee payroll tax is to be cutwith a view to job creation, surely equity con-siderations would force the government to ex-ercise the cut overall, not just for high-incomeearners. Given the forgone revenue, such aninitiative would be expensive.


Recommendation

Consideration of all the possibilities for payrolltax cuts makes it clear that employment couldbest be raised by a selective payroll tax cut onthe employer side of the market. The employertax for hiring low-wage individuals should bereduced, and to make the change revenue-neutral, I recommend simultaneously raisingthe employer tax for high-wage employees.

This package of changes would raise em-ployment without jeopardizing deficit reduc-tion or offending common tenets concerningequity. It would be equivalent to raising thelevel of the existing employer payroll tax acrossthe board to finance a wage subsidy paid tofirms for each employee whose wage is belowa certain amount, and implementation wouldnot require new administrative machinery.

The policy would also have a beneficialeffect on productivity. The three main inputsto the production process — skilled labor,unskilled labor, and physical capital — sharean important interaction. When firms hire moreof one input — say, unskilled labor — the otherinputs have more of this complementary factorwith which to work, an outcome that raisestheir productivity. If firms respond to thesehigher productivity levels by hiring additionalquantities of these complementary inputs, thenthe productivity of the first factor — in thiscase, unskilled labor — is enhanced as well.

This virtuous circle of each factor’s comple-menting the others’ productivity plays an im-portant role in the analysis of my proposal. Thehigher level of employment among low-skilledindividuals that would accompany a low-wagesubsidy would raise the productivity of theother inputs. For capital equipment, it is ap-propriate to assume a high degree of mobilityin this age of globalization; thus, I expect thatthe increased demand for capital would be metby an increased supply. This higher use ofcapital would raise the productivity of, andtherefore the wages paid to, skilled workers.

Overall, then, the low-wage subsidy wouldhave favorable effects on both the general levelof wages and investment in new capital.7

My proposal is, therefore, an example ofwhat has been called “percolate up” — asopposed to “trickle down” — economics. Whilesome of the induced increases in investmentand the wages of skilled workers may taketime, quite general benefits can be expected.

A Quantitative Estimate

How large is the favorable effect on unemploy-ment to be expected from my proposal? In theappendix, I explain that the reduction in theunemployment rate for unskilled workers thatfollows a one percentage point cut in the pay-roll tax levied on firms for employing unskilledlabor is approximated by

(1 − unemployment rate)(1 + payroll tax rate)

.

Substituting representative values into thisformula yields the conclusion that a one per-centage point reduction in the tax can lead toa reduction of four-fifths of a percentage pointin the unemployment rate for low-wage indi-viduals — a significant effect.

To look at the outcome in dollar amounts,EI contributions bring Ottawa roughly $18 bil-lion in revenue annually, $10.5 billion of whichcomes from levies on employers. About $3.6 bil-lion of this $10.5 billion is paid by employersfor their employees with annual incomes below$30,000.8 The $4 billion annual surplus thatnow exists in the EI account could be used tocompletely eliminate the levy for employinglow-income workers. Alternatively, that sur-plus could continue and the employer contri-bution rate for employees with incomes above$30,000 could be raised from 2 to 3 percent.

A Possible Problem

One difficulty with raising the employer pay-roll tax levied on skilled workers is that sucha tax hike could increase the amount of cyclicalunemployment more than the cut in the taxfor low-wage workers would decrease it.

This concern stems from the Keynesiantheory of business cycles. In the textbook macro-


economic model (which involves sticky wagesand flexible goods prices in the short run), anincrease in the employer payroll tax lowersemployment. Too much can be made of thiscaveat, however, for two reasons. First, thetextbook analysis does not distinguish betweenskilled and unskilled workers, and (taking bothgroups together) my proposal does not involveany increase in payroll taxes. Second, in aKeynesian analysis of generalized disequili-brium (with both wages and prices sticky inthe short run), the employer payroll tax doesnot have any job-destruction effect.

In any event, this concern can be alleviatedif the introduction of the proposed policy pack-age is accompanied by a one-time accommo-dation in monetary policy. In the past, Bank ofCanada officials have been comfortable ac-commodating an adverse supply-side shockwith a one-time increase in bank liquidity.Indeed, they clarify current policy as follows:“We distinguish between developments thataffect the price level once and for all and thosethat affect the rate of inflation.”9 Thus, if skep-tics are correct in thinking that the proposedpolicy package might involve an adverse effectin the short run, they must push the Bank tomaintain this response — while adopting (notrejecting) my proposal.

In general, such a policy on the Bank’s partgoes some distance toward meeting Osberg’sgeneral critique of supply-side initiatives: thatthe benefits of policies designed to lower struc-tural unemployment are delayed when cyclicalunemployment exists.10

An Extended Analysis

Supply and demand graphs can be used toclarify the rationale behind the reallocation ofemployer EI contributions that I propose.11

The Graphs Explained

Figures 4 and 5 depict the markets for skilledand unskilled labor, respectively. As usual, thewage levels for each group are calibrated onthe vertical axes, while the level of employment

and the number of available workers are meas-ured along the horizontal axes.

Supply

The vertical line in each graph represents thenumber of individuals who would like work. Atthe aggregate level, these numbers do notdepend on the level of wages.12

It is important to appreciate, however, thatthe line labeled “available workers” does notconstitute the labor supply curve in the caseof skilled workers. Skills give these individualssome bargaining power. Sometimes this poweris reflected through a union that imposes a setof wage claims on the employer, a practiceillustrated by the positively sloped curve inFigure 4. This curve summarizes the standtypically taken by a union: that it will withholdlabor unless its members are compensatedwith a higher wage settlement. A similar wage-claim schedule emerges for skilled workerswho do not have unions. Firms still have toraise wages to elicit better work effort andlower turnover from their employees. The big-ger the difference between wages received onthe job and the unemployment benefits avail-able if employees are let go, the less employeescan afford to risk being fired so the moreseriously they treat their work obligations.Firms secure this increase in effective laborsupplied by offering higher wages.

However the wage-claim line is rational-ized, its existence means the market-outcomepoint is to the left of the available- workers line,and this gap represents unemployment.

No wage-claim line appears in the diagramof the unskilled labor market (Figure 5) be-cause such workers have no bargaining power.They are not unionized, and the employer caneasily monitor whether they are doing theirstraightforward tasks adequately.

Demand

The negatively sloped lines in Figures 4 and 5represent firms’ demand for the two types oflabor. The negative slope illustrates the fact


that, for a given level of productivity and pay-roll taxes, firms find it profitable to hire moreof each kind of labor only if its unit price falls.

The Minimum Wage

With no government restriction in the un-skilled sector, the outcome is A in each graph,the point where demand and the relevant sup-ply curve intersect. Notice that the graphs arealigned so that the equilibrium wage level forskilled workers realistically exceeds that forunskilled workers. This set of outcomes does,however, have one unrealistic feature: there isno unemployment in the unskilled sector. Onlysome of the skilled individuals are unemployed.In reality, the unemployment rate for the un-skilled tends to be higher than that for skilledindividuals.

The most straightforward way of repairingthis aspect of the analysis is to introduce thewelfare state in the form of a binding mini-mum-wage law, which makes all points belowthe horizontal line in Figure 5 unobservable.As a result, the outcome point shifts to B, andthere is unemployment among the unskilledafter all.

Now recall that a particularly developedwelfare state such as Canada views its low-income problem in relative terms, linking the

value of the minimum wage to the level ofwages earned by skilled workers. This policyis included in the graphic analysis by raisingthe minimum-wage line in Figure 5 wheneversome event causes the wage determined inFigure 4 to increase.

Skills-based technological change is justsuch an event. It shifts the demand curve forskilled labor to the right, making wages riseand unemployment fall for these individuals,and it shifts the demand curve for unskilledworkers to the left. With no welfare state, thewage rate for unskilled labor must fall; withthe welfare state, this wage does not fall, butunemployment in that sector rises. With aparticularly developed welfare state, the mini-mum-wage line rises, thereby limiting the risein wage inequality but accentuating the rise inunemployment among the unskilled.

Other Influences onSupply and Demand

Several items affect the position of the demandcurves. The one for skilled labor, for example,shifts to the right in all these situations:

• a rise in the quantity of unskilled laboremployed by the firm;

• a rise in the quantity of physical capitalemployed by the firm;

Figure 4: The Skilled Labor Market

A

Number ofworkersUnemployment

Wageclaims

Individualsavailable forwork

Demand

Wage

A

B

Number ofworkersUnemployment

Minimumwage

Individualsavailable forwork

Demand

Wage

Figure 5: The Unskilled Labor Market


• a fall in the employer payroll tax levied onskilled workers; and

• the offer of an employment subsidy.

All these influences also shift the wage-claim line of skilled workers. If they demandthat their wages adjust to reflect, one for one,any increase in their productivity or, moregenerally, any increase in their employer’sability to pay, then both the labor demandcurve and the wage-claim line shift upward bythe same amount. Employers are willing topass on gains because they must compete toretain their skilled workers. The end result isthat employment is unaffected by measuressuch as a wage subsidy.

Other policies aimed at workers may, how-ever, shift the wage-claim curve without affect-ing the position of the labor-demand curve.Anything that changes the relative payoffs ofworking and not working has such an impact.For example, an increase in the employee pay-roll tax lowers the return from work, and anincrease in the generosity of employment in-surance decreases the relative return fromwork; thus, either measure raises the wage-claim line and (other things equal) increasesunemployment.

In the unskilled labor market graph, theminimum-wage line plays a similar role. In acountry that has an ongoing commitment tolimit low incomes and that defines low inrelative terms, the only shift influence for theminimum-wage line is the level of wages thatemerges in the skilled labor market. (In par-ticular, I assume that what governs this shiftis the wage rate in the skilled sector beforeaccounting for any employee payroll tax.)

If government offers a wage subsidy onlyfor unskilled labor, the relevant demand curveshifts rightward, and no upward shift in theminimum-wage line counteracts the positiveeffect on employment. This absence of a coun-teracting influence is central to the recommen-dation I advance in this Commentary.

The fact that this extended supply anddemand analysis can illustrate so conciselythe tradeoff involved in choosing between the

US and the European reaction to the phe-nomenon of skills-based technological changeshould lend credence to using the same analy-sis for exploring the efficacy of several fiscalpolicies for attacking unemployment.

Alternative Fiscal Policies

The case for any one policy initiative is incom-plete if its proponents cannot demonstratethat it is superior to other possibilities. Cer-tainly, North Americans have been offered aplethora of suggested policies to combat thegrowing wage inequality and high unemploy-ment that is resulting from skills-based tech-nological change.

Education and Retraining

One such option is investment in educationand retraining. Some investments in educa-tion raise the productivity of workers in theskilled sector. When this occurs, both firms’ability to pay wages and workers’ wage claimsare increased. As with a cut in the employerpayroll tax on the employment of skilled work-ers, wages rise and there is no effect on thelevel of employment. But if the minimum wageis increased in proportion to this increase inwages for skilled workers, the effect is higherunemployment among the unskilled.

People who think that any investment ineducation can be used to combat unemploy-ment in this technological age must identifywhat they feel is inapplicable about this analy-sis, which threatens their view. In the appen-dix, I discuss some variations on the model;here, I confine my attention to the empiricalevidence.

Does higher productivity for the alreadyskilled simply raise the standard of living forthose already employed, leaving the unemploy-ment rate for high-wage individuals unaf-fected? The evidence certainly suggests that theanswer is yes. Over this century, all Westerneconomies have seen vast increases in laborproductivity with a corresponding dramatic in-crease in wages and no long-run trend in the


unemployment rate for more skilled individu-als. (This set of outcomes should increase thereader’s confidence in the applicability of thisanalysis.)

Of course, an education and retraining in-itiative can be focused on low-skilled individu-als. If effective, this policy simply transformsthese individuals into high-skilled ones, so thatlower overall unemployment among the un-skilled results. Thus, a well-targeted retraininginitiative can help, at least in principle. There is,however, a serious question about how wellthese programs have operated in practice. Al-though Riddell’s survey indicates that some UItraining programs have worked fairly well, theverdict is often quite negative.13 Heckman con-cludes:

Government investments [in retraining]have not been shown to be effective in anymeaningful cost-benefit sense for severelydisadvantaged adults or older workers. Theavailable evidence supports the followingprescription: invest in the young; subsidizethe old and the severely disabled.14

Wage Subsidies

As already noted, one form of subsidy (thegeneral approach Heckman favors) is equiva-lent to a payroll tax cut. But other forms ofimplementation are possible. For example,some analysts have suggested a set of wagevouchers be distributed to the long-term un-employed. These individuals could then bettercompete in the job market; firms could employthem and enjoy a significant rebate of the wagebill by sending the vouchers to the governmenteach period for reimbursement of part of thewages paid.

Opponents raise several concerns aboutthe wage-voucher suggestion. Some worry thatthe result would simply be substitution: indi-viduals with vouchers would take jobs awayfrom those without. In pilot studies, othersfind that individuals with vouchers becomeearmarked in the eyes of employers as peopleto avoid. After all, if the government feels theyare unemployable without a voucher, risk-

aversion may lead some firms to avoid thesecandidates at any cost. Finally, some ob-servers worry about how to finance wage sub-sidies in an era of scarce government funds.15

A general wage subsidy would avoid thestigma issue. A wage subsidy is general if it isintroduced in the form of a reduction in theemployer payroll tax rate that each firm mustpay. Although I emphasize a subsidy that ap-plies only to low-wage employees, it is stillgeneral in the sense that it is up to the em-ployer to decide whom to hire; thus, all low-wage hires qualify for generating subsidypayments for the firm.

I address the financing issue by explaininghow an increase in the employer payroll taxlevied for high-wage workers would make thepackage self-financing. This revenue-neutralinitiative would raise both the general level ofwages and the level of investment in new capital.

Employment Subsidies

Employment subsidies are another option forgovernment. They induce firms to increase thenumber of jobs they offer (not to make higherwage payments), and so they can raise employ-ment more effectively than wage subsidies.

An employment subsidy program that isavailable to all workers, however, is simply tooexpensive, so initiatives customarily restrictthe subsidies to “new” hires and hence arecalled marginal employment subsidies. In prin-ciple, government pays no subsidy for jobsthat already exist.

There are, however, at least two difficultieswith such a policy. First, all the many new jobs(an average of some 1.25 million each year inCanada in recent years) that would have beencreated even without it would qualify for amarginal employment subsidy and thus raisethe cost of the program. Second, a marginalemployment subsidy creates an incentive forfirms to rearrange their affairs to make evenmore new hires appear in the measured data.(For example, a firm might split into two sepa-rate firms, one contracting and the other ex-panding. The expanding unit would qualify for


employment subsidies even when the overallfirm would not.) The introduction of incentivesof this sort is undesirable.

A number of programs and pilot studiesinvolving employment subsidies exist, and theevaluation of these experiments is still underway.16 The early analysis suggested that thesepolicies can add significantly to employmentgrowth.17 More recently, in a series of booksand papers, Phelps argues that employmentsubsidies for all low-income workers should bepermanent, both to improve equity and tocorrect the inefficiencies that exist in labormarkets because of distortions such as imper-fect competition and asymmetric information.18

In recent years, there has also been an-other round of theoretical analyses of thesepolicies. For example, Snower and Mortensenuse simple turnover and search models of thelabor market to argue in favor of marginalemployment subsidies.19 In the appendix ofthis Commentary, I report my extension of thiswork to an efficiency-wage specification, andthe result is some additional analytical sup-port for such initiatives.

What all these theoretical analyses ignoreare implementation and administration issues.Feldstein and others stress that these prob-lems are so far-reaching that marginal em-ployment subsidies must be rejected.20 Yet,other analysts counter that governments havehad a lot of practical experience in runningprograms of this sort. For example, the Tar-geted Jobs Tax Credit program has been oper-ating in the United States since 1978.21

My pragmatic response to all this uncer-tainty is simply to recommend further study ofmarginal employment subsidies.22 This strat-egy of buying time still leaves Canadians witha constructive option in the meantime — theless controversial policy I have already identi-fied of wage subsidies for low-wage employees.

Conclusions

Canada’s persistent and high level of unem-ployment is a serious problem. It has generatednumerous calls for putting deficit reduction

and inflation control at least partially to oneside, so that job creation can become a morecentral part of government policy. But as longas the debate is seen as either deficit reductionand inflation control or job creation, I suspectthat the unemployment problem will remainon the back burner. There is simply — andquite appropriately — little political supportfor squandering the gains that have been madeon inflation and interest rates and that arebeing established on deficit reduction. Thebest hope for a more active approach to unem-ployment is to emphasize policies that areself-financing. This emphasis forces the focusonto structural, not cyclical, unemployment(except for a plea for the Bank of Canada toconsider alternative implementation strategies,such as nominal GDP targeting).

How should the federal government usethe funds that have been freed up by the recent

C.D. Howe Institute Commentary© is a peri-odic analysis of, and commentary on, currentpublic policy issues.

William Scarth, the author of this issue, isa Professor of Economics at McMaster Univer-sity, Hamilton, Ont., and an Adjunct Scholarof the C.D. Howe Institute. The text was copyedited by Lenore d’Anjou and prepared forpublication by Wendy Longsworth and BarryA. Norris.

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tightening of the EI program? Ottawa’s originalplan was not simply to apply them to deficitreduction, but to keep most of them within theemployment envelope, and to switch from apassive approach that supported people whenout of work to an active one that supportedtheir attempts to get work.

Now, since the federal government is va-cating the labor market policy field and leavingit to the provinces, one might assume that thefunds would be used to reduce the down load-ing of the deficit problem to the provinces. Thisstrategy would allow the provinces to keepthese funds within the employment envelopeon the federal government’s behalf.

The most promising use of these funds isto finance a wage subsidy for low-wage work-ers. A small-scale version of this policy wouldbe equivalent to reducing or eliminating em-ployers’ EI contributions on behalf of theirlow-wage employees. Given this fact, my rec-ommendation is a partial support of recentcalls for a payroll tax cut.

My analysis suggests that a significantreduction in unemployment among the un-skilled can be had with such a low-incomewage subsidy policy. Improvement in unem-ployment is possible even if the savings fromEI reform are not made available to finance thenew initiative, but it is paid for instead via anincrease in the EI contributions firms make onbehalf of their higher-wage employees.

Further, this initiative should not involvepolitical resistance from those who worry about

the wages of those already employed or aboutthe level of investment in new capital. Theanalysis shows that this revenue-neutral in-itiative, while reducing unemployment, wouldraise both wages and investment.

Some may, of course, view any active labormarket initiative as a backward step, one inopposition to the trend of freeing the marketeconomy from excess regulation. To such in-dividuals, a wage subsidy is just another un-justified intrusion of government into whatshould be a private transaction between aworker and her employer. Remember, however,that the policy I recommend is equivalent to areduction in one part of the payroll tax systemthat is financed by an increase in anothercomponent of that tax, and a proponent of freemarkets, like anyone else, should remain opento any suggestion concerning tax reform.

Also remember that the support for whatis proposed here comes from an analysis thatexplains unemployment in terms of marketfailure. Even the most conservative econo-mists admit that, in principle at least, govern-ment has a role when markets fail. Those sameeconomists very much prefer corrective actionto take the form of adjusting private incentivesthrough taxes and subsidies, rather than hav-ing direct government involvement. Since thepolicy I recommend here respects this prefer-ence, I do not think it should be rejected onany underlying philosophical ground concern-ing the proper role of government.


Appendix

This appendix uses the model of structuralunemployment suggested by Summers.23 I ex-tend it to allow for various taxes and transferpayments, a variable capital stock, and thestipulation that all fiscal initiatives be revenueneutral. This extra material is included toprovide results more precise than those thatfollow from a purely graphic analysis. Theefficiency-wage theory of structural unemploy-ment, of which the Summers model is anexample, combines the rigor demanded byclassical economists (given its grounding informal optimization) with a well-definedsource of market failure (which is at the coreof Keynesian economics). As a result, manyinfluential economists regard it as the mostpromising framework for understanding un-employment.24

Within this framework, Pisauro exploresthe implications of alternative taxes and Agénorand Aizenman consider skills-based technologi-cal change.25 Compared to this work, my modelis simplified in some ways, but in others itinvolves some extensions. All my changes aremotivated by the desire to bring the work onefficiency wages to bear on the policy debate,a task Mortensen and Snower have alreadyaccomplished for search theory and labor turn-over models.26

For clarity of exposition, I divide the appen-dix into two parts. The first explains how themodel can be used to compare various labormarket policies when no distinction is madebetween a skilled and an unskilled worker. Thesecond details the modifications that convertthe model to a two-sector version.

A One-Sector Model

In the Summers model of structural unem-ployment, firms maximize profits,

F(qL,K) − w(1 + t)L − rK ,

where F is output, which depends on laboremployed, L, times an index of effort per worker,

q, and the quantity of capital, K, and where w,t, and r are, respectively, the wage rate, theemployer payroll tax rate, and the interestrate. Work effort depends on the gap betweenthe wage workers receive after the employeepayroll tax, w(1 – x), where x is the employeepayroll tax rate, and the alternative availableto them, which is z:

q = [w(1 − x) − z)]a,

where a is positive. The alternative wage is aweighted average: the employment rate (1 – u)times the after-tax wage that can be earnedelsewhere, plus the unemployment rate, u,times the employment insurance benefit (frac-tion f of before-tax wages). Thus,

z = (1 − u)(1 − x)w + ufw .

The level of structural unemployment resultsfrom the firm’s choosing w, L, and K to maxi-mize profits subject to the variable work-effortconstraint.

Combining the decision rules with the defi-nition of the alternative wage and the fact thatunits can be chosen so that u = 1 – L, the levelof structural unemployment can be determined:

u = a(1 − x)/(1 − f − x).

Despite the evidence on the aggregate wageelasticity of labor supply cited in the text, somereaders may feel more comfortable with a smallpositive value, rather than the zero that hasbeen imposed here (implicitly by defining thelabor force as unity). If so, they will feel thatan increase in the payroll tax levied on high-wage employees (used as a means of financingwage and employment subsidies) will cause(other things being equal) a small increase inunemployment.

A similar result follows from a related ex-tension — one that involves either the laborforce or the index of worker effort dependingon nonlabor income. Marchildon, Sargent, andRuggeri note that, if the basic analysis is ex-tended in this way, the wage-claim line does


not shift up one for one with the labor-demandcurve.27 Phelps stresses this extension, butKesselman argues that most workers havevery little unearned income beyond what ac-crues within their pension plans or comingfrom any appreciation in the value of theirhomes.28 My model assumes that short-runvariations in this income source play no ap-preciable role in individuals’ work-effort deci-sions. (Notice that Phelps’s specification leavesthe analyst stuck with the prediction that theunemployment rate must forever rise over thecoming decades, simply because people’s non-labor income will continue its upward trend.Any reader who is intuitively uncomfortablewith this prediction should find the basic speci-fication in this Commentary more appealing.)

The other first-order conditions and theproduction function determine wages, the capi-tal stock (given that the interest rate is as-sumed to be fixed by perfect capital mobilitywith the rest of the world), and the level ofoutput. These relationships are:

Y = F(qL,K) = [q(1 − u)]hK(1 − h),

FK = r,

and

qFqL = w(1 + t).

The effects of various policies on the un-employment rate, the accommodating tax rate(t, adjusted to maintain revenue neutrality), andthe other endogenous variables are determinedfrom these equations, given the balanced budgetconstraint for the EI fund, which is

(x + t)(1 − n) = fn,

wherenis the overall unemployment rate (whichis greater than u since some full-equilibriumunemployment occurs for reasons other thanefficiency-wage considerations). This equationcould include an exogenous constant (to coverthe government’s apparent desire to maintaina surplus in the EI account) without affectingthe analysis.

Employment Subsidies

The model is slightly more complicated withemployment subsidies. Firms now maximize

F(qL,K) − w(1 + t)L + s(L − L∗) + jL − rK,

where s is the subsidy the government paysfor each worker that the firm hires beyond itsbase-period level of employment, L*, and j is ageneral employment subsidy rate. Firms facethe same constraints as before, and optimiza-tion proceeds by choosing L, w, and K whiletaking t, x, f, s, and j as parameters. Theequilibrium unemployment rate is

u = a(1 − x)(1 + t − b − c)/1 − x − f)(1 + t).

The government sets s = bw, j = cw, andthe balanced budget constraint is now

(t + x)(1 − n) = fn + mb(u∗ − n) + c(1 − n),

where m is the waste factor that multiplies thecost of a marginal employment subsidy pro-gram. (In reality, if not in this model, turnoverand ongoing growth will mean that new hireswill exist in full equilibrium.) Subsidies areintroduced with an initial full equilibrium in-volving b = c = 0 and u* = n. As before, thebudget is balanced by letting the employerpayroll tax rate, t, be determined residually.

Calibration

Although I did not report in the text specificquantitative predictions for a one-sector analy-sis, it is useful to consider plausible parametervalues as a test of the model’s applicability.Illustrative quantitative results require onlythe following numerical assumptions:

• the EI benefit rate (the proportion of wageincome received by individuals while un-employed);

• the EI contribution rates levied on employ-ers and employees;

• the average value of the unemployment ratebefore any policy initiative is considered;

• the proportion of that unemployment thatis due to the efficiency-wage considerations


that are highlighted in this study (as op-posed to other things that cause structuralunemployment, such as imperfect matchesbetween job aspirants and vacancies); and

• labor’s share of national income.

I assume the following base-line values forthese items:

• the EI benefit rate: 0.4;

• the employee contribution rate: 0.0145;

• the employer contribution rate: 0.0202;

• the overall unemployment rate: 8 percent;

• the amount of this unemployment that isdue to variable work-effort issues: threepercentage points; and

• labor’s share of income: 0.67.

The only aspects of this set of values thatmay appear unrepresentative of reality are theEI contribution and payout rates, which arelower than the legislated values. The reasonfor this discrepancy is that the actual programinvolves no payroll taxes beyond certain in-come levels, a qualifying period involving no EIbenefits, and a maximum number of weeks ofbenefits. For simplicity, I used in the simula-tion model uncapped proportional contribu-tion and benefit rates and adjusted the valuesfor these parameters29 so that they generaterealistic revenue and expenditure totals. Theratio of the employer and the employee contri-bution rates reflects the 1.4 factor in the Ca-nadian legislation, and the adjusted rates implya balanced EI account, with revenues andexpenditures of $18 billion, given current GDPvalues.

The plausibility of the model as calibratedwith this set of numerical assumptions can befurther assessed by using it to answer a ques-tion to which analysts think they may alreadyknow the answer. Over the past 40 years, thegenerosity of the Canadian EI system wasapproximately doubled during the first twodecades and then returned to its original levelover the second two.30 What has been theeffect on unemployment?

Noting that this question has evoked muchdispute, Corak suggests that the consensus inthe literature is that increased EI generositypushed up the unemployment rate by some-where between six-tenths and one full percent-age point.31 When the EI benefit rate in thesimulation model is cut in half and the payrolltax rates are adjusted to keep the EI accountbalanced, the unemployment rate falls by eight-tenths of a percentage point.

Since this response coincides with the mid-point of the range reported in earlier studies,I conclude that the model is a reliable one andthat illustrative numerical calculations can beregarded as representative and instructive.

A General Employment Subsidy

One of the policies I examined was a generalemployment subsidy, partly because some la-bor economists highlight an analogy betweenemployment policy and a long-standing propo-sition regarding how public policy might dealwith a monopolist.32 Since a monopolist re-stricts output below the competitive outcome,economic efficiency can be enhanced if themonopolist is subsidized per unit of output —an encouragement to raise output. To keep theprogram revenue neutral and to avoid raisingmonopoly profits, the subsidy can be financedby taxing the monopolist on the basis of a per-centage of sales revenue (not physical output).

Can an analogous policy package be de-signed for employment creation?33 In this set-ting, incomplete information is the source ofmarket failure (the analogue of monopolypower). An employment subsidy and a payrolltax on the firm’s wage bill are the analogues ofthe fiscal instruments suggested for the mo-nopoly problem.

I examined this revenue-neutral packageby increasing c and raising t to keep the budgetbalanced. Such a general employment subsidyturns out to be quite impractical. Despite hav-ing a very small favorable effect on the un-employment rate, the subsidy is so expensivethat the employer EI contribution must be in-creased dramatically.


A marginal employment subsidy (an in-crease in b financed by an increase in t) turnsout to be much more effective in reducingunemployment. It is still expensive, however,since a plausible value for the waste factor, m,is in the range of 6 to 8.34

A Two-Sector Model

The model is expanded by splitting labor intotwo groups, skilled and unskilled. Firms nowmaximize

F(qL,N,K) − w(1 + t)L − v(1 + i)N − rK,

where L and N denote, respectively, the em-ployment of skilled and unskilled workers, wand v are the corresponding wage rates, and tand i are the corresponding employer payrolltax rates. Firms choose w, L, N, and K (but notv). The constraints are the same as before,except that the production function is

Y = F(qL,N,K) = [q(1 − u)]hNgK(1 − h − g),

and L and N equal P1(1 – u) and P2(1 – e),respectively, where the Ps denote the numberof individuals available in each market and uand e stand for the unemployment rates in theskilled and unskilled sectors. The first-orderconditions and the balanced budget conditionyield the following relationships:

u = a(1 − x)/(1 − f − x),(1 − e) = g(1 − u)(1 + t)p/Rh(1 + i),(1 − u)(t + x)p + (1 − e)(i + x)R = f(up + eR),(1 − h − g)Y = rK,

and

hY = w(1 + t)(1 − u)P1,

which, along with the production function andthe definition of q, can be used to verify allstatements in the text. (Note that p = P1/P2, Ris the fixed ratio of v to w, and that, forsimplicity in this two-sector setting, I assumethat all unemployment in the skilled sector isdue to efficiency-wage considerations.)

The second of the equations given aboveimplies ∆e/∆i = (1 – e)/(1 + i), which suggests,in turn, for representative parameter values,that a one percentage point reduction in theemployer payroll tax levied on low-wage work-ers can lead to a four-fifths of one percentagepoint reduction in the unemployment rate ofthe unskilled.

This calculation ignores any increase in tthat may be necessary to finance this initia-tive. Thus, it ignores both the direct effect of ton e, which is favorable, and a possible indi-rect effect of t on u (and therefore on e), anunfavorable effect that would exist if the firstequation were modified to allow for a positivewage elasticity of labor supply. Yet, even if theoutcome of this illustrative calculation is cutin half, it represents a significant change in theunemployment rate.

The only result that is in any doubt is theresponse of wages to the introduction of thewage subsidy for low-wage workers (a reduc-tion in i) when the initiative is financed by anincrease in the payroll tax on high-wage em-ployees (an increase in t).

Wages rise, as described in the text, if

gp(1 − u)(1 + t) > hR(1 − f − x)(1 − e).

Representative parameter values for f, x, t, and(h + g) have already been discussed. Given1990 income distribution data and the as-sumption that an annual family income of$45,000 divides high- and low-wage individu-als, then P1 is roughly one-half, so p = 1. Thislower-income half of the families received about30 percent of total income in 1990. If thisgroup received very little of that income fromcapital, surely a credible assumption, then h =0.42 and g = 0.28 are plausible values for theincome share parameters.

Finally, with the sizes of the two compo-nent labor forces the same, R is both the ratioof the two wage rates and the ratio of the twoshares of labor income. These assumptionsand the knowledge that e exceeds u are suffi-cient to argue that the inequality given abovecan easily be satisfied.


Notes

Without implication, I thank Ken Boessenkool, Livio DiMatteo, Angela Ferrante, Surendra Gera, Jon Kessel-man, David Laidler, Garnet Picot, John Richards, BillRobson, Graham Rose, Joe Ruggeri, Daniel Schwanen,and Mike Shannon for helpful discussion on parts ofthis material.

1 W. Scarth, “Comment,” in D.E.W. Laidler, ed., WhereWe Go from Here: Inflation Targets in Canada’s Mone-tary Policy Regime, Policy Study 29 (Toronto: C.D.Howe Institute, 1997).

2 Such a policy could deliver the same average inflationrate as direct inflation targeting does now, but with theadded benefit of strengthening the Bank of Canada’srole in limiting the effects of variations in demand onthe unemployment rate. Under current operating pro-cedures, Bank officials automatically expand demandwhen they expect inflation to fall below the lowerboundary of the announced band. But the fact thatinflation has been in the lower half of this band mostof the time in the past few years means that thispractice could have been pursued more vigorously. Ashift to nominal-income targeting is one way to keepthe Bank a little more focused on using the entire rangeof the announced band. Further, such a shift shouldmake Bank watchers less worried when they see theinflation rate extend into the upper half of the band, avariation to be expected under nominal-income target-ing. Only under direct-inflation targeting does it makesense for the Bank to fear that such a development maybe taken as a signal of its dwindling commitment. Thus,while the Bank is already operating in a way that isconsistent with what lies behind the suggestion ofnominal-income targeting, a more complete embracingof this implementing strategy could stabilize employ-ment a little more and at the same time allow the Bankto enjoy an increase in its credibility.

3 G. Saint-Paul, “Some Political Aspects of Unemploy-ment,” European Economic Review 39 (1995):575–582.

4 L. Di Matteo and M. Shannon, “Payroll Taxation inCanada: An Overview,” Canadian Business Economics,Summer 1995, pp. 5–22; R. Parker, “Aspects of Eco-nomic Restructuring in Canada, 1989–1994,” Bank ofCanada Review, Summer 1995, pp. 23–34; J. Baran,Payroll Taxation and Employment: A Literature Survey,(Ottawa: Department of Industry, Micro-Economic Pol-icy Analysis, forthcoming); and J.R. Kesselman, Gen-eral Payroll Taxes(Toronto: Canadian Tax Foundation,1997).

5 See, for example, “Which capitalism?” Globe and Mail(Toronto), January 13, 1997, editorial.

6 See Di Matteo and Shannon, “Payroll Taxation”; Parker,“Aspects of Economic Restructuring”; Baran, PayrollTaxation and Employment; and Kesselman, GeneralPayroll Taxes. The empirical work (which concernsepisodes of change in all four components of the payrolltax system) is not a perfect match for this paragraph

in the text (which concerns just part of the tax that islevied on employers). Some of the empirical results areconsistent with a small employment effect. So is mymodel. The reader can verify this point by consideringa simultaneous change in parameters t, x, and i in thetwo-sector analysis summarized in the appendix.

7 To some readers, it may seem plausible to argue that,with more of the other inputs, firms could afford to (andtherefore would want to) make do with less of the firstone. Such reasoning would be appropriate if firms wereconstrained to produce some fixed level of output. Butsince this analysis is aimed at firms that are free tochoose the overall level of output that maximizes profitswhile they make the decision about input hiring levels,the fixed-output assumption is not appropriate.

8 See Canada, Department of National Revenue, TaxStatistics on Individual Incomes, 1995 Edition (Ottawa,1996), basic table 2. Employer contribution portionsare estimated from this table by multiplying employeeportions by the legislated factor of 1.4.

9 C. Freedman, “The Use of Indicators and of the Mone-tary Conditions Index in Canada,” in T. Balino andC. Cottarelli, eds., Frameworks for Monetary Stability:Policy Issues and Country Experiences (Washington,DC: International Monetary Fund, 1994), p. 472.

10 L. Osberg, “Growth and Jobs: The Missing Link,” inK. Banting and K. Battle, eds., A New Social Vision forCanada? (Kingston, Ont.: Queen’s University, Schoolfor Policy Studies and the Caledon Institute of SocialPolicy, 1994).

11 Similar analyses are available in L.F. Katz, “ActiveLabor Market Policies to Expand Employment andOpportunity”; and P. Krugman, “Past and ProspectiveCauses of High Unemployment,” both in Federal Re-serve Bank of Kansas City, Reducing Unemployment:Current Issues and Policy Options (Kansas City, Mo:Federal Reserve Bank of Kansas City, 1994).

12 As noted earlier, empirical evidence is consistent withthis specification. It is true that some individuals enterthe labor force only as wages rise, but there are others— second-earners — who drop out of the labor force aswages increase since, with a higher wage, the family’sincome target can be met with just one partner workingoutside the home. Of course, the supply curve forunskilled labor does depart from the vertical line inFigure 5 at very low wage rates. In this range, thesupply relationship curves back down to the left of thevertical line. But with institutional arrangements, suchas the minimum-wage law, this part of the labor-supplycurve is made largely irrelevant. Thus, I do not focuson the phenomenon.

13 Riddell’s paper is forthcoming in a volume on employ-ment issues in the C.D. Howe Institute’s “The SocialPolicy Challenge” series. The evidence is also surveyedin D. Leigh, Assisting Workers Displaced by StructuralChange: An International Perspective (Kalamazoo,


Mich.: W.E. Upjohn Institute, 1995); and L. Marchil-don, “Active labor Market Policies: An Evaluation,”Working Paper 95-11 (Ottawa: Department of Finance,Fiscal Policy and Economic Analysis Branch, 1995).

14 J.J. Heckman, “Commentary,” in Federal Reserve Bankof Kansas City, Reducing Unemployment, p. 294.

15 Some excellent surveys and evaluations of these pro-grams exist. See H. Robertson, “Wage Subsidies toEncourage the Hiring of Unemployment InsuranceClaimants,” Research Paper R-95-1 (Ottawa: Depart-ment of Human Resources Development, Applied Re-search Branch, Strategic Policy, 1994); Leigh, AssistingWorkers; Marchildon, “Active Labor Market Policies”;and Baran, Payroll Taxation and Employment.

16 See the survey articles already cited: Robertson, “WageSubsidies”; Leigh, Assisting Workers; Marchildon, “Ac-tive Labor Market Policies.” Just last November, thefederal government introduced another such experi-ment. Under the New Hires program, firms with fewerthan 100 employees that make new hires can obtain awaiver of 100 percent of the associated EI premiumsdue in 1997 and 25 percent in 1998.

17 J.R. Kesselman, S.H. Williamson, and E.R. Berndt,“Tax Credits for Employment Rather Than Investment,”American Economic Review 67 (1977): 339–349; andR. Layard, “The Costs and Benefits of Selective Employ-ment Subsidies: The British Case,” British Journal ofIndustrial Relations 17 (1979): 187–204.

18 E. Phelps, “Low-Wage Employment Subsidies versusthe Welfare State,” American Economic Review 84 (Pa-pers and Proceedings, May 1994): 54–58; idem, Struc-tural Slumps (Cambridge, Mass.: Harvard UniversityPress, 1994); and idem, “Subsidize Employment,” Pol-icy Options, July/August 1996, pp. 5–9.

19 D. Snower, “Converting Unemployment Benefits intoEmployment Subsidies,” American Economic Review84 (Papers and Proceedings, May 1994: 65–70; andD.T. Mortensen, “Reducing Supply-Side Disincentivesto Job Creation,” in Federal Reserve Bank of KansasCity, Reducing Unemployment.

20 M. Feldstein, “Commentary,” in Federal Reserve Bankof Kansas City, Reducing Unemployment.

21 This experience is ably surveyed in Robertson, “WageSubsidies.”

22 One administrative issue is whether business subsi-dies could be challenged under the terms of Canada’srecent trading agreements. Since these policies wouldnot confer an advantage to any specific industry, how-ever, they should be nonactionable.

Another issue is constitutional. The federal govern-ment has just signed an agreement with Alberta (andis in advanced negotiations with other provinces) to

make wage and employment subsidies a matter ofprovincial jurisdiction. On this question, see K.J. Boes-senkool and W.B.P. Robson, Ending the Training Tangle:The Case against Federal-Provincial Programs underEI, C.D. Howe Institute Commentary 86 (Toronto:C.D. Howe Institute, February 1997). As time passes,therefore, my recommendation can be viewed as apply-ing to provincial authorities, with the federal govern-ment’s role being to transfer the necessary EI savingsto the provinces to help them finance this initiative.

23 L. Summers, “Relative Wages, Efficiency Wages andKeynesian Unemployment,” American Economic Re-view 78 (Papers and Proceedings, May 1988): 383–388.

24 See, for example, O.J. Blanchard, and S. Fischer, Lec-tures on Macroeconomics (Cambridge, Mass.: M.I.T.Press, 1989), p. 463.

25 G. Pisauro, “The Effect of Taxes on Labor in EfficiencyWage Models,” Journal of Public Economics 46 (1991):329–345; and P.-R. Agénor and J. Aizenman, “Techni-cal Change, Relative Wages, and Unemployment,“European Economic Review 41 (1997): 187–200.

26 Mortensen, “Reducing Supply-Side Disincentives”;Snower, “Converting Unemployment Benefits.”

27 L. Marchildon, T.C. Sargent, and J. Ruggeri, “TheEconomic Effects of Payroll Taxes: Theory and Evi-dence” (Ottawa, Department of Finance, EconomicStudies and Policy Analysis Division, 1996), mimeo.

28 Phelps, Structural Slumps; Kesselman, General Pay-roll Taxes.

29 As in T.C. Sargent, “An Index of Unemployment Insur-ance Disincentives,” Working Paper 95-10 (Ottawa:Department of Finance, Fiscal Policy and EconomicAnalysis Branch, 1995); and J. Martin, “Unemploy-ment and Related Welfare Benefits in OECD Countriesand Their Impact on the Labor Market” (Paris, Organ-isation for Economic Co-operation and Development,1996), mimeo.

30 Sargent, “An Index of Unemployment Disincentives,”p. 45.

31 M. Corak, “Unemployment Insurance and Canada-USUnemployment Rates,” Policy Options, July/August1996, pp. 33–37.

32 For example, G.E. Johnson and P.R.G. Layard, “TheNatural Rate of Unemployment: Explanation and Pol-icy,” in O. Aschenfelter and R. Layard, eds., Handbookof Labor Economics, vol. 2 (Amsterdam: Elsevier Sci-ence Publishers, 1986).

33 As suggested in ibid.

34 As Graham Rose has convinced me in correspondence.


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Institut C.D. Howe Communiqué · The study, A Job-Creation Strategy for Governments with No Money, by William Scarth, Professor of Economics at McMaster University in Hamilton, Ont.,