How do labor market institutions affect the link between growth and unemployment: the case of the European countries.

• Author: Adjemian, Stephane
• Position: Report

1. Introduction

   The observed high unemployment in continental Europe and the slowdown in economic growth in the last decades naturally raise the question of whether these two phenomena are related. On the empirical side, there is no consensus regarding the sign of the correlation between growth and unemployment, either across countries or over time within a country. (4) The same is true on the theoretical side. (5) Nevertheless, the endogenous growth theory predicts that distortions due to fiscal instruments lead to a lower growth whereas the equilibrium unemployment theory predicts that these distortions lead to a higher unemployment rate. This suggests that economic growth and long-run unemployment are linked through the labor market institutions.

   In this paper we investigate the issue of the long run link between growth and unemployment at two levels. First, we construct a theoretical economy to study the role of labor-market variables on the bad performance of European regions. The three main hypotheses of our model are the following: (i) Innovations are the engine of growth. (ii) Agents have the choice of being employed or being trying their hand at R&D. (iii) Unemployment is largely caused both by the wage-setting behavior of unions, and by the labor costs associated to the tax/benefit system. (6) Second, at the light of this model, we explore the growth and unemployment experiences across 183 European regions. The observed heterogeneity is so large that it is difficult to distinguish some relation between these two variables, relation that is often found at national level. Hence, we try to recover a link through the expected effects of several institutions present on the labor market. To this end, we assess the effect of institutions on the (regional) growth and unemployment rates. (7)

   The key implications of the theoretical model are the following. First, the bargaining power of unions, the unemployment compensation, the taxes on labor and the employment protection have a positive effect on unemployment and a negative effect on the economic growth. Second, a more coordinated bargaining process increases employment, at the price of a lower economic growth. The first result clearly contrast with the results of Lingens (2003) or Mortensen (2005): Lingens (2003) treats the impact of unions in a model with two kind of skills, and shows that the bargain over the low-skilled labor wage causes unemployment but the growth effect is ambiguous. Similarly, in a matching model of schumpeterian growth, Mortensen (2005) finds a negative effect of labor market policy on unemployment, but an ambiguous effect on growth.

   On the other side, the main insights from the empirical exercise are twofold. First, the tax wedge and the unemployment benefits are positively correlated with the regional unemployment rates. Conversely, the employment protection and the level of coordination in the wage bargaining process are negatively correlated with the regional unemployment rates. Second, the tax wedge and the unemployment benefits are negatively correlated with the regional growth rates of the Gross Domestic Product (GDP) per capita. Conversely, more coordination in the wage bargaining process is associated to lower regional growth rates. This points to the existence of a trade-off between unemployment and growth, if we focus on the impact of coordination in the wage bargaining process.

   These results are in accordance with the Daveri and Tabellini (2000)' results, who using aggregate (national) data, find that most continental European countries exhibit a strong positive correlation between the unemployment rate and both, the effective tax rate on labor income and the average replacement rate. Conversely, they find a strong negative correlation between the growth rate of GDP per capita and the tax on labor income, either over time and across countries.

2. The model economy

   In this section we develop a theoretical model to study the equilibrium link of economic growth and the long run unemployment at the light of the labor market institutions. (8)

   2.1 Preferences

   The economy is populated by L identical agents, each endowed with one unit flow of labor. At each time, they may be employed (x), trying their hand at R&D (n) or unemployed (u): L=x+n+u. Employed agents pay a tax [[tau].sup.w] on their labor income whereas unemployed agents receive the unemployment benefits B.

   All agents have the same linear preferences over lifetime consumption of a single final good:

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)

   where [??] > 0 is the subjective rate of time preference and [C.sub.t] is the per capita consumption of the final good at time t. Each household is free to borrow and lend at interest rate [r.sub.t]. However, given linear preferences, the optimal agent's behavior implies

   [??] = [r.sub.t] [for all]t. Hence, the level of consumption is undefined. A standard solution to this problem is to assume that agents consume all their wage income. This assumption allows us to analyze the impact of several labor market policies.

   2.2 Goods sector

   The final good is produced by perfectly competitive firms that use the latest vintage (v) of a continuum of intermediate inputs [x.sub.j],

   C = [[integral].sup.1.sub.0] [A.sub.j] [x.sup.[alpha].sub.j] dj, 0

   [A.sub.j] represents the productivity of the intermediate good j and is determined by the number of technical improvements realized up to date t, knowing that between two consecutive innovations the gain in productivity is equal to q > 1 ([A.sub.v+1] = [qA.sub.v]). In turn, intermediate goods are produced by monopolistic firms. Production of one unit of intermediate good requires one unit of labor as input.

   2.3 R&D sector

   Technology improvements lead to good-specific public knowledge allowing to start improvement efforts upon the current vintage v. Innovations on good j arrive randomly at a Poisson rate [hn.sub.j], where [n.sub.j] is the amount of labor used in R&D, and h>0 a parameter indicating the productivity of the research technology. Finally, the size of the R&D sector is given by the arbitrage condition: (9)

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (3)

   That is, the opportunity cost of R&D is the hourly net wage prevailing in industry j, j, (1 - [[tau].sup.w]) [W.sub.j], [v.sub.1] J times the expected duration of the innovation process, 1/h. (10) On the other hand, the expected payoff of next innovation, [V.sub.j,v+1] is equal to the net discounted value of an asset yielding [[PI].sub.j,v+1] per period until the arrival of next innovation, at the arrival rate [hn.sub.j,v+1].

   We assume that the employment protection laws imply a cost E (a firing tax) of shutting down a firm, which occurs as current producers are replaced by next ones. Then:

   [V.sub.j,v+1] = [[[PI].sub.j,v+1] - [hn.sub.j,v+1] [E.sub.v+1]]/[r + [hn.sub.j,v+1]] (4)

   Assuming that Firms pay a proportional payroll tax [tau] over employment, the instantaneous monopolistic profits earned by the successful innovator are:

   [[PI].sub.j,v+1] = p([x.sub.j,v+1]) [x.sub.j,v+1] - [W.sub.j,v+1] (1 + [tau])[x.sub.j,v+1] (5)

   Since the final-good sector is perfectly competitive, the price intermediate good j of vintage [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], is equal to its marginal product:

   p([x.sub.j,v]) = [partial derivative]C/[partial derivative][x.sub.j,v] = [alpha][A.sub.j,v][x.sup.[alpha]-1].sub.j,v] (6)

   Then, after normalization of last expressions by the productivity level associated to the [(v+1).sup.th] innovation, we obtain:

   [[pi].sub.j,v+1] = [alpha][x.sup.[alpha].sub.j,v+1] - [w.sub.j] (1 + [tau]) [x.sub.j,v+1] (7)

   Hence the free entry (3) condition becomes:

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. (8)

   2.4 Government

   The government faces the following budget constraint:

   Bu + T = 9[tau] + [[tau].sup.w]) [[integral].sup.1.sub.0] [w.sub.j] [x.sub.j] dj + Eh [[integral].sup.1.sub.0] [n.sub.j] dj (9)

   Any change in the revenue caused by changes in taxes and subsidies is rebated to household through the lump-sum transfer T.

   2.5 Wage bargaining and labor demand

   The wage rate is the solution to the bargaining problem between the monopolistic producer of good j and the trade union representing the workers' interests. We model the bargaining process as a a generalized Nash bargaining game, with union's relative bargaining power 0

   [W.sub.j,v+1] = arg max{[[((1 - [[tau].sup.w])[W.sub.j,v+1] - [B.sub.j,v+1])x([W.sub.j,v+1])].sup.[beta]] [([[PI].sub.j,v+1] - [hn.sub.j,v+1] E-[[bar.[pi]].sub.j,v+i]).sup.1-[beta]]} (10)

   [[bar.[pi]].sub.j,v+1] [equivalent to] - [hn.sub.j,v+1] E is the firm's disagreement point.

   2.6 Equilibrium

   Given [??]>0, for all intermediate good sector j and for all vintage v a steady-state (or balanced growth path) equilibrium is defined as follows:

   Wage rule:

   w = [[beta].sub.1]b/1 - [[tau].sup.w], [[beta].sub.1] [equivalent to] 1 + [beta](1 - [alpha])/[alpha] (11)

   for w [equivalent to] W/A

   (ii) Labor demand:

   [x = ([[alpha].sup.2](1 - [[tau].sup.w])/(1 + [tau])...