DP4898 | Do Social Policies Harm Employment? Second-Best Effects of Taxes and Benefits on Labour Markets

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In the presence of Walrasian labour markets, social policies harm hours worked, employment and output. In non-Walrasian labour markets with trade unions, efficiency wages and/or costly search and mismatch progressive taxation and corporatism induce wage moderation and boost employment and output. Although unconditional unemployment benefits destroy jobs, conditional benefits spur job growth. In a second-best world the usual effects of social policies are thus overturned. In addition, the incidence of taxation and the effects of tax progression depend crucially on the specific features of the welfare state, e.g., whether benefits are indexed to after-tax wages or not and unemployed people share fully in the tax burden or not. In a full political-economic equilibrium a more equitable distribution of income and assets leads to a more affluent median voter who votes for less 'populist' policies. Hence, employment and economic growth are higher and inflation lower.