Chapter 5 : Economic Freedom and Unemployment

Unemployment is costly to the individuals and families directly affected as well as to the economy and society as a whole. It is a waste of scarce resources, leading to a loss of income and potential output. For example, from his review of the relevant literature, Dawson (1992) concludes that, for the United Kingdom, an unemployment rate of almost 11% in 1983 entailed the loss of at least 11% to 12%, and probably 14%, of potential GDP. In the United States, an unemployment rate of 9% was associated with the loss of almost 7% of GNP. Kenyon (1998) estimates that, in Australia, the loss of GDP associated with an unemployment rate above the full employment level is the equivalent of a whole year's worth of GDP over the past two decades. Long spells of unemployment erode the technical and social skills of those who are out of work, reducing their employability. The longer someone remains out of a paid job, the less attractive he becomes to a potential employer. Thus unemployment may become persistent, causing a permanent loss of human capital and potential output. As unemployment benefits in most countries are low and their duration short, and as they are non-existent in many developing countries, laid-off workers and their families often end up in poverty. If they are unable to pay their rent or mortgages, they may even become homeless. Furthermore, unemployment is associated with fiscal costs to the government. A rise in unemployment increases government outlays—particularly, unemployment benefits and other welfare payments. As unemployment reduces output and aggregate income, it also lowers tax revenues, both from direct taxes such as income tax and from indirect taxes such as value-added tax. The fiscal costs can be substantial—especially in countries with generous benefit systems, high tax rates, or both. For example, fiscal costs were equivalent to 4.2% of GDP in Germany in 1999, when its unemployment rate stood at 8.4% (Franz, 2003). Joblessness leaves permanent scars on individuals. In Britain, a spell of unemployment has been found to carry a wage penalty of 6% on re-entry and 11% in the long run (Arulampalam, 2001). In the United States, the effect of displacement on earnings has been found to be quite persistent too. For example, according to Stevens (1997), earnings reductions six years after a job loss are 9%. She finds that much of this persistence can be explained by additional job …