Labor market policy instruments and the role of economic turbulence

Times of high unemployment always inspire debates on the role of labor market policy and its optimal implementation. This paper uses a dynamic model of search unemployment and bilateral wage bargaining, rich enough to analyze a set of policy instruments with respect to their employment and welfare effects: payroll, output and firing taxes as well as wage, hiring and recruitment subsidies. It is shown that in presence of unemployment benefits a first best implementation using only firing taxes in the spirit of Blanchard and Tirole (2008) is not possible if job acceptance is endogenous. However, the socially optimal allocation can be implemented even if the Hosios-condition does not hold using a mix of the aforementioned instruments unless firms are liquidity constrained. In a second exercise, the model is extended to allow for worker transitions between skill classes reflecting economic turbulence. It is shown that the effectiveness of intergroup redistribution schemes as suggested by Mortensen and Pissarides (2003) is considerably reduced in the presence of economic turbulence. Instead of redistribution from high to low-skilled workers or from firing firms to unemployed workers, the paper identifies a scheme involving redistribution from firing to hiring firms to be optimal.