Marginal wage subsidies: a rent-extracting instrument for employment creation

Purpose – This paper aims to examine the effects of marginal and general wage subsidies on employment and income distribution. Design/methodology/approach – The paper constructs a theoretical, partial-equilibrium model of an economy in which a large number of competitive firms produce a homogeneous output good. Involuntary unemployment arises from a too high and rigid wage. By conducting comparative static analyses, the paper evaluates the impact of general and marginal wage subsidies on employment and incomes. Findings – The paper shows that a marginal wage subsidy is a fiscally more efficient instrument for employment creation than a general wage subsidy because it resembles a combination of a general wage subsidy with a profit tax. These favorable effects persist even if between-firm displacement effects are taken into account. Research limitations/implications – In line with most of the literature on marginal employment subsidies, attention is restricted to a partial-equilibrium analysis in which the wage is assumed to be fixed. This helps to sharpen the focus on between-firm competition, but is perhaps implausible when analyzing a general-equilibrium setting. The inclusion of endogenous wage setting is bound to provide an interesting area for future research. Practical implications – If politicians want to implement a wage subsidy scheme that has to be self-financing, marginal wage subsidies are an effective policy instrument for employment creation. Its downside is an inefficient allocation of labor among firms, because some firms become larger than is necessary. Originality/value – The paper provides a novel approach to model the between-firm displacement effects of marginal wage subsidies and derives policy conclusions.