Trade unions have been successful in compressing the wage distribution but not in influencing the share of national income going to labour. This paper claims that a compressed wage distribution provides insurance in the same way that the tax and benefit system does and thus may be welfare-improving. Moreover, a union-based wage compression system may be better than a conventional tax-benefit system in providing such insurance and may well complement the operation of the latter. Models of wage compression and of taxes and benefits are evaluated and then combined in a single model. The wage compression system works well for the least skilled but the tax-benefit approach is better if average utility is being maximized. In the combined model the two mechanisms complement one another. Equity-efficiency trade-offs in the combined system mostly dominate those obtained from each mechanism acting on its own. A key factor is the willingness of skilled workers to defect from a wage compression agreement. Encouraging defection may appeal to policy-makers (labour markets are more flexible) but the benefits of a compressed wage distribution may be lost, placing stress on welfare state institutions and undermining the insurance function that the combined wage-compression/tax-benefit system delivers relatively efficiently.
