Targeted fiscal policy to increase employment and wages of unskilled workers

Dr Wei Jiang

by Konstantinos Angelopoulos, Wei Jiang and James Malley, discussion paper KDPE 1704, January 2017.

Non-technical summary

The evolution of inequality has been well documented in the data. Inequality in earnings has increased in recent decades and, in particular, wage inequality has increased dramatically since the beginning of the 20th century. As a result of this rise and its deleterious implications for the welfare of a large part of the population, societies and policymakers at large are paying increasing attention to better understanding causes and consequences of inequality.

This paper aims to contribute to the inequality literature by studying the difference in employment opportunities and labour productivities for workers with (skilled) and without (unskilled) college education which is a main contributor to wage and earnings inequality. The paper, in particular, focuses on the U.S. economy. The literature on the skill premium has demonstrated that there are significant differences in the wages between skilled and unskilled labour, and that the skill premium has increased in recent decades to its highest levels in a century. We investigate the so-called “college premium” or “skill premium” in the U.S. and its relationship with basic earnings inequality.

To this end, we model inequality in wages jointly with differences in employment opportunities between skilled and unskilled workers over the business cycle, with the aim of evaluating the effects of supply side fiscal interventions which intend to increase labour productivity and employment for the unskilled and to reduce inequality. We employ a standard approach to modeling unemployment using a setup with search and matching frictions that belongs to the Mortensen-Pissarides (MP) family, and extend this by allowing for ex ante heterogeneous workers who are employed in skilled or unskilled jobs and produce output under capital-skill complementarity. While their skill type is given, workers productivity benefits from lifelong learning associated with working experience and on-the-job learning (OJL), so that workers productivity is endogenous and a positive function of employment. As a result, differences in employment opportunities and inequality in wages are closely linked. This paper also allows for capital-skill complementarity in production. These extensions capture key characteristics of skilled and unskilled labour markets in the data.

We find that increases in public spending to enhance unskilled productivity via OJL are beneficial to employed unskilled workers and reduce earnings in-equality between employed skilled and unskilled labour. However, unskilled unemployment and labour income inequality within the group of unskilled labour rises. We next find that vacancy subsidies work to increase employment and returns to unskilled workers. However, unemployment for skilled workers rises and skilled wages and labour income fall in the short-run. We finally show that it is possible to increase skilled vacancy subsidies to nullify the negative effects on skilled employment following an increase in unskilled vacancy subsidies.

You can download the complete paper here.