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In-Work Benefits and the Nordic Model

Abstract Welfare bene…ts in the Nordic countries are often tied to employment. We argue that this is one of the factors behind the success of the Nordic model, where a comprehensive welfare state is associated with high employment. In a general equilibrium setting, the underlining mechanism works through wage moderation and job creation.

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The bene…ts make it more important to hold a job, thus lower wages will be accepted, and more jobs created.

Moreover, we show that the incentive to acquire higher education improves, further boosting employment in the long run. These positive e¤ects help counteracting the negative impact of taxation. JEL codes: H24, J21, J24 Keywords: Nordic model, in-work bene…ts, wage adjustment, unemployment, education, skill formation, earnings 1 Introduction A prominent feature of the so-called Nordic model is a comprehensive welfare state …nanced by taxes on labor.

In fact, the public sector in many We want to thank Torben Andersen, Martin Floden, Richard Freeman, Mathias Herzing, Eddie Lazear, Ethienne Lehman, Bruno van Linden, and participants at the Conference on the Economics of the Nordic Model. y Department of Economics, Stockholm University, S-106 91 Stockholm, Ph. +46 8 163547. Fax +46 8 161425, E-mail address: ann-so…e. [email protected] su. se z Economics Division, University of Southampton, UK; Economics Department, UniCredit & Universities Fellow, Central European University, Budapest; and IZA, Bonn.

Email address: m. [email protected] ac. uk 1 of the Nordic countries is responsible for the distribution and allocation of resources amounting to more than half of their country’ GDP (Eurostat, s 2012). With an emphasis on redistributional transfers and service provision …nanced by taxes on labor, a concern with the model is, of course, that it induces weak incentives to work. In a more long term perspective, such a system may also reduce incentives to acquire skills, with a negative impact on future pproduactivity and labor market outcomes.

However, external observers are often surprised that the Nordic countries manage to combine low unemployment and high labor force participation with high taxes and generous welfare arrangements. So, how is this possible? One answer to this question is that many of the welfare arrangements in the Nordic countries are closely tied to market work. The generosity of the bene…ts are, in general, related to earnings. In addition, eligibility to a number of bene…ts and social services is conditional on employment.

Subsidized childcare, for example, is, in principle, only available to employed workers. Also, some generous elements of the paid paren’tal leave schemes are only accessible to employed workers. In addition, the more recently introduced earned income tax credit is by de…nition exclusively targeted to employed workers. The idea is that these bene…ts, by increasing the returns from working, increase the supply of labor. The observation that the Nordic countries have sustained high economic aactivity because bene…ts are closely tied to market work is not new.

In fact this was noted as a contributing factor to the high participation rate observed in Sweden when a group of NBER economists studied the Swedish welfare state in the mid 1990s (see Freeman et al. , 1997). This was also an important message in the discussion on the prospects and challenges of the Scandinavian model in Andersen (2008). The starting point for this paper is that entitlement to many of the bene…ts available in the Nordic countries is conditional on employment. As discussed above, this tends to increase the gains from working, which encourages labor supply.

However, we argue that this is not the end of the story. To investigate the full impact of welfare state arrangements of this type, one needs to account for the general equilibrium e¤ects. This is particularly relevant because many bene…ts have been available to the whole population for a long period of time. Clearly, to investigate the e¤ects of these bene…ts on employment, which is an equilibrium outcome, both supply-side and demand-side factors must be iincluded in the analysis. Moreover, beside considering the equilibrium outcome for the existing workforce, it is important to account 2 or the impact of these bene…ts on incentives to acquire skills. The equilibrium composition of the workforce in terms of educational attainment is a crucial variable for the sustainability of the Nordic model, both in terms of its growth potential and international competitiveness (Andersen, 2008) and in terms of the political support for the welfare state (Hassler et al. , 2003). To carry out such an analysis, we develop a simple model of a non-clearing labor market featuring involuntary unemployment as an equilibrium outcome.

Labor force participation is also endogenously determined. Moreover, individuals di¤er in their ability to acquire education and choose educational attainments based on a cost-bene…t analysis. In particular, we focus on the choice between proceeding to higher, i. e. tertiary, education or not. The aim is to investigate the implications of bene…ts that are conditional on work on unemployment and labor force participation, accounting for their long term impact on educational attainments.

We show that bene…ts available only to employed workers moderate wages, reduce unemployment rates, and increase labor force participation and employment. Moreover, one could expect that welfare bene…ts, even if conditional on work, could induce an outright reduction in education as they represent an important subsidy for low skilled workers. What we …nd instead is that the incentives to proceed to higher education are actually strengthened. This is a consequence of the relatively sthronger increase in labor market opportunities for highly educated workers that follow when wages are moderated.

Wages, in turn, fall because workers are more willing to accept lower wages when bene…ts are conditional on work and thus the value of having a job is higher. Lower wages increase job creation and lower the unemployment rate. Thus, total employment increases for three sets of reasons. First, the bene…ts reduce the unemployment rate for workers at all educational levels. Second, more workers choose to proceed to higher education where expected unemployment spells are shorter. Third, as labor force participation increases with the bene…ts, a larger share of the population will be employed.

We also look at the impact of bene…ts when they are …nanced through a proportional tax on wages. Taxation actually reinforces wage moderation and, as such, does not overrule that bene…ts reduce wages, increase job creation, and reduce unemployment rates. However, it weakens the incentives to acquire higher education and participate in the labor force, thus inducing a counteracting e¤ect on educational attainment and labor force participation. The element of the Nordic model that this paper underlines is the wage moderation stemming from bene…ts conditional on work.

Also, we …nd this 3 mechanism to be very robust to the choice of model. Moreover, looking at bene…ts through this channel highlights how they have a positive impact on educational attainment and participation, thus counteracting, at least partly, the negative e¤ect that taxation has on skill acquisition and labor force participation. The analytical results are followed up with a numerical example illustrating the e¤ects of the bene…ts on labor market performance and educational attainment.

The simulations indicate that bene…ts can have an important impact on unemployment for both low- and high- skilled. Without distortinary taxation, bene…ts also have a positive impact on skill acquisition, thus further reducing overall unemployment in the long run. When …nancing through proportional taxation on wages is iincluded in the model, the negative e¤ect of taxation on educational attainment dominates the positive e¤ect of bene…ts, thus resulting in a decrease in the share of the workforce acquiring tertiary education.

Nonetheless, bene…ts still have a positive overall impact on unemployment. Considering the previous literature, there are a number of studies that have tried to explain why the Nordic countries have performed so well despite high taxes and generous welfare arrangements. As mentioned, some of these studies have emphasized the importance of that bene…ts are tied to market work for the successful outcome in terms of employment and participation (see Aronsson and Walker, 1997).

A related view is provided by Rogerson (2007). He argues that the governments’spending pattern in the Scandinavian countries, compared to other high tax countries, can potentially explain the large number of aggregate work hours observed in these countries. He shows, holding tax rates constant, that it matters if the revenue is spent on disability payments which may only be received when an individual does not work or subsidies for day care for working mothers. The reason is that childcare subsidies create jobs.

Our study also …nds that how the government choose to spend tax revenues matters for labor market performance, although for a di¤erent reason. In contrast to Rogerson (2007), our results materialize through general equilibrium e¤ects working through wage moderation. There is also a large number of studies focusing on particular features of the welfare state in the Nordic countries, looking for instance at the impact of childcare subsidies and paid paren’tal leave schemes on labor supply and a number of other outcome variables. 1 In contrast to our study, this literature