Long Run Effects of Employment and Payroll Taxes in an Efficiency Wage Model

Abstract

In equilibrium models of unemployment, e.g. efficiency wage models, the level of unemployment generally depends on the level of taxes on labor (see. e.g. Johnson and Layard (1986) and Pisauro (1991)). Considering labor taxes levied on firms, the tax authorities may choose between employment and payroll taxes where the former is a head tax on the number of employees while the latter is a tax on the cost of labor to firms. Pisauro (1991) has shown in a short run efficiency wage model that the incidence of employment and payroll taxes generally differ and, in particular, that employment taxes lead to less wage restraint than payroll taxes. Extending his model to the long run by allowing for free entry and exit of firms we go one step further and consider whether changes in the composition of labor taxes, balancing the government budget, affect equilibrium unemployment in the long run. Our results reveat that, perhaps somewhat surprisingly given the result that payroll taxes lead to more wage restraint than employment taxes, that more extensive use of employment taxes instead of payroll taxes, balancing the government budget, increases the level of employment and decreases unemployment.Efficiency wages, long run, employment taxes, payroll taxes, tax equivalence