Optimal policy combines employment and job retention subsidies

A new working paper from De Nederlandsche Bank analyzes the efficiency of employment subsidies and job retention schemes. It finds that welfare can be improved by optimally combining both types of subsidies, especially when human capital depreciation and endogenous job destruction are considered.

Endogenous destruction complicates labor market policy

Standard search-and-matching models often assume that job separations are socially efficient, especially when job creation distortions are addressed by employment subsidies.

However, this paper introduces two crucial frictions: endogenous job destruction and human capital depreciation (HCD) during unemployment.

These factors fundamentally alter the policy landscape.

Under this revised framework, employment subsidies, while beneficial for job creation, can inadvertently raise the job destruction threshold, leading to excess labor turnover.

This occurs because the increased value of unemployment, driven by higher job creation rates, makes firms more willing to destroy existing matches.

Consequently, employment subsidies alone become partly self-defeating, as they fail to fully correct the inefficiencies arising from the job destruction margin.

The research demonstrates that a combination of both employment subsidies and job retention (JR) schemes is necessary to achieve the highest level of welfare, as JR schemes effectively contain this excess job destruction.

The self-defeating subsidy paradox

The core intuition behind the paper's findings highlights a paradox: while employment subsidies boost job creation and the overall match surplus, they also increase the value of unemployment.

Under conditions of endogenous job destruction, this elevated unemployment value can perversely raise the job destruction threshold, leading to more workers entering unemployment and generating excess labor turnover.

This mechanism renders employment subsidies partly self-defeating, as their positive effects on job creation are partially offset by increased job destruction.

Numerical analysis of a calibrated model confirms these dynamics.

It shows that a decentralised allocation without policy intervention is inefficient.

While both employment and job retention subsidies improve welfare when applied in isolation, the highest welfare gains are achieved through an optimal combination of both instruments, especially when financing taxes are distortionary.

This rationalizes the joint use of these policies in modern labor market toolkits.

Beyond simple fixes for labor markets

This research offers a vital theoretical justification for combining employment and job retention policies, moving beyond single-instrument solutions.

It highlights how complex labor market dynamics, particularly human capital depreciation and endogenous job destruction, necessitate a nuanced policy mix.

For central banks and governments, this implies that effective labor market interventions require a sophisticated, integrated strategy to truly optimize welfare.