Wage Subsidies and Distortionary Taxes in a Mobile Capital Harris-Todaro Model

Abstract

In prescribing policy to eliminate or mitigate the effects of labour market distortions, some form of wage subsidy is usually among the highest ranking options. Rarely is the source of revenues for these subsidies treated as an explicit issue.' This omission has special significance for the Harris-Todaro (H-T) model of the labour market, since the policy most frequently recommended, whether capital is sector specific or intersectorally mobile, is an across-the-board wage subsidy.2 This effectively eliminates the possibility of taxing one subset of sectors rather than subsidizing its complement-an option often favoured by those theorists who concern themselves with revenue considerations. The next section of this paper sets forth the model of a small, open H-T economy with mobile capital that is the basis for this analysis. Section II re-examines three wage subsidies: on manufacturing wages; on agricultural wages; or on both sectors-assuming that resources for the subsidies are raised by an across-the-board tax on profits. This is in the tradition of CordenFindlay, and we replicate their results-though stating them in more precise form-so that we might have a standard for later comparison. The subsequent sections examine the effects of these subsidies on unemployment and resource allocation if they are financed by a tax on profits in the manufacturing sector (Section III) or by import tariffs (Section IV). Owing to the second-best nature of the H-T model, it will be demonstrated that taxes normally considered distortionary in their own right can be superior to an across-the-board tax if revenues are constrained, and can be very useful instruments if it is the variety of policy tools that is limited. Section V concludes with a ranking of the various subsidy/tax packages.