Ifo Viewpoint No. 71: Six Principles of the Combi-Wage

Hans-Werner Sinn
Munich, 17 January 2006

The plans for introducing wage subsidies, called “combi-wages” in Germany, are entering a final stage. After all three coalition parties have explicitly come out in favour of subsidised wages, the goal is clear. But caution is in order. Mistakes must be avoided and the plan must have a cogent economic design. Hence this review of the problem and its solution.

Given the qualifications of the workforce, the technological knowledge, the capital stock and the international wage competition there is a quasi natural spread of domestic wage rates, which would ensure full employment in all segments of the labour market. This wage spread would come about automatically with competitive labour markets, and it would be efficient because the available human labour would be exploited fully and the national product maximized correspondingly. However, the inequality would be immense. Many people would not be able to make a living from the resulting earnings.

This is the reason that the welfare state ensures a subsistence level by means of wage replacement payments, in particular in the form of social welfare and, in Germany, the new Unemployment Benefit II. These wage replacements compress the accordion of wage distribution from below, thus producing unemployment. Wages in the lowest level of qualifications must be at a certain distance above the wage replacement income, and all the rest of the wage distribution builds on this level. By means of a chain of substitution, low to medium wages are shifted above the market clearing level. The unemployment caused by the wage increase is greatest among the lesser qualified and decreases gradually into the area of the more highly qualified. Wages of university graduates are so far above the level of social welfare that the accordion effect is lacking here. No wonder that Germany with its high wage replacement level is the OECD champion in unemployment for the lesser qualified, whereas joblessness among the more highly qualified is average in an international comparison.

The shift from wage replacement payments to wage supplements or combi-wages allows the return to the natural wage spread because wage subsidies do not form any minimum wage claims. The outsourcing of simple labour is slowed down, fewer people are replaced by robots, fewer factors of production are forced away from the labour-intensive domestic sectors to the capital-intensive export sectors, and above all people can afford to acquire the services that others offer. At the same time poverty is avoided because low wage earners receive a state supplement to their wages. For these effects to occur, six basic principles must be followed.

First: The state must grant its wage subsidies permanently. Only in this way can the larger wage spread be made socially acceptable, which is the precondition for a permanently higher level of employment.

Secondly: The combi-wage must not be linked with statutory minimum wage constraints since it has its effect precisely because it eliminates the minimum wage constraint implicit in the replacement wage system. Wages for simple jobs will nevertheless not experience free-fall since at some point there are more vacancies than unemployed and employers compete for workers by offering higher wages. According to estimates by the Ifo Institute, wages for simple labour will fall by approximately a third if an additional 2.3 million lesser qualified are to find employment.

Third: It is impossible to create more jobs without lowering labour costs, and it is impossible to lower labour costs only for newly employed persons because otherwise there would be revolving door effects. Cheaper outsiders would replace more expensive insiders. For this reason combi-wage models that seek the reintegration of the unemployed with temporary monetary benefits make no sense. And for this reason combi-wages must also be paid to insiders with jobs when their wages fall.

Fourth: In order to identify the needy insiders, combi-wages must be oriented around personal income and family circumstances. The wage subsidy must therefore be designed as a negative income tax. Mere wage subsidies to enterprises would lead to inequity, inefficiency and increased fiscal burdens. Utter chaos would be the result.

Fifth: A combi-wage that would be available to all previously unemployed persons is out of the question. This was the self-proclaimed core of the Hartz reforms. These reforms sought to reduce the labour costs of all previously unemployed persons, without time limits, down to 50% of negotiated wages. The idea was absurd. Its implementation would have cost gigantic sums. Only subsidies at the lower end of the wage scale are feasible.

Sixth: For such combi-wages to be financed, wage replacements must be correspondingly reduced. Today the state spends about €100 billion per annum for unemployed persons, including early retirees. A part of this money must be employed for combi-wages. Giving low-wage earners subsidies to their wages can be cheaper than continuing to finance the unemployed a hundred percent. According to calculations of the Ifo Institute, a combi-wage in the form of activating social welfare would cost approximately €5 billion less than the Hartz IV reforms. The state should spend its money for joining the labour force instead of for staying away, and it will not need to expend any more money for this than it already does.

Hans-Werner Sinn
Professor of Economics and Finance
President of the Ifo Institute

Published as “Sechs Grundsätze”, Wirtschaftswoche, no. 3, 12 January 2006, p. 128.