Ifo Viewpoint No. 37: The Heart of Hartz

Hans-Werner Sinn
Munich, 19 August 2002

If an economic research institute had submitted an expertise to the Ministry of Labour anything like the report of the Hartz Commission, the ministry would have sent it back. An analytical section is missing, and no financial calculations were made. Instead, there is a colourful potpourri of creative recommendations, many attractive colour graphs, but hardly any numbers. Policy advice has never been so simple!

Nevertheless, the proposals of the Hartz Commission are welcome in principle because they bring movement into the ossified political discussion in our country. The taboo that policy-makers had imposed on labour market issues has finally been broken.

The expertise is strong in its efforts to reform the Federal Labour Office and to make job placement more effective. It is reasonable that the new Job Centers take all the unemployed by the hand and help activate them by using a bundle of measures, including restricting the conditions under which a job offer can be refused and shifting the burden of proof to the job seeker.

The report is weak when it comes to fighting unemployment. Here, not much can be achieved through better job placement. The revolving door between the working world and unemployment is already turning very fast today. The proposals of the Hartz Commission would have it turn even faster. New hiring will increase but so will dismissals.

Jobs are in short supply, and more jobs will only be created if labour costs fall. The report does everything to avoid this simple truth. Entitlement wages, defined on the basis of unemployment assistance and social welfare benefits, are too high for low-skilled workers for sufficient affordable workplaces to be created at these wages. These workers constitute about 40% of the unemployed although they are only 15% of all employable persons.

Even though an analysis is missing, the Hartz Commission seems to accept the labour-cost problem in principle. The tax-favoured Ich AG (one-person “company”) and the tax-deductible mini-jobs in private households (the old "housemaid privilege") are attempts to create jobs by way of lowering labour costs. Unfortunately the Commission does not say how it wants to offset income from an Ich AG or mini-job against the social welfare entitlements of former moonlighters. Under current law the proposals are largely ineffective since welfare benefits are cut on a one-to-one basis for any income from a mini-job or an Ich AG. A commission that does not manage to submit an integrated progression system for state transfers and taxes in the low wage area has failed to do its work properly.

The "heart" of the recommendations of the Hartz Commission lies, according to its authors, in the personnel service agency (PSA), which re-introduces the unemployed to the working world on a loan-employment basis. This proposal is borrowed from the Ifo study, “Activating Social Welfare”, that came out in May 2002. Unemployed persons must accept employment from a loan-employment agency or accept a cut in their benefits. During the six-month probation period, wages correspond to unemployment benefits, and after the probation period a PSA contractual wage is agreed that should amount to approximately 70% of the last gross wage. The loan-employment agency lends the worker to the private economy. During the probation period it does this free of charge, if necessary, and afterwards at a wage that is fifty percent below cost. The employment relationship with the PSA carries full legal protection, including security against dismissal.

Assuming that the unions go along with the bargaining for the PSA wages, this proposal will certainly lead to a massive increase in employment since it will lead to a lowering of the hourly wage costs by two thirds for the workers affected (see p. 155). Here, the Hartz Commission only assumes that a few hundred thousand jobs will be involved. But in reality, this wage cost reduction would even lead to full employment since econometric studies demonstrate that a general lowering of labour costs of only 10%, and most definitely a lowering of 20%, would be sufficient to have this effect.

The real problem is the financing. The Ifo Institute's proposal limits subsidised, public loan employment, along with a subsidy for wages for a normal job in the private sector, to low-skilled workers. The Scientific Advisory Council to the German Ministry of Economics in its expert opinion, "Reform of the welfare state for more employment of low-skilled workers” of June of this year reached the same conclusion. With a limitation to the lowest sector of the labour market, the fiscal burden remains controllable. A full financing of the wage subsidy in the low-wage area is possible with a reduction of normal social welfare rates and the fusion of unemployment benefits and welfare payments.

We can only guess at how expensive the Hartz proposals will be since the Commission provided no financial calculations, but the costs will certainly go beyond what is feasible. The problem with all such proposals is the inevitable free-rider effect. Enterprises will dismiss non-subsidised employees and replace them with cheaper, subsidised workers. This process may take years, but it cannot be stopped. The Commission apparently has no intention of stopping it, since it has explicitly demanded that the Temporary Employment Business Law no longer apply, according to which the re-employment of previously dismissed persons is forbidden by means of loan employment (p. 157).

The Ifo proposal calculated that 4.5 million lesser qualified would have to be subsidised in the long run in order to create 2.3 million new jobs for the lesser qualified. According to the same logic, with the Hartz proposals we can expect to subsidise the entire private labour market in the long run. This would presently amount to 32 million persons, and, if we extrapolate from the costs mentioned by the Commission itself per PSA employee (fig. 23), more than €300 billion or two thirds of the tax revenue of the Federal Republic of Germany. Of course this is not found in the Commission’s report, but the laws of economics still apply despite what the Hartz Commission would like.

The Commission will now probably counter that PSA employment must then be limited in time or restricted in some other way. This is possible but only without the desired employment effects. More jobs are only possible in the long run if labour costs are lowered permanently, and this will only work, without corresponding wage concessions, if wages are permanently subsidised.

The idea of subsidising labour in all qualification segments of the labour market via PSA employment will lead to creeping Socialism in the labour market as a whole and is not compatible with a free market economy. The heart of the Hartz proposal is unrealisable.

Only the proposals of the Ifo Institute and the Scientific Advisory Council, which are more modest and which focus specifically on the lesser qualified, can be implemented. The welfare state must provide permanent help for the lesser qualified whose value added is too small to earn a sufficient livelihood. But this should be done on the condition that those affected make a contribution themselves, and not, as is the case today, that they have no earned income. This is the logic of the proposals submitted by economists. If we follow it, a good deal of unemployment can be eliminated without any costs for the state.

Once the election is over, politicians will hopefully remember the serious concepts that had been presented long before the Hartz proposals.

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

German original published in similar version reprinted in Handelsblatt No. 158, August 19, 2002, p. 8.