Ifo Viewpoint No. 74: Subject versus Object

On the design of wage subsidies
Hans-Werner Sinn
Munich, 10 April 2006

Germany will surely get wage subsidies, the so-called “combi wage programme”. Politicians have recognised that Germany’s mass unemployment of the unskilled can only be ended if public support is granted for participating in the labour market rather than for staying away. The only question is whether the combi wage is to be introduced as object or subject support, i.e. whether the firm or its employees are to be subsidised. Public discussion of the combi wage is beset by confusion because no clear distinction is made between these alternatives.

This confusion becomes evident when the argument is made that the introduction of wage subsidies would induce employers and employees to conspire and agree lower wages in order to receive higher subsidies. Statutory minimum wages, it is maintained, are needed to guard against this.

To a certain extent the argument is understandable when subject support is meant. The lower the wage, the bigger the subsidy that the government must pay the employee if he is to be guaranteed a given income. It is incomprehensible, however, in the case of object support, because in that case it is just the reverse: the higher the wage, the higher the subsidy that the government must grant the employer if a given level of labour costs is not to be exceeded. According to this logic, one would have to demand a statutory maximum wage to prevent the state from being exploited.

The idea of a conspiracy between the employer and his employees is wrong, however. Firstly, the government will neither fully compensate wage reductions nor wage increases but set subsidy rates that always imply only partial compensation. Secondly, Germany has a labour market in which companies compete with one another.

To be sure, in the case of subject support, there will be a reduction in wage demands to the extent of the support, and that is exactly why more jobs will be created. But even with very generous subsidies, the wage cannot fall to zero. The market equilibrium may be reached at a wage that is estimated at one third below today’s low-wage level. Even with more generous subsidies, lower wages are not possible as employers would bid up wages when competing for scarce employees. Statutory minimum wages at today‘s low-wage level are not only unnecessary, they are harmful. They would prevent the creation of new jobs.

In the case of object support, labour costs fall in the extent of the support. With limited subsidies, gross and net wages are unchanged because they are constrained above the market clearing level by the available public replacement incomes. If the subsidy is sufficiently generous, market equilibrium will be reached here, too, and only then can the employers' competition for scarce labour force lead to higher wages.

Regardless of subject or object support, the resulting market wage is independent of where the money goes. Both types of support will yield the same labour costs, the same net wages and the same employment effects if the government realises the same support volume and subsidizes the same economic activity.

However, the same activities are not being supported. In contrast to subject support, object support cannot take account of the individual characteristics of the employees. In particular, it is hardly possible to consider other incomes like interest, rents and government benefits, and if so, only at prohibitive administrative cost and at the expense of privacy. As a consequence, there would be many losses due to the scattershot approach to support. An uncontrolled subsidy machinery would be set in motion whose costs could hardly be contained. The negative experiences made with German public housing construction show what may be expected.

Those in favour of object support argue that subject support would create a revolving-door effect because employers would be induced to replace expensive already working employees with cheaper new employees. This would cause the greater fiscal burdens. The revolving-door effect would be pre-vented in the case of object support if this support were limited to an increase in employment compared to a historical base year. This argumentation is wrong.

For one, subject support can be financed despite the full revolving-door effect if German “unemployment pay II” (ALG II) is redesigned according to the Ifo Institute’s Activating Social Aid programme. The free earnings bracket where own income does not imply subsidy cuts would have to be raised from €100 to €500 and ALGII at inactivity would have to be cut by one third. And if need be, community loan jobs would have to be created at wages equal to the level of today’s ALGII. This would create more than three million jobs, reduce government outlays by €5 billion, and raise poor people’s standard of living markedly above the level of ALGII.

Furthermore, the revolving-door effect would come about with object support, too, and would, in addition, have dramatic effects on firm structure. New firms, founded after the base year, would enjoy the full support, whereas old firms that have reached maturity would get nothing. Therefore, old firms would be driven into bankruptcy and give way to new firms. In view of the foreseeable mass protests of the established firms, I pity the political party that promoted such an approach.

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

Published under the title “Subjekt versus Objekt”, Wirtschaftswoche, No. 15, 10 April 2006, p. 186.