Ifo Viewpoint No. 75: A Suit from a Cabinetmaker?

Hans-Werner Sinn
Munich, 06 June 2006

The CDU/CSU have presented their combi-wage proposals. Fearing that the combi-wage will be too expensive, they want to limit the wage subsidies to sub-groups of the labour market. Their fears are justified. Under no circumstances is it possible to channel all dismissed employees back into the labour market with permanent subsidises. That would be exorbitantly expensive.

But it is also not possible to limit subsidies in the way that the general secretaries of the CDU/CSU intend by restricting them to the so-called long-term unemployed and to new, young entrants to the labour market. If these groups are subsidized at 40 percent, as in the proposal, little more than a displacement effect will be achieved. No new jobs will be created due to the so-called marginal principle, one of the elementary laws of economics.

According to the marginal principle, market price and transaction volume on markets where competition prevails are always determined by the providers with the highest costs who are just barely able to stay in the market: The expensive providers make the prices, and the cheaper providers make the profits! Imagine a market for cars with initially only equally expensive domestic traders. The price of cars is so high that these traders just manage to get by. Now a limited contingent of cheap re-imports is thrown onto the market. Since the price of cars sold by domestic traders cannot fall, the overall turnover volume can also not increase. The re-imports will replace cars sold by domestic traders one by one.

It is very similar on the labour market. Currently there are only expensive providers of labour. At their labour costs there is not a sufficient number of jobs. Now the CDU/CSU wants to infiltrate the labour market with previously unemployed persons at lower labour costs by reimbursing the firms for part of the labour costs. The result will be that the subsidised workers will be fully employed because they are cheaper than the others. Since the other workers cannot as a result work for less, however, the overall volume of labour also cannot change. After an exhaustion of the contingency of subsidised employees, it will only be the normal workers whose labour costs will play a role in decisions to create new jobs. As a result, we can expect a virtually complete displacement effect. The plan will be very expensive and the labour market effect will be zero.

We would have a repeat of what Germany’s so-called 400 euro jobs, which were freed from tax and social security contributions, have already shown. Since the recipients of replacement wages did not profit from the exemption from payroll taxes because the advantage was automatically swallowed by transfer withdrawals, they have not been able to offer their labour more cheaply than before. For this reason these jobs were taken on by pupils, students, assisting spouses and pensioners, who were not faced with a deduction in welfare payments and whose wage demands were correspondingly lower. They replaced normal employees one to one, but, since they only represented a sub-group on the labour market who as such could not conquer the market as a whole, no effects on overall employment resulted.

Any attempt to increase employment by subsidising sub-groups of a market while the demands of normal employees remain unchanged are doomed to failure. Either all providers on a market are subsidized or none at all. Partial solutions make no sense. Only if everyone is subsidised can one guarantee that the marginal providers of labour become cheaper and the transaction volume increases.

This does not mean that combi-wages are only possible at immense costs. One can keep the costs low by limiting the subsidies to a sub-group of the labour markets themselves rather than to portions of the labour forces within all labour markets. In concrete terms, one can subsidise especially the lowwage earners, who as a rule are the low skilled, and in this way populate only particular, demarcated labour markets.

This is precisely the concept of Activating Social Welfare, which grants widespread personal wage subsidies to everyone in the lower income groups, also to those with jobs, thus comprehensively lowering wage demands and ensuring social equilibrium. The Ifo proposal of Activating Social Welfare, which could easily be implemented via a slight modification of Germany’s second-tier unemployement system (Arbeitslosengeld II), would save the state 8 million euros annually in the short term, provide jobs for 3.2 million people in the medium term and raise the standard of living of low-wage earners clearly above the Hartz IV level. But one could also choose the proposal of the German Council of Economic Experts or that of the Scientific Advisory Board of the Federal Ministry of Economics, both of which are similar to the Ifo plan.

Economists are constantly amazed at how politicians seek to re-invent the wheel and introduce flaws into their legislation because they only think in legal and political terms and neglect even the simplest laws of economics. This is precisely the case with the combi-wage. Why does the CDU/CSU not trust the advice of the specialists who have dealt with this problem for some time and have reached a unanimous proposal. You don’t take shoes to the baker to be repaired or have a suit tailored by a cabinetmaker.


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

Published as "Ein Anzug vom Schreiner?“, Wirtschaftswoche, No. 23, June 3, 2006, p. 178.