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There is a type of employment subsidy that has long had great appeal. It is the idea that employment can be raised by rewarding each employer in proportion to the additional employees taken on as compared to some starting date. This form of subsidy was actually implemented in the UK for a short while two or three decades ago under the name “Small Firms Employment Subsidy”. The big idea, of course, is to raise employment overall.

In late 2009 something of this sort is being proposed by the Obama administration under the guise of "tax credits for new jobs" or similar.

A number of economists have kept themselves employed over recent decades writing papers and articles about the finer points of marginal employment subsidies (MES). They have wasted their time. None of them (as far as I know) have tumbled to the basic flaw in the idea. A variety of these articles and papers is easily obtained by typing "marginal employment subsidy" into a search engine.


An introduction to subsidies, marginal and “not marginal”.

All subsidies can be divided into two sorts. First there are marginal subsidies. As pointed out above, these involve subsidising just the additional units that get produced or employed as a result of the subsidy. As to the second type of subsidy, there is unfortunately no one widely accepted name, but the phrases “average subsidy” and “intra-marginal subsidy” are sometimes used. I’ll use the latter, i.e. “intra-marginal subsidy”. This second type involves subsidising all units, e.g. all apples, all youths, all steel production, etc.


The big attraction of marginal subsidies (if you can get away with it) is that they cost less. E.g. if someone wants to subsidise apples by enough to raise apple sales by 10%, then subsidising just the “marginal apples” would be 1/10th the cost of subsidising all apples.

The problem is that it is not always possible to effectively distinguish between the additional (or marginal) units and the intra-marginal units. With apples, its virtually impossible. With MES, there is no problem – at least initially. The problem comes a few months after implementing the subsidy as is explained below.

Incidentally, any readers who have had a quick look at the "Government as employer of last resort" blog (in the list above) may be puzzled by the claim here that MES doesnt work, because the subsidy advocated in the latter blog is actually a marginal one. The reason for this apparant contradiction is that the paragraphs above and below deal with what might be called the simplest or most popular marginal subsidy (which doesnt work). The subsidy advocated in "Government as employer....." takes into account the basic flaw in traditional MES, thus it ought to work. I.e. for accuracy's sake the subsidy considered below might better be described as a "simple basic marginal subsidy", but I'll stick with MES.


The flaw in MES.

Explaining the flaw in MES requires a basic understanding of what goes wrong with economies as demand and employment rises and, at some point, inflation kicks in (result: no more demand is possible – unless you want hyperinflation).

Let’s start with a hypothetical economy where unemployment is far too high. In this situation, raising employment is easy: just raise demand. This can be done, for example by printing more money and dishing it out; the money gets spent, which in turn employs people.

At first there is no problem. Employers require various types of labour to increase production (skilled, semi-skilled, etc) and for the most part, whatever employers want, labour-wise, they can find amongst the unemployed. But as the total number of unemployed shrinks, the variety of skills available on each local labour market also shrinks.

The point comes where employers begin to satisfy their need for more labour by poaching it from other employers, rather than take such labour from the dole queue. Of course there is no one level of unemployment at which “poaching” suddenly kicks in. But the rise of poaching as unemployment falls has been studied and measured. And these studies confirm what is little more than common sense, namely that as unemployment falls, poaching rises.

This poaching is not necessarily conscious on the part of employers. The point is that the more desperate employers are for the right kind of labour, the more attractive their job offers and remuneration offers become. This inevitably attracts labour from other firms.

In addition to poaching, employers resort, as unemployment falls, to raising wages in their own firm, so as to discourage other employers from poaching. But this is clearly a zero sum game. The only net result is rising pay (in money terms) for the country as a whole. And the further unemployed falls, the faster the wage rises become and the worse inflation gets.


Incidental point on rising pay.

Some readers may be puzzled by the objection raised in the above para to rising pay. After all, why should anyone object to higher pay for employees? The reason for the objection lies in the phrase "in money terms" in the above para. That is, so long as "rising pay" just consists of more £ or $ and no increase in pay in real terms, the increased pay is useless.

Indeed, and ironically, if we start as in the above illustration from very high levels of unemployment, there is initially no tendency for pay to rise in money terms, in that employers do not need to outbid each other for labour. Yet pay will be rising in real terms for the simple reason that everyone pays less tax to support the unemployed!

In contrast, when the economy reaches NAIRU, it's the other way round: pay will tend to rise in money terms in that employers are outbidding each other for labour, but real pay will not rise in that a further rise in employment and real output for the economy as a whole is just not possible. And rising pay in money terms without a rise in real pay is pretty well the definition of inflation.

We now return to the hypothetical economy where demand has risen as far as it can, and employers are engaged in poaching labour to such an extent that inflation kicks in.

There is clearly a trade off between inflation and unemployment, and economists normally call the minimum level of unemployment compatible with acceptable inflation NAIRU (which stands for Non Accelerating Inflation Rate of Unemployment).

If unemployment is above NAIRU, there is no case for any employment subsidy: unemployment can be lowered simply by raising demand. I.e. the big question is whether MES can lower NAIRU. Well, the answer is it can, for a while. The way it does so is as follows. Let’s assume MES in introduced on 1st Jan.

Employers who previously rejected dole queue labour because of the latter’s unsuitability will be tempted to take on such labour because the subsidy compensates them for the unsuitability. I.e. MES certainly lowers NAIRU initially. Indeed it lowers it till the remaining unemployed are so unsuitable, that even the subsidy does not persuade employers to take on this labour: i.e. inflation will rear its ugly head again if demand is raised further. But at least NAIRU has been lowered a bit.


Incidental note on cost push inflation.

Some readers may want to object to the argument here on the grounds that it seems to be assumed here that there is only one cause of inflation: excess demand or labour shortages. Put another way, keeping demand for labour within bounds may not influence inflation because it is possible the latter is being caused by “cost push”.

The answer to the above objection is “if your car’s poor fuel consumption is caused by several factors other than a poorly tuned carburettor, this is no excuse for not attending to the carburettor”. I.e. where a problem has several causes, or potential causes, each cause must be remedied.


Incidental note on “suitable” versus “skilled”.

Most economists when discussing labour shortages refer to “skilled” labour shortages. I will use words suitable and unsuitable instead because the latter words more accurately describe the nature of the problem. To illustrate, the supply of skilled labour available from the ranks of the unemployed certainly diminishes as employment rises, but it’s never just skilled labour that employers are looking for. They look for semi-skilled and unskilled as well. And even the so called unskilled (or 95% of them) have some sort of skill or experience to bring to a job, which employers almost invariably enquire about at the job interview stage.

Moreover, employers when they look for skilled labour are not looking for “skilled labour” in the simplest and most banal sense of the phrase. For example if an employer has a vacancy for a fully qualified plumber (a “skilled” vacancy) a fully qualified electrician is certainly skilled, but the latter will not be suited to the former job. In sort, the word which captures what employers are after is suitable rather than skill.


Returning to the subsidy.....

Returning to the subsidy, to keep things simple, lets assume that the additional employment created by the subsidy happens almost instantaneously, or at least within the first week of the subsidy. Employers take on additional labour, and the subsidy compensates them for the unsuitability of new employees. No problem. The subsidy works.

But a problem gradually emerges which is as follows. Labour markets are in constant flux: employees retire, fall ill or quit voluntarily. Plus employers requirements labour-wise change over time. Six months or a year after implementing the subsidy, employers (in exactly the same way as before the subsidy was implemented) will be looking every month for an assortment of different types of labour to replace those who have retired, quit, fallen ill etc.

But there is a big diffeence between the initial week of the subsidy and the situation a few months down the road is that in the former case the employees taken on were all relatively unsuitable, and employers were compensated for this unsuitableity. In contrast, a few months down the road, employers are not just on the look out for relatively unsuitable labour: they are on the look out for all types of labour, including the highly skilled and the "very suitable" (becaue a proportion of the latter will have retired, quit voluntarily, etc). And these latter types of labour just aren’t there in the dole queue in sufficient numbers. (Remember NAIRU: there is a minimum feasible amount of unemployment for a given level of demand).

The latter point can be put another way. On implementing the subsidy, it is obvious to employers (and everyone else come to that) which employees are being subsidised. In contrast, a few months later, the subsidy simply becomes a monthly cheque that comes from government which is not obviously applicable to any particular group of employees. Most importantly, the subsidy is not even necessarily applicable to the employees who were initially taken on as a result of the subsidy because not all of them will still be unsuitable. For example, some will have gained firm specific skills and will have become perfectly viable without the subsidy. In addition, most employer’s labour requirements will have changed over the months, and some employees who were perfectly suited to their work are allocated to different jobs within their firm, jobs to which they are not so suited. Some of these latter employees in the absence of the subsidy and rise in demand would have lost their jobs and would have been available to help other employers fill vacancies. Unfortunately they are not available.

Conclusion: a few months after implementing MES, its modus operandi evaporates. So is there a solution to this "modus operandi" failure? Well for a way round the problem, see the "Government as employer of last resort blog" (link at top right).