We explore the far-reaching implications of low-wage subsidies on skill formation, aggregate employment and welfare. Low-wage subsidies have three important effects. First, they promote employment of low-skilled workers (who tend to be the ones who earn low wages). Second, by raising the payoff of low-skilled work relative to skilled work, low-wage subsidies reduce the incentive to become skilled. So they increase the low-skilled labor force which faces a relatively low employment rate. Third, the government budget constraint has to be taken into account, which is supposed to cause an additional tax burden for the skilled workers. This amplifies the negative e¤ect of low-wage subsidies on the incentive to acquire human capital. Thus, the first effect on the one hand and the second and third effect on the other hand pull in opposite directions in terms of employment.
This paper presents a theoretical model of the labor market in which these effects can be analyzed. We then calibrate the model with respect to the German labor market to shed light on the relative strengths of these effects and thereby assess the degree to which low-wage subsidies encourage or discourage employment.
The calibration shows that low-wage subsidies have a negligible effect on aggregate employment. Although they do stimulate low-skilled employment, they also reduce medium-skilled employment, and the net effect is very small.