We explore the far-reaching implications of low-wage subsidies on skill formation, aggregate
employment and welfare. Low-wage subsidies have three important e¤ects. First, they promote
employment of low-skilled workers (who tend to be the ones who earn low wages). Second,
by raising the payo¤ of low-skilled work relative to skilled work, low-wage subsidies reduce
the incentive to become skilled, so that there are more low-skilled workers associated with 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
ampli es the negative e¤ect of low-wage subsidies on the incentive to acquire human capital.
Thus, the rst e¤ect on the one hand and the second and third e¤ect 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 e¤ects can be ana-
lyzed. We then calibrate the model with respect to the German labor market to shed light on
the relative strengths of these e¤ects and thereby assess the degree to which low-wage subsidies
encourage or discourage employment.