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Chapter 12: Government and the Labor Market

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1. Public-Sector Employment and

Wages

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Government Employment

0.02.04.06.08.0

10.012.014.016.018.020.0

1950 1960 1970 1980 1990 2000

Mill

ions

Federal Civilian Military State and Local

• The number of federal civilian and state and local government employees has risen over time.

• The growth of federal employment has been much smaller than the growth at the state and local level.

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Relative Government Employment

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

1950 1960 1970 1980 1990 2000

Mill

ions

Federal Civilian State and Local

• The share of employment in the

public sector has risen over time.

• This increase is due to increased demand for government services due to factors such as the schooling needs of the baby boom, higher real income, public sector unions, and increased regulation.

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Most government units attempt to set pay equal to those to comparable private-sector workers.

In the past, Federal government workers earned premium relative to their private sector counterparts. The premium has fallen over time.

Public sector workers receive a greater fraction of the their compensation in the form of fringe benefits.

Public Vs. Private Pay

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2. The Military Sector: The Draft Versus the

Voluntary Army

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Before 1973, the military used to draft or compel people to serve in the military. The pay for those serving in the military

was low. In 1973, military switched to an all

volunteer army. Military pay was raised significantly.

Draft vs. Voluntary Army

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Draft vs. Voluntary Army• If the military drafts OG number

of workers and pays them OA, the wage bill to taxpayers (OAfG) will be less than the

total opportunity costs (OBcG) to those drafted.• Under a voluntary system, the

relevant demand curve becomes Dv, the cost to taxpayers increases (OBeH as

compared to OAfG), those who volunteer are fully

compensated for their opportunity costs (OBeH) and

the military is likely to reduce its total workforce (OG to OH).

• The true cost of employing any specific group of workers is independent of the wage bill.

Dv

H

e

Quantity of Labor Hours

Wage rate

S

G

A

B

Dd

f

c

O

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Questions for Thought:1. Explain why a voluntary army may be less

expensive to society than an army composed of draftees. Which will be less expensive to taxpayers?

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3. Nonpayroll Spending by Government:

Impact on Labor

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Government purchases include procurement of items such as computers, tanks, paper clips, and weather satellites.

This spending creates a derived demand for workers who make these kinds of products.

In sectors where the government is a larger purchaser, changes in government spending will affect the wages and employment of workers.

Government Purchases of Private-Sector Output

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Transfer payments such as Social Security and unemployment compensation transfer income from the government to individuals and families. Recipients provide no current productive

activities in return. Subsidy is a transfer payment for firm,

institution, or household that consumes or provides a specific good or service. For example, Medicare for the elderly and

public education for youth.

Transfer Payments and Subsidies

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Transfer payments and subsidies increase the product demand by certain groups of individuals and families.

This will translate into higher derived demand for workers that make those products. Medicare programs increases the demand

for workers in the medical field.

Demand Effects

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Transfer payments create an income effect that reduces work effort by recipients. The payments increase income that

enable recipients to purchase more of all goods including leisure.

If the transfer payment is inversely related to earned income, then it creates a substitution effect that reduces work effort by recipients. This occurs because the opportunity cost

of leisure is reduced.

Supply Effects

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Transfers and subsidies may also reduce long-run labor supply decisions. Transfers may reduce the incentive to

invest in human capital since the gains from education are reduced by the loss in transfer payments.

Transfers and subsidies may increase long-run labor supply decisions. If the government lowers the private cost

of education, then the incentive to invest in human capital is greater.

Supply Effects

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4. Labor Market Effects of Publicly Provided Goods and Services

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Provision of a public good that is a complement in either consumption or production of a private good will increase the demand for workers who help produce the private good. A new dam will increase the demand for

farm workers due to more irrigation. Provision of a public good that is a

substitute in either consumption or production of a private good will decrease the demand for workers who help produce the private good.

Demand Effects

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Supply Effects

Leisure

Public & Private Goods

240

• If real income is defined as the total quantity of public and private goods and services obtainable from any specific level of work, then the

presence of $60 per day of public sector goods shifts the budget constraint has a parallel shift.• Assuming leisure to be a normal

good and disregarding the tax consequences of the increased public-sector provision, this creates an income effect that increases the optimal number of hours of leisure by 1 hour (and reduce work effort by 1 hour).

$240

I1

16

U1 I2

17

U2

$300

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Questions for Thought:1. Assuming that “income” includes both private

and public goods, and that leisure is a normal good, explain how a major reduction in governmentally provided goods might increase a person’s optimal number of hours of work.

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5. Income Taxation and the Labor Market

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Wages and Employment: Inelastic Labor Supply

• The demand curve D is the before-tax wage rate that firms face.

• If the labor supply curve is perfectly inelastic (S), then the quantity of labor supplied does not depend on the wage rate.

• Without an income tax, the market wage is $9.00.

Dt

S

7.20b

6

a9.00

0 Quantity of Labor Hours

Wage rate

D

15.00

• With an income tax, the after-tax demand curve facing the worker is Dt.

• The amount of the tax is measured by the vertical distance between D and Dt. ($9.00-$7.20=$1.80).

• Since the pre-tax wage does not change, workers bear all of the burden of the income tax.

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Wages and Employment: Positive-Sloped Supply

• If the labor supply curve is positively-sloped (S), then the quantity of labor supplied depends on the wage rate.

• Without an income tax, the market wage is $9.00.

S

0 Quantity of Labor Hours

Wage rate

D

15.00

• With an income tax, the equilibrium hours work drops

from 6 to 5.• As a result, the pre-tax wage

will rise to $10.00. The after-tax wage will be $7.75.

• Since the pre-tax wage rises, firms bear some of the burden of the income tax.

6

a9.00

• The greater the elasticity of labor supply, the larger is the employment loss and the greater is the rise in the wage rate.

Dt

5

7.75

10.00

b

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Income Tax and Individual Labor Supply

Leisure

Income/day

240

• An income tax shifts the after-tax wage downward and may either raise or lower a person’s optimal number of hours of work.

$240

I1

I2

16

U2

• Prior to the income tax, the optimal hours of work is 9 (15 hours of leisure) at point U1.

15

U1

$360

• The optimal hours of work would increase if the income effect was larger than the substitution effect.

• After the income tax, the optimal hours of work

decreases to 8 (16 hours of leisure) at point U2. This implies the substitution effect caused by the tax is larger than the income effect.

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The presence of the income tax will likely increase the amount of public goods which will produce an income effect which will reduce hours of work. This will end to offset the income effect

of the income tax which tends to increase hours of work.

As a result, only a substitution effect may remain and thus the income tax may reduce labor supply.

Caveat

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For men, the income effect tends to slightly outweigh the substitution effect. The income tax tends to slightly raise

hours of work for men. For women, the substitution effect

outweighs the income effect. The income tax tends to lower hours of

work for women. In the aggregate, labor supply is highly

inelastic and so workers bear most of the burden of the income tax.

Empirical Analysis

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EndChapter 12