Labor Adjustment, Productivity and Output Volatility: An Evaluation of Japan's Employment Adjustment Subsidy: Working Paper 2005-10

Working Paper
December 2, 2005

Naomi N. Griffin

This paper provides a theoretical examination of the impact of Japan’s Employment Adjustment Subsidy, a major employment insurance policy since 1975, on labor adjustment, productivity and output fluctuations in the iron and steel sector. A partial equilibrium industry model with heterogeneous establishments and aggregate uncertainty shows that the EAS reduces steady-state labor productivity by encouraging labor hoarding, while reducing job flows and increasing average firm-level employment. While the directly measured impact on productivity is proportional to the fraction of subsidized workers, the indirect effects of the subsidy on output and employment volatility can be substantially larger. First, the subsidy can lead to a sizable increase in output fluctuations over business cycles by symmetrically increasing the output response to shocks. This result is achieved through lower output via subsidy during unfavorable aggregate shocks and higher output via less spending on hiring during favorable aggregate shocks. Second, the subsidy meets its primary objective of reduced employment volatility. The reduction can be considerable when hiring and firing costs are set equal to the annual wage.