Wage subsidies during COVID-19 are a bad idea

Small stacks of coins

By June Ma, Rohan Pitchford and Rabee Tourky

This morning the Finance Minister Mathias Cormann confirmed that the government is working on a wage subsidy scheme for workers in distressed firms. While exact details of this plan will be announced in coming days, the Australian Financial Review reported that that workers may be paid up to 80 per cent of their wages before the shutdown under the scheme, though Senator Cormann suggested that it would differ from the scheme in the UK. The scheme is likely to be welcomed by industry unions and the businesses that have lobbied for it.

In this post, we argue that a wage subsidy is not good policy during economic hibernation, and is likely to impede the recovery process after hibernation.

Subsidies are used by Government to increase the subsidised activity. Since many of the firms targeted by the subsidy are almost fully shut down, there is no (current) activity that a subsidy can encourage. Workers are unemployed, and we have a system of unemployment insurance to deal with this — a wage subsidy aimed at this problem is mis-targeted.

For this above reason, we will assume that the goal of a wage subsidy is to boost future activity, i.e. by preserving the value of investments into the business that are made by a firm and its workers so as to allow them to emerge quickly after the crisis. Value that we may want to preserve could include, for example, the best allocation of tasks for employees taking account of aptitude, availability, personality, etc, along with training in operation of the specific equipment at that firm, understanding of local conditions and so on. Such value is often referred to as the “going-concern” value of a firm, but we will refer to this as the “future-concern” value for firms in (close-to) full hibernation.

If a firm has a positive future value, it has a clear incentive to entice workers back to its enterprise. There are a number of private contractual mechanisms to do this such as signing bonuses or option-to-hire contracts. Even putting aside these more sophisticated mechanisms — perhaps only available to certain kinds of businesses — smaller firms can keep in touch with their workers, larger firms can offer training packages or agree on extended leave, etc.

What, then, is the likely economic impact of a wage subsidy aimed at future concern value? To make it simple, think of a worker, W, whose wage is subsidised if she works at a specific firm called F. Assume there is a positive future concern value when W works in F, and this value is not realised in any other firm. Now suppose W finds a better job in another firm and that this employment situation generates higher joint value than the old firm. If the new firm does not receive a wage subsidy, W will stay at firm F instead of pursuing the new opportunity whenever the value of the new arrangement falls below the subsidised value of the old arrangement. Two things have happened. First, a higher value new opportunity has been destroyed. Second, taxpayers must face the cost of financing the wage subsidy e.g. with future tax increases.

A wage subsidy may lock-in old lower-value economic arrangements. Indeed, there will likely be permanent effects of the pandemic, depending on its duration, such as a shift to greater online sales, a decline in certain industries and a growth in others. By way of example, a business that employs labour that does not have internet skills may be reluctant to adapt and go online because that would normally mean replacing existing labour with labour with computer skills, a prospect rendered far more costly under the scheme. We have experienced a significant economic shock that imposes costs on everyone. However, we need the environment to be flexible enough to adapt to any new economic reality that may emerge.

There is also a political economy element to a wage subsidy that can be analysed by what economists refer to as the “incidence” of the subsidy. Whenever a tax or subsidy is introduced, it is shared between the supply and the demand sides of the market. As we emerge from this period of significant downturn, the presence of significant unemployment means labour supply is likely to be highly elastic. By this we mean that labour will respond rapidly by seeking new jobs, not needing much wage increases to be enticed back to work. Conversely, the demand for labour by distressed businesses emerging from hibernation is likely to be quite inelastic. By this we mean that firms will probably not increase the amount of labour they demand in response to lower wages by very much, wanting instead a basic workforce as the get back into things. This implies that the subsidy will accrue mainly to firms, not workers, ending up as a form of corporate welfare. The grim reality is that some, perhaps many, firms will need to adapt and reorganise the longer the crisis continues or the more changed is the future environment in which they operate. Private banks, not government subsidisers are in the best position to evaluate whether or not a future concern should be “preserved” or a new type of business emerge.

Our proposal is to keep things simple and not to attempt to introduce complicated (even convoluted) policies that are counter to the welfare of workers which introduce corporate welfare into the policy mix, and which will very likely hinder recovery. Far better to increase unemployment benefits: use the existing tools of our (already elaborate) safety net. As argued in a previous post, firms’ value is better addressed by renegotiation of contracts terms with banks and suppliers, supported by RBA liquidity policy.

Rabee Tourky is the Director of the Research School of Economics at the Australian National University and The Trevor Swan Distinguished Professor of Economics. His interest has been the operations of markets and market incompleteness.

Rohan Pitchford is a Professor of Economics in the Research School of Economics at the Australian National University. He works on financial stability and securitisation. he has published papers on default, securitisation, and contracts in the leading journals in Economics. He is a graduate from MIT.

June Ma is a pre-doctoral researcher at the Australian National University.