Labor Demand Response to Labor Supply Incentives: Lessons from the German Mini-Job Reform

Tax benefits for low-earning workers have become a very popular anti-poverty policy in developed countries. The literature has shown that these tax benefits achieve their main goal of encouraging the disadvantaged—or low-earning workers—to participate in the labour market. However, as a side effect, they end up lowering the wages of these workers. This paper analyzes how firms respond to such movements in employment and wages, an area generally unexplored in the literature.

I use the expansion of tax benefits in Germany’s 2003 Mini-Job Reform as a case study and data on firms matched to administrative information on workers from 2000–07. Looking across firms with different proportions of low-earning workers before 2003, I explore what happens within those firms after the reform takes place. I construct a general equilibrium model that reproduces the observed pattern of changes in low-earning and high-earning employment. The model allows me to predict the impact of the policy on total employment and output.

I find that firms with a large proportion of low-earning workers before the reform increase their employment of both low- and high-earning workers because of the savings in labour costs brought about by the policy. Firms with a small proportion of low-earning workers before the reform, that do not save on labour costs directly, respond to the incentive to replace their relatively more expensive high-earning workers with cheaper low-earning ones. According to model simulations, total employment increases but output falls due to reallocation of resources and production across firms. The paper overall shows that a policy intended to help low-earning workers affects total employment and output through firms’ decisions.