Equilibrium Unemployment and the Finance of Unemployment Benefits

Abstract This paper examines the impact of a tax scheme that considers a flat tax rate on employment income on equilibrium employment within a general equilibrium framework, incorporating Shapiro and Stiglitz's (1984) theory of wage rigidity. We consider taxation of wages, which are used to finance, under a government’s balanced budget regime, unemployment benefits, and analyse the effects on labour market outcomes. Our results show that the introduction of taxation on wages leads to an upward shift of the no-shirking condition (NSC) curve and a new equilibrium point at a higher level of unemployment and higher wages. The results underscore the significance of tax scheme design in shaping labour market equilibrium. These results may have a role in policy decisions aimed at promoting employment and economic growth and offer some insight for empirical studies on the estimation of the level of equilibrium unemployment.