Efficiency Wages and Tax Policy
Lai, Ching-Chong, Chang, Wen-Ya, Atlantic Economic Journal
It is well known in the conventional theory that a tax increase can be regarded as an anti-inflation device because it reduces the aggregate demand. However, recent contributions, particularly the literature in supply-side economics, devote their attention to the relationship between taxes and labor supply, and find that an increase in the rate of income taxation may stimulate the price level (Blinder  and Beck ).
Recently, the efficiency wage hypothesis has been accepted as a powerful theory to explain persistent involuntary unemployment, from the viewpoint of employers (Solow , Yellen , Katz , and Lindbeck and Snower ).(1) As is well known in the existing literature, the principal themes of the efficiency wage model are that the firm possesses market power in determining the wage offer and that the workers' effort depends on the real wage received by them. Based on these tenets, the efficiency wage theory can answer the questions why the wage may exceed the market-clearing level and why involuntary unemployment is persistent. This paper makes a new attempt to examine the conventional belief concerning the impact of tax policy on the price level by explicitly taking the efficiency wage hypothesis into consideration.
The remainder of the paper proceeds as follows. In Section II, the theoretical framework which incorporates the essential features of the efficiency wage theory is developed. Section Ill investigates the relationship between tax policy and the domestic price level. Finally, the concluding remarks are presented in Section IV.
II. The Framework
The macro model embodying the tenets of the efficiency wage theory can be expressed by the following equations:
(1) y = C(y - ty) + I(i) + G
(2) L (y,i) = M/p
(3) y = S(t) where y = domestic output; C = consumption expenditure; t = income tax rate; I = investment expenditure; i = interest rate; G = government expenditure; L = real demand for money; M = nominal supply of money; p = price of domestic output; S = aggregate supply function. As customary, we impose the following restrictions on the behavioral functions: [Mathematical Expression Omitted]
Equations (1) and (2) describe the economy's IS and LM curves, respectively. The aggregate supply function characterized by the efficiency wage hypothesis is presented in equation (3). We now turn to derive this function in detail.
As described by Lindbeck and Snower [1989, pp. 62-3], the efficiency wage theory rests on the following fundamental assumptions: (i) the firm exerts market power in wage setting; (ii) the productivity of the employees increases as the real wage they receive is increased. Define E to be the effort per employee, N the number of employees, [lambda](=E.N) the firm's workforce measured in efficiency units, the firm then has a short-run effort-augmented production function:
(4) y = F([lambda]), F[lambda] > 0, F[lambda][lambda] < 0.
According to the viewpoint of the efficiency wage hypothesis, the productivity of the workers is positively related to the real wage they receive, i.e., the after-tax real wage rather than the pre-tax real wage.(2) Hence
(5) [Mathematical Expression Omitted]
The objective of the firm is to choose labor input, N, and wage offer, w, so as to maximize profits, [pi], where profits are the excess revenue over factor cost,
(6) Max [pi] = pF(E.N) - wN
Substituting equation (5) into equation (6), the first-order conditions for equation (6) are
(7) [Mathematical Expression Omitted]
(8) [Mathematical Expression Omitted]
Equation (7) indicates that the demand for labor is determined by setting the marginal product of labor equal to the real wage, both in terms of efficiency units. Putting equations (7) and (8) together gives
(9) [Mathematical Expression Omitted]
Equation (9) is the well-known Solow condition in the efficiency wage literature. …