Trade and the (Dis)Incentive to Reform Labor Markets: The Case of Reform in the European Union

Abstract

In a closed economy general equilibrium model, Hopenhayn and Rogerson (1993) find large welfare gains to removing firing restrictions. We explore the extent to which international trade alters this result. When economies trade, labor market policies in one country spill over to other countries through their effect on the terms of trade. A key finding in the open economy is that the share of the welfare gains from domestic labor market reform exported substantially exceeds the share of the goods exported. In our baseline case, 105 percent of the welfare gains are exported even though the domestic economy only exports 30 percent of its goods. Thus, with international trade a country receives little to no benefit, and possibly even loses, from unilaterally reforming its labor market. A coordinated elimination of firing taxes yields considerable benefits. We find the welfare gains to the U.K. from labor market reform by its continental trading partners of 0.21 percent of steady state consumption. This insight provides some explanation for recent efforts toward labor market reform in the European Union.