Unemployment and Labor–market Reform: A Contract Theoretic Approach

Why do many democracies fail to reform their labor–market institutions? To answer this question we study the feasibility of reforms that include compensation to insiders for the removal of labor–market regulations. Under asymmetric information, a reformer who wants to buy the approval of voters has to pay them an informational rent in addition to the pure costs of compensation that would arise under symmetric information. In this setting, unemployment may be constrained Pareto–efficient. Labor–market reforms may fail politically because none of the reform packages proposed wins the approval of a majority of voters. We also discuss the role of capital taxation in a reform program. JEL classification: D70; E61; J68