Fiscal Policy and Youth Unemployment – Direct intervention in youth labour markets is also called for

One of the most consistent findings of the literature on the causes of youth labour market outcomes is that aggregate demand is a fundamental determinant of the state of the youth labour market. Recent research has also reaffirmed the importance of expansionary fiscal policy in counteracting, or at least mitigating, the negative effects of the global economic crisis, raising employment rates and reducing unemployment at the aggregate level. Thus far, little work has been undertaken looking at the potential for fiscal policy to ameliorate the effects of recessions on youth labour markets. This paper seeks to fill that gap.

Young people suffered disproportionately from the recent downturn in OECD economies. For example, in the EU between 2007 and 2014, the youth unemployment rate increased by 41% representing an 8 percentage point rise compared to 4 percentage points for ‘adults’ aged 25 or over3; of even more concern, the prevalence of long-term unemployment amongst young people rose by 30% over the same period – compared to 9% for adults.

It is also well established that extended periods of unemployment early on in one’s labour market experience has long-lasting repercussions; the effects of unemployment and/or joblessness early on are likely to be felt in terms of employment prospects and wages throughout a person’s life (e.g. Gregg, 2001, and Gregg and Tominey, 2005). The regularity with which such scarring has been found, at least in the European context, as well as more recent attempts to control for these selectivity effects suggest that there really is a scarring effect that goes beyond unobserved individual heterogeneity; extended difficulties in the search for work early on are likely to have long-term negative consequences. In the context of the current prolonged recession, this creates the spectre of a lost generation of young people who become permanently excluded from productive employment .

Figure 1 on the EU illustrates that although there is a clear positive relation between changes in real GDP consequent on the economic and financial crisis and changes in youth employment, there is also much heterogeneity across countries in the youth employment response to the recession. Thus, although aggregate demand is the defining factor, it is also likely that inter alia the structure of macroeconomic and fiscal policies will be important in determining youth labour market outcomes.

To summarise the currently available evidence, it is reasonable to suggest that there is room for expansionary fiscal policy to be used to increase GDP. The second question which arises is the effect this may have on employment and – of specific concern here – on youth employment and unemployment. Over the last decade or so, and more particularly following the onset of the crisis, a number of papers produced by the ILO have looked at the relationship between economic and employment growth and the potential for and advisability of using expansionary fiscal policy to increase employment has recently be re-affirmed in the ILO’s Work of Work 2014 report. The analysis in IMF (2014) provides further evidence of the negative effects of fiscal consolidation on employment, although these are weaker when the reduction in the deficit is the result of reduced government expenditure (as opposed to increased taxation), and the adjustment does not take place following a protracted recession, with positive (non- Keynesian) employment effects discernible after three years. Indeed, the analysis finds that following a protracted recession (of two years or more), reduced government expenditure has greater negative effects on employment than does increased taxation.

Main conclusion

The results presented here provide clear evidence that countercyclical fiscal policy is an instrument well-suited to ameliorating youth unemployment; although they also suggest that the instrument is more effective if preceded by a relatively conservative fiscal policy in non-recessionary circumstances – if one likes, a fully countercyclical fiscal policy with fiscal expansion during recessions and contraction during periods of growth. Decreasing the budget surplus, particularly during a recession, leads to substantial reductions in youth unemployment rates. Reducing the discretionary surplus by one percentage point is associated with an immediate decrease in youth unemployment of between 0.33 and 0.51 percentage points. Equally importantly, decreasing the budget surplus by one percentage point relative to trend is also associated with an increase in the rate of youth employment of between 0.19 and 0.34 percentage points. Thus, the traditional Keynesian prescription of countercyclical fiscal policy is upheld. In order to reduce youth unemployment and increase youth employment, governments should increase expenditure and reduce taxation during recessions, whilst doing the opposite in when the economy is expanding.

On a slightly more nuanced note, increasing an existing deficit is much less effective than reducing an existing surplus in combatting youth unemployment or promoting youth employment rates; countercyclical fiscal policy is clearly more effective for countries that are already running surpluses at the onset of recession. That is, countries which also stabilise by running surpluses in good times are most able to benefit from reducing those surpluses when a recession hits.

The impact of fiscal policy on the youth/prime-age unemployment ratio is rather less marked; this suggests that the impact of fiscal policy does not differ very much between the youth labour market and the labour market for prime age adults. There is a positive and statistically significant effect implying that expansionary fiscal policy is slightly more effective for young people; although statistically significant, the size of the coefficient is very small. This does imply, however, that since youth unemployment is higher in absolute terms (especially in recession), any positive impacts will be larger (in absolute terms) for young people. Perhaps more detail – in terms of the destination of expenditure and the source of revenue might change this picture, however, on the basis of the evidence presented here, youth unemployment rates are responsive to fiscal policy (slightly more than) proportionately to adult rates; this is consistent with the empirical regularity noted above that youth and adult unemployment rates respond more or less proportionately to the business cycle. Perhaps of equal importance in this context, stronger regulation of temporary employment contracts is also associated with a higher youth/adult unemployment ratio.

The analysis also went on to examine the effects of discretionary fiscal policy on long-term unemployment and temporary employment forms. Here the evidence suggests that expansionary fiscal policy can reduce the prevalence of long-term unemployment, again so long as the budget is in surplus, although in this case the effect does not vary with the cycle. It would moreover appear that expansionary fiscal policy tends to reduce the rate of temporary employment at least during periods of expansion (and budget surplus).

All-in-all, the picture is one in which fiscal policy can play a useful role in ameliorating problems in youth labour markets due to insufficient aggregate demand. The results suggest that expansionary policy during recession is at least as effective for young people as it is for adults, and may also go some way to mitigating some of the specific problems facing European youth labour markets today such as the increasing duration of unemployment and the falling duration of employment contracts. However, it is clear that such demand management policies can complement but cannot replace action also at the microeconomic and institutional levels. The moderate size of the effects of fiscal policy on youth labour market outcomes and, in particular, on long-term youth unemployment, are clearly supportive of the idea that direct intervention in youth labour markets through, for example, Active Labour Market Programmes (ALMPs) in general and the Youth Guarantee in particular is also called for.

Chosen excerpts by Job Market Monitor. Read the whole story at  Fiscal policy and the youth labour market