## wpiea1992074-print-pdf

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### Introduction: purpose and context
- Different forms of wage controls have been introduced in most of Eastern Europe's stabilization plans (Poland, Czechoslovakia, Yugoslavia, Bulgaria) and are regarded as important for Russia and other republics of the former USSR.
- Heterodox stabilization programs (Israel, Mexico, Argentina, Brazil in the mid-eighties) combined incomes policies with a nominal exchange rate anchor to reduce inflation while minimizing output costs; incomes policy aimed to lower inflation expectations and overcome "coordination failures" in wage and price setting.
- Incomes policy is less effective and less credible if not accompanied by consistent monetary and fiscal policies aimed at reducing inflation, or if a similar plan has been unsuccessfully tried before.
- For formerly centrally planned (FCP) economies, the main rationale for wage controls differs: they address a "corporate governance problem" in state enterprises where workers and managers may appropriate firm assets and reduce investment.
- Price controls are largely excluded from policy discussion because they hamper relative price adjustment and signal lack of commitment to reform.

### Channels linking wage claims, fiscal position, and macro outcomes
- Three links between income distribution in state enterprises and macro performance (Lane (1991a)):
  - (1) Redistribution of firm revenues toward wages reduces government revenue from the profit tax, implying larger recourse to money creation and therefore more inflation.
  - (2) Higher wages feed into higher prices if firms follow automatic mark-up rules after price liberalization.
  - (3) Higher wages may reduce investment: uncertainty about property rights and firm survival can lead to lack of maintenance and capital run-down; structural adjustment increases need for capital upgrading.
- Empirical stylized facts:
  - In the former Soviet Union, output and productivity declined considerably in 1991, but real wages rose well above their 1990 level.
  - The average real wage—"consumption fund per worker in industry"—was very volatile in 1991: by November it was almost 50 percent above the January level according to some estimates.
  - In Poland in 1991, one measure of the real wage rose by 12 percent while output fell considerably.

### Model overview and key assumptions
- Objective: formalize effects of "excessive" wage claims in a one-sector economy with constant employment to analyze consequences for inflation, output, and the fiscal position; study the role of wage controls in stabilization.
- Main assumptions:
  - Employment is constant; labor force normalized to unity so wage bill equals wage rate; k = capital per worker.
  - Government fiscal revenues come primarily from profit tax and payroll tax; basic formulation assumes government raises revenue out of the profit tax only and "all profits are 'taxed away'".
  - Depreciation allowances are considered costs and are not taxed.
  - Government spending comprises government consumption (c_t§) and transfers proportional to wages.
  - No bond market exists; any shortfall in revenues is covered by printing money (money creation finances budget deficit).
  - Private agents face a cash-in-advance (C-A) constraint: nominal money demand M_t^s is proportional to real private consumption c_t via parameter a; money is the only asset available to private agents because capital is state-owned.
  - Output produced with a Cobb-Douglas technology using capital and labor; inflation π_t may negatively impact total factor productivity.
  - Consumers hold money balances only to satisfy the binding C-A constraint; they do not save.
- Notation conventions preserved as in the source (e.g., y_t, P_t, W_t, l_t, T_t, G_t, M_t^s, k_t, π_t).

### Fiscal links and budget implications
- Two fiscal channels linking nominal wages to the government budget:
  - Higher wages reduce government profit-tax revenue (P_t y_t − W_t).
  - Higher wages increase transfers for social benefits to private individuals (b W_t).
- A payroll tax at a rate higher than b could more than offset the second effect; Appendix III discusses profit tax rate less than unity and a payroll tax 0_W by replacing b with (b−0_W).
- Policy insight:
  - For a given tax structure (treated as given in the short run), the distribution of firms' income between wages and profits matters for government revenue.
  - Money creation as residual financing implies that lower revenues generate higher money creation and inflation, undermining stabilization credibility.
  - Tax reform (e.g., applying same tax rate on wages and profits) would eliminate the direct link between internal distribution and the budget but is a medium- to longer-term measure.

### Role and design considerations for incomes (wage) policy
- In FCP economies wage ceilings may be essential to limit appropriation of enterprise assets and to limit wage payments until proprietary structure issues are resolved.
- Incomes policy can supplement traditional stabilization when wages closely link to price inflation and the fiscal deficit.
- The paper does not focus on optimal design or enforcement of wage controls; distortions and enforcement feasibility are acknowledged as important and discussed in related literature.

### Competitive economy: equilibrium implications
- Competitive equilibrium: real wage w^ = W^/P^ equals marginal product of labor.
- If capital does not depreciate and government consumption is a fixed share of output, money growth and inflation will be zero; workers' consumption equals real wages plus real benefits.
- With binding C-A constraint, inflation raises the "effective price" of consumption (since money balances lose purchasing power), reducing real purchasing power.
- Summary implication: raising real wages above market-clearing level can be self-defeating—higher real wage claims lead to higher inflation which reduces real purchasing power and, if productivity is inversely related to inflation, lowers steady state output and private consumption.

### Inflation and real wages when the labor share is too large
- Two wage-claim cases analyzed:
  - (a) fixed real wage above competitive level;
  - (b) nominal wages partially indexed, reacting to gap between actual and desired real wage.
- General outcome: higher real wage → lower profit tax revenue → higher money creation → higher inflation → erosion of purchasing power and potential reduction in output (if productivity falls with inflation).

a. Fixed Real Wage
- If real wage is fixed above competitive level, steady inflation is determined by setting (16) = 0 and using (18).
- Key conclusions:
  - Inflation is higher the larger the difference between the actual wage share and the competitive one.
  - Inflation is lower the greater the demand for money generated by the C-A constraint (the higher is a).
  - If productivity is negatively related to inflation, steady state output and private consumption are lower the higher the inflation rate.

b. Partially Indexed Real Wage
- Nominal wage dynamics depend on inflation (indexation parameter) and gap between actual and desired real wage; desired real wage denoted o>.
- Steady state characterized by intersection of loci in (π, w) space (equations (21) and (22) in the source).
- Special cases and results preserved:
  - If φ → 0 (wages do not respond to gap), steady state inflation is zero and real wage is (y - c8)/(1 + b).
  - If φ > 0, steady state inflation π^ is positive if workers' real disposable income at desired wage, (1 + b) a), exceeds output available for private consumption, y - c£.
  - Unless wages are fully indexed (e = 1), w_SS is always below w. With full indexation the steady state inflation rate does not depend on φ; it is higher the larger the gap between target real wage w (plus benefits bw) and resources available for private consumption, y - c&.
- Fiscal deficit under partial indexation:
  - Steady state real fiscal deficit (rate of creation of real money balances) is larger the larger the indexation parameter and the larger the target real wage; it is zero only if workers' disposable income equals resources available for private consumption.
  - If public consumption is a fixed fraction of output (as in (12)), budget is in balance when real wage equals its competitive level.

c. Wage Push
- Under a wage push, inflation rises more:
  - the higher the indexation parameter,
  - the larger the wage push,
  - the more reactive nominal wages are to gaps between actual and target real wage.
- Mechanism: wage push raises real wage; inflation must rise to reconcile inconsistent income claims by increasing the effective price of consumption; real wage stops short of target unless indexation is full.

### Stabilization and the role of incomes policy
- Reduction in transfers (b reduced):
  - TTTT locus shifts right and flattens; immediate fall in inflation (A → B) followed by rise in real wage and inflation to new steady state C with:
    - steady state real wage w_ss' higher than v_ss
    - steady state inflation π_SS' lower than π_SS
  - If accompanied by incomes policy (reduction in indexation parameter), subsequent rises in real wages and inflation are smaller; new steady state D has lower inflation and real wage than C.
  - Policy implication: incomes policy accompanying fiscal adjustment (reducing wage indexation) can reduce inflation more for a given fiscal adjustment.
- Reduction in government consumption:
  - Analogous effects to transfer reduction; private consumption increases in the new steady state if b unchanged.
  - Inflation zero only if target real wage compatible with government consumption (TTTT and ww intersect on horizontal axis).
- Variable output (inflation affects productivity):
  - Disinflationary program can achieve both lower inflation and higher output.
  - Lowering wage indexation leads to lower steady state inflation and higher output; initial step reduction in inflation followed by productivity increases.
  - In this setting incomes policy has increased scope because reducing inflation enhances productivity, allowing private consumption to rise for given government consumption.
- General result: an incomes policy lowering indexation reduces necessary inflation and the real budget deficit by lowering steady state real wage and hence reduces reliance on seigniorage.

### Real wages and capital depreciation: an example
- Context: excessive wage claims can induce managers to forego capital maintenance → capital decumulation → lower output, consumption, and real wages.
- Constructed example assumptions:
  - Capital depreciation allowances are tax deductible.
  - State-owned enterprises must pay a minimum "profit tax" p_t (y_t - v_t^ec1) to be allowed to choose wage policy, where w_t^ec1 is competitive real wage from equation (10).
  - This tax policy equivalently imposes a 100 percent tax (subsidy) on wage payments above (below) the competitive level.
  - Government expenditure modified so real government consumption corresponds to the competitive share of capital in output (implies structural budget deficit).
- Implications:
  - Gross capital accumulation equals revenues minus wage and tax payments; insufficient revenues to finance depreciation shrink capital stock.
  - Government transfers proportional to wages; seigniorage revenue finances transfers to workers.
  - Private consumption equals the real wage (equation (28)); steady state inflation derived in the text.
  - Parameter b represents structural budget deficit and money creation; a is the inverse of constant velocity of money.

1. Unsustainable wage awards
- If workers set real wage each period at a level higher than competitive (as in (30)), no steady state exists; output and consumption decline continuously.
  - Steady state requires private consumption = competitive labor share since government consumption = competitive capital share; excessive real wage makes total consumption exceed net output → capital must shrink.
- Dynamics:
  - Substituting real wage (30) into resource constraint (25) yields capital dynamic (equation (32)).
  - Consumption shrinks over time with capital at a rate higher when difference between actual and competitive wage (proportional to a - β) is larger.
  - Inflation is positive and rising over time (equation (34)).
- Example: if government makes no transfers to workers (b = 0), money supply is constant but inflation remains positive because output is shrinking; benefits proportional to nominal wage simply raise inflation.

### Wage dynamics, incomes policy and the path of capital and inflation
- Desired real wage cj_t depends on gross output x_t = A k_t^a; nominal wage responds to the gap between actual and desired real wage with time-varying parameter <£_t inversely proportional to the real wage.
- Differences from earlier wage-setting:
  - Desired real wage is endogenous (depends on output).
  - The unindexed part of nominal wage grows at same rate as money growth, so inflation cannot systematically lower the real wage in steady state.
- System components: dynamic wage equation (35); money creation (27); binding C-A constraint (7); instantaneous budget constraint (8); dynamic resource constraint (25); money market equilibrium.
- Inflation and consumption dynamics:
  - Inflation is above constant money growth as long as real consumption is falling (equation (37)).
  - Real private consumption dynamics coincide with real wage dynamics (consumption = real wage by (28)).
  - Rate of growth of real private consumption given by (39).
- Steady state (section a):
  - Steady state gross output, consumption, and inflation given by solving rates of change = 0 (equation (40)).
  - Steady state levels of consumption and output are inversely related to the target real wage.
  - In steady state actual real wage must be lower than target; this requires output below its optimal level.
  - Incomes policy can affect steady state only if it affects the target real wage or responsiveness 7 of wages to output.
  - Lowering target real wage raises capital and output; lowering indexation parameter does not affect steady state but affects convergence.
- Dynamics and local stability (section b):
  - Capital accumulation (25), consumption dynamics (39), and inflation (37) determine paths; rewritten as equations (41) and (42).
  - Two main cases:
    - Case 1: initial real wage too high and target real wage higher than competitive one ("structural" disequilibrium).
    - Case 2: initial real wage too high but target real wage equals competitive one (initial disequilibrium only).
  - Case 1: economy converges to equilibrium with output lower than initial.
    - Subcases: monotonic decline to new steady state (1a) or cyclical behavior where consumption falls faster than output and cycles may be damped or explosive (1b).
  - Case 2: output must recover eventually to initial level; possible convergent or cyclical paths (2a or 2b).
  - Stability conditions (Appendix II): equilibrium stable if <f> is large and 7 sufficiently large; model unstable if 7 = 0.
  - High indexation parameter makes instability more likely.
- Policy implications for incomes policy (section c):
  - Initial disequilibrium:
    - Structural disequilibrium (Case 1): reducing indexation will not prevent output fall; raising 7 (making real wages more responsive to output) reduces output decline.
    - Non-structural disequilibrium (Case 2): reducing indexation speeds transition, damps cycles, and reduces overall fall in private consumption despite an initial sharper consumption drop and a temporary rise in inflation.
  - Initial equilibrium:
    - If government reduces budget deficit by lowering transfers and nominal wage trend reflects lower money creation, inflation falls to new steady state without effect on real wages or consumption.
    - Incomes policy targeting indexation has no effect in this case.
  - Limitation: incomes policy that only reduces indexation cannot systematically lower inflation when there is a structural fiscal deficit because positive money growth persists (equation (36)).

### Policy conclusions and overall findings
- Corporate governance problems in state enterprises can yield excessive wage claims and/or capital decumulation as workers and managers appropriate enterprise assets; excessive wage claims reduce profits and profit tax revenue, generating fiscal problems.
- The framework links excessive wage claims to government budget shortfalls (via profit tax) and to capital decumulation if firms forego maintenance to meet wage/tax payments.
- Severity of fiscal and recessionary problems depends on:
  - size of excessive wage claims;
  - workers' ability to obtain desired real wage;
  - sensitivity of wage claims to macroeconomic conditions.
- If initial wage claims are "too high", capital stock may fall and economy can settle in a low-output steady state.
- Incomes policy that reduces indexation can speed convergence to low-inflation equilibrium and, in some cases, affect the equilibrium nature:
  - If inflation systematically affects real wages (Section III), lowering indexation can lower steady state inflation.
  - If steady state real wages are not affected by inflation (Section IV), lowering indexation affects only the transition path, not the steady state.
- Appropriate design:
  - Reduction in wage indexation is appropriate if real wage claims are temporarily high; limited help if claims are systematically excessive.
  - Making real wages more responsive to output conditions can help contain output decline.
  - Incomes policy can reduce inflation via link between wage claims and government fiscal position (profit tax revenue and money creation).
  - Where the government budget is in structural deficit, reducing inflation requires fiscal tightening; incomes policy can complement by enabling firms to finance capital accumulation.

### Conclusions regarding usefulness, limitations, and extensions
- Incomes policy usefulness depends on existence of excessive wage claims; effectiveness declines over time and induced distortions grow.
- Incomes policy is a temporary support to stabilization; urgent complementary tasks:
  - Solving proprietary structure of state-owned enterprises.
  - Implementing tax reforms.
- Model shortcomings:
  - Focus on state enterprises and constant employment; ignores reallocation to private sector and unemployment.
  - Labor is only purchased input; implications differ where labor costs are a small fraction of total costs.
  - No explicit intertemporal consumption decisions; agents only "save" to satisfy C-A constraint.
- Interaction with exchange rate and monetary policy:
  - Fiscal revenues heavily dependent on profit tax; no developed bond market; monetary policy endogenous.
  - Credibility of restrictive monetary stance to support exchange rate is doubtful if excessive wage claims exist.
  - Excessive wages could cause rapid loss of foreign exchange reserves and a balance of payments crisis.
  - With corporate governance problems, advisable to accompany a fixed exchange rate anchor with wage controls.
  - Longer-term requirements: tax reform and solution of corporate governance problem.

### Appendix insights (selected)
- Impact of inflation on output:
  - Inflation negatively impacts overall productivity; steady state output determined as function of steady state inflation.
  - If y' (impact of inflation on output) is small, a higher target real wage implies higher equilibrium inflation and lower private consumption.
- Local stability of the steady state:
  - Linearization of differential system yields conditions for smooth convergence: eigenvalues real and negative.
  - Condition for dampened cycles: </>/€ > 2 (1 - a).
- Government budget (closer look):
  - Generalized budget with profit tax 0_p and payroll tax #_w shows channels by which wage dynamics affect fiscal deficit.
  - If profit tax below unity, firms control fraction of output; fraction ft of untaxed profits may be distributed to workers while residual finances capital maintenance.
  - Risk: workers appropriating untaxed profits to detriment of capital maintenance can produce inflation plus capital decumulation outcomes.
  - Consequence: wage controls ineffective if they fail to control share of profits accruing to workers; accurate policy design necessary.

*Source: wpiea1992074-print-pdf*

### 1.  The competitive economy                                 8

### 1.  The competitive economy                                 8

### Introduction: purpose and context
- Different forms of wage controls have been introduced in most of Eastern Europe's stabilization plans (Poland, Czechoslovakia, Yugoslavia, Bulgaria) and are regarded as important for Russia and other republics of the former USSR.
- Heterodox stabilization programs (Israel, Mexico, Argentina, Brazil in the mid-eighties) combined incomes policies with a nominal exchange rate anchor to reduce inflation while minimizing output costs; incomes policy aimed to lower inflation expectations and overcome "coordination failures" in wage and price setting.
- Incomes policy is less effective and less credible if not accompanied by consistent monetary and fiscal policies aimed at reducing inflation, or if a similar plan has been unsuccessfully tried before.
- For formerly centrally planned (FCP) economies, the main rationale for wage controls differs: they address a "corporate governance problem" in state enterprises where workers and managers may appropriate firm assets and reduce investment.
- Distortions from wage controls must be weighed against the severity of the corporate governance problem; price controls are largely excluded from policy discussion because they hamper relative price adjustment and signal lack of commitment to reform.

### Channels linking wage claims, fiscal position, and macro outcomes
- Lane (1991a) highlights three links between income distribution in state enterprises and macro performance:
  - (1) Redistribution of firm revenues toward wages reduces government revenue from the profit tax, implying larger recourse to money creation and therefore more inflation.
  - (2) Higher wages feed into higher prices if firms follow automatic mark-up rules after price liberalization.
  - (3) Higher wages may reduce investment: uncertainty about property rights and firm survival can lead to lack of maintenance and capital run-down; structural adjustment increases need for capital upgrading.
- Empirical stylized facts noted:
  - In the former Soviet Union, output and productivity declined considerably in 1991, but real wages rose well above their 1990 level.
  - The average real wage—"consumption fund per worker in industry"—was very volatile in 1991: by November it was almost 50 percent above the January level according to some estimates.
  - In Poland in 1991, nominal wage dynamics: the real wage in one measure rose by 12 percent while output fell considerably (Estrin et. al. (1992) cited).

### Model overview and key assumptions
- Objective: formalize points (1) and (3) above in a one-sector economy with constant employment to analyze consequences of "excessive" wage claims for inflation, output, and the fiscal position; and study the role of wage controls in stabilization.
- Main assumptions and structure:
  - Employment is constant; labor force normalized to unity so wage bill equals wage rate and k = capital per worker.
  - Government fiscal revenues come primarily from profit tax and payroll tax; in the basic formulation the government raises revenue out of the profit tax only and "all profits are 'taxed away'".
  - Depreciation allowances are considered costs and are not taxed.
  - Government spending comprises government consumption (c_t§) and transfers (benefits) proportional to wages.
  - No bond market exists; any shortfall in revenues is covered by printing money (money creation finances budget deficit).
  - Private agents face a cash-in-advance (C-A) constraint where nominal money demand M_t^s is proportional to real private consumption c_t via parameter a (velocity): private agents need money to settle a given fraction of transactions; money is the only asset available to private agents because capital is state-owned.
  - Output produced with a Cobb-Douglas technology using capital and labor; inflation π_t may have a negative impact on total factor productivity to capture disruptive effects of inflation.
  - Consumers hold money balances only to satisfy the binding C-A constraint; they do not save (constraint always binding).
- Notation conventions used in the model:
  - Capital letters indicate nominal variables; lower case real variables unless otherwise stated.
  - A dot over a variable indicates its time derivative.
  - Key variables listed in the text include: y_t (real output net of capital depreciation), P_t (price of a unit of output), W_t (nominal wage), l_t (labor force), T_t (nominal taxes), G_t (nominal government spending), C_tS (c_t§) nominal (real) government consumption, B_t nominal government transfers, M_t^s nominal money supply, k_t capital, π_t inflation rate.

### Fiscal links and budget implications
- The budget deficit formulation highlights two channels linking nominal wages to the government budget:
  - Higher wages reduce government profit-tax revenue (P_t y_t − W_t).
  - Higher wages increase transfers for social benefits to private individuals (b W_t).
  - The second effect could be more than offset by a payroll tax at a rate higher than b; Appendix III (not summarized here) discusses the case of profit tax rate less than unity and introduces a payroll tax 0_W by replacing b with (b−0_W).
- Policy insight: for a given tax structure (treated as given in the short run), the distribution of firms' income between wages and profits matters for government revenue; money creation as residual financing implies that lower revenues can generate higher money creation and inflation, undermining stabilization credibility.
- Tax reform (e.g., applying same tax rate on wages and profits) would eliminate the direct link between internal distribution and the budget but is likely a medium- to longer-term measure.

### Role and design considerations for incomes (wage) policy
- Incomes policy in heterodox programs served to lower inflation expectations and ameliorate coordination failures; in FCP economies wage ceilings may be essential to limit appropriation of enterprise assets and to limit wage payments until proprietary structure issues are resolved.
- Wage controls can supplement traditional stabilization roles where wages closely link to price inflation and the fiscal deficit.
- The paper does not focus on optimal design, enforcement, or distortions introduced by wage controls; these aspects are acknowledged as important and discussed in related literature (Lane (1991a), Lane (1991b)).

### Paper organization (as stated)
- Section II: presents the basic model (fiscal variant of Lin and Osband (1992) with differences noted).
- Section III: defines equilibrium in a competitive economy; compares with outcomes when real wages are pushed above the competitive level; derives implications for inflation rate and output level.
- Section IV: examines implications of wage policy for output, inflation, and capital stock when capital depreciation is explicitly taken into account; considers impact of different forms of incomes policy.
- Section V: conclusions.
- Appendices cover: 1) The Impact of Inflation on Output; 2) Local Stability of the Steady State; 3) A Closer Look at the Government Budget.

*International Monetary Fund. Not for Redistribution*

### 1.   The competitive economy

### 1.   The competitive economy

### Competitive market equilibrium and real wage
- Let w^ = W^/P^ be the real wage.  In a competitive market economy the equilibrium real wage would adjust to be equal to the marginal product of labor (using (4)).
- Because money is the only privately held asset, it would be demanded even in the absence of a cash-in-advance constraint, and if the latter exists it may not hold with equality.
- For simplicity the analysis abstracts from money savings other than for the purpose of satisfying the C-A constraint; a more complete treatment of seigniorage revenue is noted as available in Lane (1992).
- The assumption that workers do not hold inflation-proof assets is noted as less realistic for countries like Poland, in which foreign currency deposits are large.
- Ideally, workers' behavior would be derived from utility maximization considering intertemporal consumption decisions; this is complicated here by the absence of a bond market and by "irrationality" of excessive wage claims.

### Fiscal balance and zero inflation case
- Assuming capital does not depreciate (6 t - 0) and using the normalization (6), the budget deficit consistent with a competitive equilibrium real wage can be expressed (see text).
- If government consumption is such that budget (11) is in balance, then government consumption is a fixed share of output (as implied by (12)).
- If (12) holds, money growth and inflation will be zero, and workers' consumption will be equal to real wages plus real benefits.

### Production side and government budget in the presence of wage claims
- Firms are assumed bound to keep employment levels constant; capital does not depreciate (5 t = 0); production is described by y t =* A k t a.
- The government's budget constraint combines (3) and (4); equation (14) highlights endogeneity of monetary policy with respect to the real wage:
  - For a given production tax, revenue will be lower and money creation higher the higher is the real wage.
  - This implies higher inflation; a higher opportunity cost of holding money; and lower output, assuming output depends negatively on inflation.

### Cash-in-advance constraint and effective price of consumption
- Workers are assumed not to hold "excess" money balances, so the C-A constraint is always binding.
- Differentiating the C-A constraint with respect to time expresses change in money holdings as a function of inflation rate and change in real consumption (text reference).
- Substituting (15) into private agents' budget constraint (8) yields (16), which shows a positive rate of inflation increases the "effective price" of consumption because individuals must hold money balances that lose purchasing power when inflation is positive.
- The resource constraint requires (text reference). If public consumption is a constant fraction of output then private consumption will be a constant fraction of output, independently of the real wage level (text note).

### Summary implication
- Attempts by workers to raise the real wage above the market-clearing level can be self-defeating: higher real wage claims lead to higher inflation which reduces real purchasing power and, when productivity is inversely related to inflation (as assumed in (5)), lowers steady state output and private consumption.

---

### 2.   Inflation and real wages when the labor share is too large

### Setup: wage claims above competitive level
- Abandoning the assumption that real wage equals marginal product, assume workers claim a larger share of output than in a competitive market.
- Two cases studied:
  - (a) real wage is a fixed fraction of output, above its competitive level;
  - (b) nominal wages are partially indexed, reacting to the gap between actual and desired real wage.
- Production side and dynamic budget constraints are described before wage behavior; firms keep employment constant and capital does not depreciate (5 t = 0); production function y t =* A k t a.
- Equation (14) again shows monetary policy endogeneity: higher real wage → lower revenue → higher money creation → higher inflation.

### Effect of inflation on consumption and resources
- Since the C-A constraint binds, inflation raises the effective price of consumption (equation (16)), eroding purchasing power via the required money balances.
- Resource constraint example: if public consumption is constant fraction of output, private consumption is residual and determined independently of real wage level (see (17)).

### a. Fixed Real Wage
- Suppose real wage is fixed at a given level (text reference).
- The corresponding rate of inflation is constant and determined by setting (16) = 0 and using (18).
- If public consumption is as in (12), then (text reference) yields (example).
- Key conclusion: inflation will be higher the larger the difference between the actual wage share and the competitive one.
  - Intuition: if workers demand a real wage too high relative to the residual share of output available to private consumption, inflation reconciles inconsistent income claims by reducing the real wage (unless fully indexed) and "taxing" money balances needed to purchase goods.
  - Inflation increases the "effective price" of consumption goods so workers can purchase only the residual output share.
  - Inflation will be lower the greater the demand for money generated by the C-A constraint (the higher is a).
  - If productivity is negatively related to inflation (as in (5)), steady state output and private consumption are lower the higher the inflation rate.

### b. Partially Indexed Real Wage
- Alternative: workers cannot fix real wage; nominal wage dynamics depend on:
  - (1) inflation through an indexation parameter; and
  - (2) the gap between actual and desired real wage.
- Wage equation given in text where o> is the exogenously given desired real wage.
- Assume output level is independent of inflation and real government consumption is constant.
- With constant real output and public consumption, private consumption is constant. From (16) and (17) one can determine relation between real wage and inflation in every period.
- In steady state real wage and inflation are constant. From wage equation (20) derive locus of points in (π, w) space where real wage is constant (equation 21).
- Figure la (text reference) depicts loci TTTT (equation 21) and ww (equation 22); the economy lies on locus TTTT. For a given inflation rate:
  - If real wage is above (below) level in (22), it will be falling (rising) because of nominal wage dynamics (20).
  - Intersection of the two lines determines steady state levels, given by expressions in text.
- Special cases:
  - If wages do not respond to the gap between actual and target real wage (φ -- 0), steady state inflation is zero and real wage is (y - c8)/(1 + b); if initial real wage too high, inflation erodes it toward price stability.
  - If φ > 0, steady state inflation π^ is positive if workers' real disposable income at desired wage, (1 + b) a), exceeds output available for private consumption, y - c£.
  - Steady state real wage w ss is higher the higher the target real wage, but this implies a higher inflation tax on money balances rather than higher consumption.
  - Unless wages are fully indexed (e - 1), w SS is always below w. With full indexation the steady state inflation rate does not depend on φ; it is higher the larger the gap between target real wage w (plus benefits bw) and resources available for private consumption, y - c&.

### Fiscal deficit under partial indexation
- Using (14) and (22a) one can calculate steady state real fiscal deficit equal to the rate at which real money balances are created.
- The real fiscal deficit is larger the larger the indexation parameter and the larger the target real wage; it is zero only if the latter ensures equality between workers' disposable income and resources available for private consumption.
- If public consumption is a fixed fraction of output as in (12), so that the budget is in balance when real wage is at its competitive level, expressions in (22a) simplify to (text reference).
- When desired real wage equals its competitive level, (1 - a) y, steady state inflation is zero and actual and desired real wage coincide.

### Comparative statics and dynamics
- A higher target real wage w shifts the ww locus right, implying higher inflation and higher real wage.
- A higher indexation parameter and more rapid nominal wage adjustment (larger φ) make the ww locus steeper, implying higher real wage and higher inflation.
- The model characterizes the impact of a wage push and of a stabilization plan from an initial steady state.

### c. Wage Push
- Under a wage push, inflation will rise more the higher the indexation parameter, the larger the wage push, and the more reactive nominal wages are to gaps between actual and target real wage.
- Mechanism:
  - Initial wage push raises real wage.
  - Inflation must rise to increase effective price of consumption and reconcile demands.
  - Real wage stops short of target unless indexation is full; the stopping level is higher the larger the indexation parameter.
  - Therefore inflation must be higher the larger is e to reduce purchasing power via a higher inflation tax on money balances.

*Source: wpiea1992074-print-pdf - 1.   The competitive economy*

### 3.   Stabilization and the Role of Incomes Policy

### 3.   Stabilization and the Role of Incomes Policy

### Reduction in transfers
- A reduction in wage benefits shifts the TTTT locus to the right and makes it flatter (locus TT' *•').
- For a given initial real wage w_ss there is a decline in money creation and therefore an immediate fall in inflation; the economy moves from point A to point B.
- The immediate fall in inflation causes the real wage to start rising because the current wage is below the target real wage and the lower level of inflation fails to keep the real wage "in check". Inflation then rises as the economy moves along the TT' locus until a new steady state at point C with:
  - steady state real wage w_ss' higher than v_ss
  - steady state inflation π_SS' lower than π_SS
- If the reduction in transfers is accompanied by an incomes policy (reduction in the wage indexation parameter), the ww line becomes flatter (w1 w'). Effects:
  - Inflation falls on impact by the same amount (A to B).
  - Real wages and inflation subsequently rise by less, until point D.
  - Explanation: initial fall in inflation raises real wages; with lower indexation the required subsequent rise in inflation to keep real wages "in check" is smaller, so equilibrium inflation and real wage at D are lower than at C.
  - A lower real wage does not imply lower private consumption: lower inflation reduces the tax on money balances and workers' purchasing power is unaffected in this model.
- Policy implication: an incomes policy accompanying a stabilization plan (reducing wage indexation) can reduce inflation more for a given fiscal adjustment.

### Reduction in government consumption
- The TTTT locus shifts to the right analogously to a reduction in wage benefits.
- Inflation falls on impact and workers gain additional purchasing power (same real transfers; inflation tax falls). Private consumption increases to its new level.
- Real wage and inflation will then rise until the new steady state; in equilibrium real wage and inflation are at the same levels as in the transfer-reduction case, but real transfers are higher (b has not been reduced), implying higher consumption.
- The consequences of reducing the indexation parameter on real wage and inflation are the same as in the transfer-reduction case.
- Additional points:
  - Inflation will be zero only if the target real wage is compatible with the level of government consumption (TTTT and ww intersect on the horizontal axis).
  - Example: if government consumption is determined as in (12), inflation will be zero if the target wage equals the competitive wage, regardless of the indexation parameter.
  - A high speed of adjustment of the real wage to its target is beneficial if the target real wage is correct, but inflationary otherwise.
- General result: starting from an inflationary equilibrium, an incomes policy (reducing wage indexation) can by itself create conditions for reducing inflation without explicit fiscal measures to reduce money creation because:
  - Inflation affects the real wage; the real wage affects the fiscal position and money creation.
  - Lower indexation → nominal wages rise less rapidly → lower necessary inflation to achieve sustainable real wage.
  - Lower indexation lowers steady state real wage and reduces the real budget deficit (reducing reliance on the inflation tax).
  - Thus an incomes policy based on lowering indexation (or real wages) allows the government to raise more revenue via profit tax and reduce seigniorage reliance.
- This result assumes inflation can systematically affect real wages even in steady state.

### Variable Output
- If output depends on the inflation rate, dynamics are more complex because private consumption is no longer constant; characteristics and steady state sketched in Appendix I.
- In general, a disinflationary program can achieve both lower inflation and higher output.
- Example: lowering the coefficient of wage indexation implies from (22) a new steady state with lower inflation and higher output.
  - Impact effect: step reduction in inflation.
  - Subsequently, real wages decline along with inflation until reaching new steady state.
  - Productivity path mirrors inflation (by assumption): initial step increase followed by further increases until new steady state.
- For a given government consumption level, setting the target real wage lower can imply higher private consumption if inflation negatively affects overall productivity.
  - Rationale: real wage is not the appropriate measure of purchasing power because money holdings are required to buy consumption goods; higher inflation raises the effective price of consumption goods and lowers productivity.
  - A higher real wage can therefore be associated with lower real private consumption due to higher money creation and inflation raising effective consumption prices and lowering productivity.
- In this setting the scope for incomes policy is increased because reducing inflation enhances productivity, allowing private consumption to rise for a given government consumption level.
- Even here, an incomes policy alone can reduce money growth and inflation because it directly improves the government's fiscal position.

### IV. Real Wages and Capital Depreciation: an Example
- Context: even with profit taxes, "excessive" wage claims can induce managers to forego capital maintenance → capital decumulation → lower output, consumption, and real wages.
  - Foregoing capital maintenance may reflect stakeholders appropriating firm assets amid privatization expectations.
  - Alternatively, post-reform required new investment and reorganizing production may raise depreciation temporarily, so pre-reform wage and tax claims compatible with capital maintenance may need curtailment after liberalization.
- Constructed example assumptions:
  - Capital depreciation allowances are tax deductible.
  - State-owned enterprises must pay a minimum "profit tax" p_t (y_t - v_t^ec1) to be allowed to choose wage policy, where w_t^ec1 is the competitive real wage determined in equation (10).
  - This tax policy is equivalent to a 100 percent tax (subsidy) levied on wage payments above (below) the "competitive" level, since y_t - v_t^ec1 = (y_t - v_t) + (w_t - w_t^ec1).
  - Government expenditure equation modified: real government consumption corresponds to the competitive share of capital in output (assumption simplifies model and implies structural budget deficit; alternative assumptions do not alter qualitative results).
- Implications and constraints:
  - The economy's resource constraint (9) can be expressed as in the text (see equation references).
  - Gross capital accumulation equals revenues minus wage and tax payments; if insufficient to finance depreciation, capital stock shrinks.
  - Government transfers to private agents are proportional to wages.
  - Budget deficit determined using (23), (24), and (26) (given by equation (27)); seigniorage revenue finances transfers to workers.
  - Private consumption equals the real wage (equation (28)).
  - Substituting (28) into (16) yields the steady state inflation rate given by the expression in the text.
  - Parameter b represents the structural budget deficit and money creation; a is the inverse of constant velocity of money.
- Wage determination assumption: initial real wage higher than competitive level (as in (30)).
  - Initial conditions: money M_Q and capital k_Q given; private consumption determined since consumption = real wage given by (30); price level set by C-A constraint (7).

### 1. Unsustainable wage awards
- If workers set real wage each period at a level higher than competitive (as in (30)), regardless of excess wage tax, no steady state exists; output and consumption decline continuously.
  - Reason: steady state requires private consumption = competitive labor share since government consumption = competitive capital share; but with real wage too high, private and public consumption exceed net output → capital stock must shrink.
  - Model lacks adjustment mechanism to modify claims as output shrinks → shares demanded exceed net output every period → capital driven to zero.
- Mathematical dynamics (referenced equations in text):
  - Substituting real wage (30) into resource constraint (25) and using real wage = real consumption (28) yields dynamic equation for capital (equation (32)).
  - Consumption dynamics deduced by differentiating c_t = (1 - j8) A k_t^a and using (32); consumption shrinks over time along with capital and net output at a rate higher when the difference between actual and competitive wage (proportional to a - β) is larger.
  - Inflation dynamics from (16), (28), and (31): inflation is positive and rising over time (equation (34)).
- Example: if government makes no transfers to workers (b = 0), money supply is constant but inflation remains positive because output is shrinking (see equation (32)). Benefits proportional to the nominal wage rate simply raise inflation.

*Source: wpiea1992074-print-pdf - 3.   Stabilization and the Role of Incomes Policy*

### 2.   Wage Dynamics, Incomes Policy and

### 2.   Wage Dynamics, Incomes Policy and the Path of Capital and Inflation

### Wage-setting, nominal wage dynamics, and model structure
- The desired real wage is denoted cj_t and depends on gross output x_t (equal to A k_t^a), so that when output is above (below) its initial level the target real wage is adjusted upwards (downwards) from its initial target level w.
- The nominal wage responds to the gap between the actual and desired real wage; the time-varying parameter <£_t' represents the speed of adjustment of nominal wages to that gap and is assumed to be inversely proportional to the real wage (adjustment is faster the lower the real wage).
- Equation (35) implies nominal wage partial indexation and a trend given by the steady state level of inflation, b/a.
- Differences from the previous wage-setting equation (20):
  - (i) the desired real wage is not fixed but depends on the current economic situation;
  - (ii) the unindexed part of the nominal wage grows at the same rate as money growth, so inflation cannot systematically lower the real wage in a steady state.
- The system components (given initial MQ, k_g, and VQ) include:
  - dynamic wage equation (35);
  - money creation equation (27);
  - binding C-A constraint (7);
  - instantaneous budget constraint for individuals (8);
  - dynamic resource constraint (25);
  - money market equilibrium condition.
- Combining (27), (7), and equality (28) between real wages and consumption yields an expression for the rate of growth of money supply (equation numbering preserved in the source).

### Inflation dynamics and consumption
- Inflation dynamics derive from the workers' budget constraint (expressed as in (16)) and equality (28) between real wages and consumption.
- Equation (37) shows:
  - Inflation will be above the constant money growth rate as long as real consumption is falling.
  - Rationale: individuals hold real money balances equal to a constant fraction of private consumption; when consumption falls they reduce money holdings and prices rise faster than money growth.
- Real private consumption dynamics coincide with real wage dynamics (since real wage and consumption are always equal by (28)).
- Substituting the nominal wage dynamic (35) into (38) and using (37) and equality between consumption and the real wage yields an expression for the rate of growth of real private consumption (preserved as equation (39) in the source).

### Steady state (section a)
- Steady state values of gross output, consumption, and inflation are obtained by setting the rates of change of private consumption and capital in (25) and (39) equal to zero (solutions displayed as (40) in the source).
- Key steady state result:
  - Steady state levels of consumption and output are inversely related to the target real wage.
- Intuition:
  - In steady state the real wage cannot equal its target level because that would imply real income claims incompatible with a constant capital stock (see (35)).
  - The actual real wage must be lower than the target; this requires output below its optimal level so that the low output exerts downward pressure to offset upward pressure from the wage gap.
- For a given difference between the target real wage w and the competitive real wage (1 - a) XQ, the gap between actual output and optimal output is larger the smaller is 7 (sensitivity of wage dynamics to output conditions).
- Policy insight:
  - Incomes policy can affect the steady state only if it affects the target real wage or the responsiveness of wages to output (7).
  - Lowering the target real wage moves the real wage closer to the competitive real wage and raises capital and output.
  - An incomes policy that lowers the indexation parameter does not affect the steady state (because in steady state actual and trend inflation coincide), though indexation affects convergence and potential stability.

### Dynamics of the system (section b) and local stability
- The dynamic system studied: capital accumulation equation (25), consumption dynamics equation (39), and inflation dynamics equation (37); focus is on gross output x_t for simplicity.
- Rewriting (39) using (40) yields a consumption dynamic (preserved as equation (41)).
- The capital dynamic in terms of gross output becomes (42), whose RHS rate of change of output depends negatively on its level.
- Local stability examined via first-order Taylor expansion of RHS of (42) around steady state x^5 and c".
- Two main cases considered:
  - Case 1: initial real wage too high and target real wage higher than the competitive one, i.e., co - WQ > (1 - a) XQ ("structural" disequilibrium).
  - Case 2: initial real wage too high, but target real wage equals the competitive one, i.e., w - (1 - a) XQ and w - (1 - a) XQ (initial disequilibrium only).
- Behavioral differences:
  - Case 1: economy converges to equilibrium with output lower than initial.
  - Case 2: final output equals initial output.
- Case 1 dynamics (two subcases):
  - (1a) Output and private consumption fall monotonically to a new steady state at point B (Figure 2a).
  - (1b) Private consumption falls faster than output; output recovers first, consumption lags, leading to possible cyclical behavior (Figure 2b). Cycles may be damped or explosive depending on parameters.
- Stability conditions (Appendix II): equilibrium will be stable if <f> is large and 7 sufficiently large. Model is unstable if 7 = 0 (real wage cannot equal target with constant capital).
- A high indexation parameter makes instability more likely because when output is low inflation is high (money growth constant); if real wage is not significantly affected by inflation, only low output drags real wages down, requiring larger output falls before recovery.
- Lower indexation parameter:
  - Does not necessarily imply quicker convergence overall—speed of convergence is faster initially but slower thereafter.

### Case 2 dynamics (illustrative Figure 3) and cyclical possibilities
- Initial dynamics mirror Case 1: too-high initial real wage drives excessive private consumption, capital and output decline, inflation rises, wages moderate and consumption falls.
- Because steady state output equals initial output, output must recover eventually; consumption falls faster than output, then capital and output recover while inflation falls below steady state.
- Two possibilities:
  - (2a) Capital, private consumption and inflation rise to steady state at point B (Figure 3).
  - (2b) Cyclical behavior: after recovery consumption may still be too low, driver of continued rises, eventually leading to renewed declines—cycles could be convergent or divergent depending on parameters.
- Stability conditions similar to Case 1. When stable:
  - Case 1: consumption and output fall monotonically to sub-optimal steady state.
  - Case 2: consumption (and the real wage) must undershoot long-run equilibrium to reverse initial capital decumulation.

### Implications for incomes policy (section c)
- Two contexts considered: initial disequilibrium and initial inflationary equilibrium.

(i) Initial Disequilibrium
- Structural disequilibrium (Case 1):
  - Reducing indexation will not prevent output from falling.
  - Decline in output can be reduced by raising 7 (making real wages more responsive to output): higher 7 implies smaller gap between actual and initial output is needed to prevent real wage from rising for a given excessive target real wage.
- Non-structural disequilibrium (Case 2):
  - Reducing the indexation parameter speeds the path towards steady state by ensuring real wage and real consumption react more rapidly to gaps between actual and optimal output, and actual and desired real wage.
  - Lower indexation:
    - Consumption falls faster initially (equation (41)), so output falls less before recovery; cycles are dampened.
    - Overall fall in private consumption is lower when indexation is lower because output falls less.
    - Initially causes higher inflation (consumption falls faster, people reduce money holdings), but inflation is less persistent and helps bring real wages back to equilibrium-compatible levels.
- General implications:
  - Making real wages more responsive to macro conditions (raising 7) can improve transition performance and steady state.
  - But this alone cannot restore output to initial level unless the target real wage is market-clearing (competitive) — output needs to be lower to contain real wage pressures if target remains excessive.
  - If initial disequilibrium is temporary, reducing indexation speeds transition and limits cycles.
  - If real wage demands are systematically excessive, reducing indexation will not prevent output decline; moreover, high indexation can cause instability, so reducing indexation may be essential to reach steady state.

(ii) Initial Equilibrium Situation
- If government reduces budget deficit by lowering transfers to workers and nominal wage trend reflects lower money creation:
  - Rate of inflation falls to new steady state without effect on real wages or consumption—the lower incidence of the inflation tax fully compensates workers for lower transfers.
  - An incomes policy targeting indexation has no effect.
  - Note: although aggregate private consumption may be unaffected, there may be redistributive consequences if benefits accrue to non-workers.

- Limitation: An incomes policy that only reduces the indexation parameter cannot systematically lower the rate of inflation when there is a structural fiscal deficit (equation (27)) because a positive rate of money growth persists (equation (36)). This contrasts with the model in Section III where money growth is not exogenous and steady state inflation can depend on indexation.

### Policy conclusions and overall findings (section V)
- Corporate governance problems in state enterprises can yield excessive wage claims and/or capital decumulation as workers and managers appropriate enterprise assets; excessive wage claims reduce profits and profit tax revenue, generating fiscal problems.
- The paper provides a framework starting from "excessive" wage claims and outlines consequences for the government budget (via profit tax shortfalls) and for capital decumulation if firms forego maintenance to meet wage/tax payments.
- Intensity of fiscal and recessionary problems depends on:
  - size of excessive wage claims;
  - workers' ability to obtain desired real wage;
  - sensitivity of wage claims to macroeconomic conditions.
- If initial wage claims are "too high", capital stock may fall and economy can settle in a low-output steady state.
- Incomes policy that reduces indexation can speed convergence to low-inflation equilibrium and, in some cases, affect the equilibrium nature:
  - If inflation can systematically affect real wages (as in Section III), lowering indexation can lower steady state inflation.
  - If steady state real wages are not affected by inflation (this section), lowering indexation affects only the transition path, not the steady state.
- A reduction in wage indexation is appropriate if real wage claims are temporarily high; of limited help if claims are systematically excessive. Higher indexation may imply instability.
- Making the real wage more responsive to output conditions can help contain output decline triggered by excessive wage and tax claims.
- Incomes policy can reduce inflation via the link between wage claims and the government fiscal position (and money creation) through the impact of wages on profit tax revenue.
- If the government budget is in structural deficit, reducing inflation requires fiscal tightening; nonetheless, appropriately designed incomes policy can strengthen output by enabling firms to finance capital accumulation.

*Source: IMF Working Paper section 2, "Wage Dynamics, Incomes Policy and the Path of Capital and Inflation."*

### conclusions  regarding incomes policy need, to be qualified by  emphasizing

### conclusions  regarding incomes policy need, to be qualified by  emphasizing

### Incomes Policy: Usefulness and Limitations
- Conclusions about the need for incomes policy are obtained by "simply modifying exogenous wage behavior in line with the incomes policy restriction."
- The usefulness of wage controls in the model depends on the existence of excessive wage claims.
- Experience suggests:
  - The effectiveness of wage controls declines over time.
  - Induced distortions (for example in labor allocation) increase over time.
- Implication: an incomes policy can provide only a temporary support to a stabilization program in a formerly centrally planned economy.
- Urgent complementary tasks:
  - Solving the problem of the proprietary structure of state-owned enterprises.
  - Implementing tax reforms.

### Model Shortcomings and Useful Extensions
- Model limitations noted:
  - Focuses only on state enterprises and assumes constant employment; it ignores:
    - Reallocation of human and capital resources to the private sector.
    - The role of unemployment. 1/
  - Labor is assumed to be the only purchased input in the production process; implications:
    - For firms where labor costs are a small fraction of total costs, the problems outlined become less relevant.
  - No explicit intertemporal issues in consumption decisions; workers "save" only to satisfy the cash-in-advance constraint.
- Despite shortcomings, the model yields insights on:
  - Impact of wage behavior and incomes policy on output and inflation.
  - Interaction between incomes policy and exchange rate policy.
- Footnote: 1/ In this context, a reduction in the capital stock in the state enterprise sector because of re-allocation of resources to the private sector would indeed be desirable.

### Interaction with Exchange Rate and Monetary Policy
- Stylized features of an FCP economy in the model:
  - Fiscal revenues heavily dependent on the profit tax.
  - No developed bond market.
  - Monetary policy becomes endogenous — directly affected by wage developments.
- Implications:
  - Feasibility and credibility of a restrictive monetary stance to support the exchange rate is doubtful if there is potential for excessive wage claims.
  - Direct impact of wages on the budget could imply a rapid loss in foreign exchange reserves and a balance of payments crisis if wages are set too high.
  - With a corporate governance problem generating excessive wage claims, it may be advisable to accompany a fixed exchange rate anchor, or a crawling peg, with wage controls.
- Longer-term requirements for effective fiscal and monetary policy:
  - Implementation of tax reforms.
  - Solution of the corporate governance problem.

### The Impact of Inflation on Output
- Assumption: inflation has a negative impact on overall productivity and public consumption is a constant fraction a of output.
- Consequences:
  - Changes in private consumption can be expressed as derived in the model.
  - Dynamic equation relating real wages and inflation is obtained from equation (20) in Section III.2.
  - The locus of points in (TT, w) space along which inflation is constant (obtained by setting (A3) equal to zero) is highly non-linear.
  - Intersection of the (A3)=0 locus with the (A4)=0 locus determines the steady state level of inflation and real wages.
  - The steady state level of output is determined as a function of steady state inflation.
  - Example outcome: if y' does not depend on inflation and the impact of inflation on output is relatively small, a higher target real wage implies:
    - A higher equilibrium rate of inflation.
    - A lower level of private consumption.
- Notation preserved:
  - y' t is the derivative of output with respect to inflation.
  - Equations referenced: (A3), (A4), (20), and consumption budget relations as specified.

### Local Stability of the Steady State
- Coefficients matrix referenced for the linear system of differential equations (42) and (44).
- Solutions for consumption and output deviations from steady state take the form in (A14), where A, B, C and D are constant parameters.
- Smooth convergence to steady state requires both eigenvalues to be real and negative.
- Necessary and sufficient conditions for convergence are as given in the appendix (equations cited).
- Eigenvalues derived from solutions to det(A - λI) = 0 and explicitly given in the text.
- If instead the solutions have a negative real part and a complex part, cyclical behavior results; condition for dampened cycles:
  - </>/€ > 2 (1 - a)

### A Closer Look at the Government Budget
- Text initially made restrictive assumptions: budget deficit always equal to government benefits (a constant fraction of the wage bill), implying the path of the real deficit coincides with the path of real wages (and hence private consumption).
- Generalized specification maintained revenue sources as the profit and payroll taxes, and government expenditure as the sum of government consumption and social benefits:
  - where 0 p and # w are the tax rates on profits and wages respectively.
- Budget deficit expression highlights channels by which wage dynamics affect the fiscal deficit:
  - If the profit tax is higher than the payroll tax, higher wages imply lower after-tax profits for a given level of enterprise gross revenue, hence lower tax receipts.
  - If social benefits are automatically linked to wages, higher wages imply higher government outlays for social benefits.
- Integration issue: what happens to untaxed profits when the profit tax is below unity.

### Profit Tax, Untaxed Profits, and Capital Maintenance
- When profit tax is below unity, firms control a fraction of output. 1/
- One specification: a fraction ft of untaxed profits is distributed to workers; enterprises finance capital maintenance with residual untaxed profits.
- Workers' disposable income in that case is given by the formula in the appendix.
- Risk: if workers appropriate untaxed profits to the detriment of capital maintenance and upgrading, outcome could be inflation plus capital decumulation similar to previous sections. 2/
- Consequence for incomes policy:
  - Wage controls would be ineffective if they fail to control the share of profits accruing to workers.
  - Necessity of accurate design of incomes policy measures.
- Footnotes preserved:
  - 1/ When the profit tax was set equal to unity instead, once the wage policy was given it was not necessary to specify firms' behavior, since net capital accumulation was determined by the residual of gross output once taxes and wages had been taken out.
  - 2/ If workers get a share of gross profits and capital depreciation is not deductible one should replace net output y t with gross output x t in equations (A13) and (A14).

*Source: wpiea1992074-print-pdf - conclusions  regarding incomes policy need, to be qualified by  emphasizing*

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_Source: https://www.imf.org/-/media/files/publications/wp/wpiea1992074-print-pdf.pdf_