Our study investigates how Germany’s Hartz IV labor market reform (implemented in 2005) reduced workers’ bargaining power and contributed to the decline of the labor share (the ratio of labor compensation to economic output). The research combines theoretical modeling with rigorous empirical analysis to demonstrate that reductions in the “outside option” (unemployment benefits) significantly decreased workers’ negotiation leverage, leading to a measurable drop in the labor share.
In this paper we investigate the relevance of bargaining institutions in the decline in labor share. Several explanations for the decline exist, which consider the relevance of technology, globalization and markups. Surprisingly neglected so far, however, is the influence of bargaining institutions, in particular with a focus on changes in the outside option. Find out more in our latest SFB 823 discussion paper No. 12/2021.
Abstract:
We provide evidence of this issue, using the Hartz IV labor market reform in Germany as an exogenous shock in the wage bargaining of employees, and investigate its impact on the labor share. We begin by developing a theoretical model in which we outline the effect of a decrease in the outside option within a wage bargaining framework. Thereafter, the approach is twofold. Combining the EU KLEMS and Penn World Table databases, we first endogenously identify the Hartz IV reform as a significant structural break in the German labor share. Second, we estimate the effect of the Hartz IV legislation on the aggregated labor share using a synthetic control approach in which we construct a counterfactual Germany doppelganger. Finally, we use rich firm-level panel data compiled by Bureau van Dijk to support our results on the aggregated labor share. We find that the reform decreases the labor share by 1.6 – 2.7 percentage points depending on method and aggregation level. The synthetic control approach furthermore provides evidence that this effect is persistent over time since the reform.
Key Findings
Theoretical foundation The authors develop a bargaining model showing that a reduction in the outside option (wa) lowers negotiated wages (w), increases labor demand, and boosts profits. Crucially, the derivative ∂ls/∂wa > 0 confirms that a lower outside option directly reduces the labor share (ls = w/p).
Empirical evidence
- Structural break identification:
- Endogenous Wald tests and Bai-Perron tests confirm a significant structural break in Germany’s labor share in 2005 (coinciding with Hartz IV implementation).
- The labor share declined persistently after the reform, with no similar breaks in comparable economies.
- Magnitude of impact:
- OLS estimates show a 2.7 percentage point reduction in the labor share attributable to Hartz IV.
- Synthetic control method (constructing a counterfactual Germany) confirms a 1.6–2.7 percentage point decline.
- Firm-level data analysis supports these findings, showing consistent negative effects across specifications.
- Mechanism: Hartz IV reduced unemployment benefits by merging long-term assistance programs and shortening benefit duration (Figure 1). This weakened workers’ threat point during wage negotiations, particularly affecting vulnerable groups like long-tenured workers and low-skilled employees.
Broader Implications
- Labor market institutions matter significantly for income distribution, complementing explanations centered on technology or globalization.
- Policy design: Reforms affecting unemployment benefits can have lasting distributional consequences beyond employment effects.
- Methodological contribution: The paper demonstrates how structural break tests and synthetic controls can identify causal impacts of policy reforms on macroeconomic aggregates.
Conclusion
The Hartz IV reform provides a quasi-natural experiment proving that reductions in workers’ outside options decrease the labor share. This highlights bargaining power as a key determinant of income distribution, with Germany’s experience offering insights for other economies facing labor share declines.
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