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How a wage subsidy can alleviate South Africa's youth unemployment

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How a wage subsidy can alleviate South Africa's youth unemployment

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18th September 2015

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Over the past 20 years, South Africa’s unemployment has doubled. Youth unemployment in particular has skyrocketed. The hardest hit are school leavers.

There are multiple reasons behind the broad rise in unemployment. One likely explanation for the high unemployment rate in individuals in their 20s has to do with the quality of post-apartheid secondary education.

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In a well-functioning labour market, schooling provides important information with which employers can sort potential workers. In South Africa, it’s not just that the quality of schooling is poor, but there is also tremendous variance in this quality across schools.

Simply holding a matric, the qualifying year of high school, does not convey sufficient information to employers. Uncertain worker quality by itself need not be a huge problem if firms can hire and keep workers are good while dismissing those that are not. In South Africa, though, regulations to protect worker job security make dismissing workers potentially difficult and costly.

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The cost of unemployment

From a macroeconomic viewpoint, unemployed workers represent potential but unrealised output. From a microeconomic viewpoint, unemployed workers leave households with fewer resources and hence more vulnerable.

Workers in their 20s typically begin to accrue the on-the-job human capital that they will use during ensuing decades. Missing this opportunity may convey costs that remain for decades.

Finally, the very high unemployment rate for young South African adults contributes to the social ills that accompany a loss of hope. These include crime, disengagement with the political process, and a lack of investment in one’s future well-being.

Pragmatic policy proposals, then, must work on those margins where change is most feasible and accept constraints that are unlikely to yield in the near term. Better schools, for example, are a fine proposal.

But reforming the education sector is not likely to happen quickly enough to really impact youth unemployment in the short-term. Similarly, a broad overhaul of labour laws is not likely to happen any time soon.

Wage subsidy may be the best solution

A policy which is doable is a targeted wage subsidy to facilitate the school-to-work transition. A critical component of the targeted wage subsidy is a probationary period during which subsidies workers may be dismissed at will.

Such a policy is already being piloted by the country’s National Treasury.

A tax on formal sector wages is the norm in many developing countries. This fiscal policy discourages employment in the formal sector and, on the margin, encourages investment in capital instead of labour.

By lowering the cost of labour employed in the formal sector, a wage subsidy increases the demand for labour in the formal sector, increases employment in the formal sector, favours labour over capital, and costs the Treasury. A targeted wage subsidy does this for only a subset of workers, thereby increasing the relative attractiveness of hiring the targeted group relative to those who are not targeted.

The data overwhelmingly suggest that there is something that is preventing young school leavers from entering the labour market, but that once employed, they tend to stay employed albeit not necessarily in the same job. This might be because firms are unwilling to incur the costs of training workers if the workers will then be hired away.

A wage subsidy, while not first best, addresses this issue. The subsidy also addresses the externalities associated with high youth unemployment such as crime, as well as the market imperfection that arises due to negotiated wages.

When dismissal is difficult, it is risky to take on a new worker if that worker’s quality is unknown before hiring. When dismissal is easy, firms can offer a job at a wage that, in expectation, is appropriate to the worker’s expected productivity and then dismiss those that are sub-par while retaining and adjusting upwards the wage of those that are acceptable. When dismissal is difficult, this sort of “experimentation” on the part of the firm is curtailed.

Dismissal costs in South Africa are also perceived to be high. There are compelling historical reasons for many of the rules governing dismissal.

How concerns can be addressed

There are several caveats associated with a targeted wage subsidy for youth. First, the free dismissal provision is subject to abuse. This concern is alleviated because it is lousy business to fire good workers, because any training costs would need to be re-incurred, and because even if this happens, the worker still picks up some potentially valuable experience.

Second, the targeted wage subsidy favours young workers so there is the possibility that firms might just substitute the subsidised workers for the existing non-subsidised workers. But the same dismissal rules that make it hard to dismiss workers alleviate this concern.

It is also possible that the subsidy might stigmatise subsidised workers, but if it is nationally implemented, this seems unlikely.

Finally, the policy might be subject to potential fraud. This is a real concern but careful programme design can minimise the problem.

Crafting the best wage subsidy

A well-crafted wage subsidy might be implemented as follows. Every South African would become eligible for the wage subsidy upon turning 18 years old. The subsidy would be for a fixed amount of money and would not expire. Each youth would be given an individual subsidy account with a given balance in it.

When the youth took a job for a registered firm, a fraction of the individual’s wage would be drawn from the individual’s account. For a youth earning the average minimum wage, the subsidy might comprise up to half of the wage.

The subsidy would be completely portable. If the individual left a job or was dismissed, the remaining subsidy balance could be used with another employer. The subsidy would not expire so as to lessen the incentive to leave school early.

Finally, employment with the subsidy would allow for a probationary period during which a “no-questions-asked” dismissal policy would be in effect. The period should be long enough for the firm to ascertain whether the worker is a good fit.

Over the longer run, it is important not to lose sight of the underlying issues around school quality and labour market regulations. In the near term, a targeted wage subsidy for recent school-leavers coupled with a probationary period allowing free dismissal is a step in the right direction.


This is an extract from The Oxford Companion to the Economics of South Africa, edited by Haroon Bhorat, Alan Hirsch, Ravi Kanbur and Mthuli Ncube, and published by Oxford University Press.

The Conversation

James Levinsohn, Director of the Jackson Institute for Global Affairs, Charles W. Goodyear Professor in Global Affairs & Professor of Economics and Management, Yale University

This article was originally published on The Conversation. Read the original article.

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