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Unemployment and stability

Albert van der HorstCPB, The Hague

October 29, 2003

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Just a minute

European comparative analysis► EU enlargement (immigration)► Tax competition in the European Union ► Regional policy (geographical economics)► European labor markets ► Competition and harmonization in Europe

(a Level Playing Field)

Workshop► Stability and growth pact (January 9, 2004)

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Outline

Equilibrium unemployment► our approach► in Europe► & structural growth► versus the EC approach► & stability and growth pact

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Stable?

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Equilibrium

Equilibrium is central in economic theory► equilibrium = where we go► today = where we come from

Unemployment is a persistent phenomenon► demand = supply fails► short-run imperfections are insufficient► seems to be a stable equilibrium

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Equilibrium unemployment

L

W

Wage curve

Labor demand

Labor supply

-- u --

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Wage negotiations

Firms prefer low labor income share► opt for low wages

Workers prefer high wage income► take into account that unemployment leads to a

reduction in income

Negotiations ► => tax shifting & sharing► role of benefits (replacement rate)

uww

RRTaxyl

pw

4min

321lnln

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Wage equation

Tax RR w(min) u(-1) Stationary

France 0 0,14 0,25 -0,79 yes

Germany 0,73 0 -2,10 yes

The Netherlands 0,13 0,75 -1,07 yes

Spain 0,21 0,25 -0,68 yes

United Kingdom 0,20 0,05 -0,79 yes

United States 0 -0,40 no

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Labor demand

Firms maximize profits► Higher wages reduce profits► Reduction in employment improves profits

Substitution between labor and capital

pw

yl lnlnln

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Equilibrium unemployment

Equilibrium unemployment rate depends on:► Tax wedge► Benefits► Minimum wage rate► Interest rate

y

kpp

fww

RRTaxu

11 min

3214

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France and Germany

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The Netherlands and Spain

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United Kingdom

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Labor tax and unemployment

Higher labor tax (1% GDP)► raises equilibrium unemployment immediately► raises actual unemployment gradually

Jade simulation

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Labor tax and growth

A tax increase► reduces structural GDP immediately► reduces actual production gradually► creates positive output gap (dotted line)

Jade simulation

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Structural growth

Y* depends on► Labor supply► Labor productivity► Equilibrium unemployment

CPB EC

LS Projection HP filter

Y/L HP filter HP filter

U* ‘Equilibrium’ ‘NAIRU’

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EC Nairu

Alternative approach by the European Commission► trend estimate► depend on change in inflation rate► backward looking

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Labor tax and unemployment (2)

Higher labor tax (1% GDP)► raises actual unemployment gradually► raises equilibrium unemployment gradually, but

even before the implementation date

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Labor tax and growth (2)

A tax increase► reduces structural GDP gradually► reduces actual production gradually► slightly positive output gap initially (dotted line)

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Meet the EMU-norm

What if a country proposes the EC to improve its budget by raising its labor tax rate (by 1% GDP)

Choice 1: does the EC take negative growth effects into account?

If yes, how?1) Structural approach:

ΔEMU < 1% GDPPositive output gap: ΔEMU(structural) < ΔEMU

2) EC approachΔEMU < 1% GDPSmall output gap: ΔEMU(structural) ≈ ΔEMU

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Towards SGP

The impact of tax changes differ between countries

It is therefore suboptimal to opt for a single fiscal regime