Artikel (05/10/2007)

Unemployment benefits and the long-term effectiveness of labour tax cuts

If unemployment benefits are indexed to gross wages and the replacement rate between unemployment benefits and net wages affects the wage rate, then cutting taxes falling on the supply of labour (personal income taxes or employees' social-security contributions) increases employment more than reducing taxes falling on the demand for labour (employers' social-security contributions).

The macroeconomic effectiveness of cuts in personal income taxes, and employers' and employees' social-security contributions (SSC) generally depends on the mechanism that drives wages. Furthermore, the feedback of wages to unemployment benefits matters as well. Aggregate demand-driven models featuring exogenous real gross wages usually imply that cutting employers' SSCs generates more jobs than reducing employees' SSCs or personal income taxes. Even models featuring negotiated wages do not necessarily impose equivalence between labour taxes on supply and demand, at least not in the short run. Whether long-run equivalence among these three policy instruments holds or not, depends on the nature of the feedback of wages to unemployment benefits. This follows from experiments with LABMOD, the FPB's labour market model of the market sector, which features a wage rate that depends on labour productivity, the unemployment rate, the replacement rate between unemployment benefits and take-home wages and the fiscal wedge, and which assumes homogeneous labour categories.

If macroeconomic feedback from labour productivity, the unemployment rate, and the replacement rate are ignored, then the source of taxation (on the supply side through employees' SSCs or personal income taxes or on the demand side through employers' SSCs) does not matter for the long-run outcome: identical percentage point cuts in tax rates (relative to the wage rate) will have identical long-term effects on output and employment.

In the present version of LABMOD the share of the employers in the labour tax burden is 30%: in the long run and ignoring other effects on the wage rate, 30% of an increase (decrease) in the fiscal wedge is borne (appropriated) by the employers through a rise (fall) in the real wage rate whereas 70% is absorbed (appropriated) by the employees through a downward pressure on (an adjustment upwards of) the real take-home wage. Notwithstanding the identical impact on the real wage rate of identical percentage point cuts in labour supply and demand side taxes, the decomposition of the wage rate into the gross wage and employers' SSCs differs between labour supply and demand side taxes. Cutting the employees' SSC or personal income tax rate would decrease the gross wage, whereas reducing the employers' SSC rate would raise the gross wage.

Long-run equivalence among the three policy instruments also holds after allowing for macro-economic feedback if the average unemployment benefit is indexed to consumer prices, making the replacement rate endogenous. A 1% cut in any payroll tax rate lowers the real labour cost by 0.6% and raises employment by 1% in the long run. The differences in the decomposition of the wage rate across policies would be irrelevant because the gross wage rate would not impact on the replacement rate. Notice that a rise in the real take-home wage - resulting from a cut in labour taxes - in conjunction with consumer inflation proof unemployment benefits would mean a drop in the replacement rate. The latter would cause a further drop in the wage rate and stimulate output and employment even more than in the case of an exogenous replacement rate.

In contrast, long-run equivalence would collapse if the average unemployment benefit were indexed to the gross wage: labour supply tax cuts would create more jobs than labour demand tax cuts (plus 1.3% versus plus 0.8%), reflecting a bigger fall in the real labour cost (minus 0.9% versus minus 0.5%). On the one hand, cutting the employees' SSC or personal income tax rate would trigger a chain of downward pressures on the gross wage, hence on the average unemployment benefit, hence - for an initial rise in the take-home wage - on the replacement rate and finally on the wage rate itself. On the other hand, cutting the employers' SSC rate would put upward pressure on the gross wage, weakening the initial fall in the replacement rate and the wage rate.

It is not clear which hypothesis about the replacement rate best matches Belgian institutions. At the level of the individual, unemployment benefits are either a percentage of the gross wage last earned prior to unemployment, or a fixed stipend for those without prior employment history, but they are also capped, limited in time and consumer inflation proof. The hypothesis of gross wage indexed unemployment benefits might suit low-wage earners well, whereas the hypothesis of consumer inflation proof unemployment benefits may fit high-wage earners better.

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