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In this paper, we use the nime model to assess the medium-term macro-economic effects for the European Union (eu) of a one percentage point cut in the social security contribution rate, and a one percentage point increase in the labour participation rate. In the case of a cut in the social security contribution rate, we consider two variants. First, we consider the variant in which the tax cut is ex ante financed by an across the board cut in public outlays. Next, we consider the variant in which the tax cut is ex ante financed by an increase in the indirect tax rates. In the long run, such measures increase unambiguously employment and potential output, thereby raising the standard of living of the eu citizens and reinforcing the sustainability of the social protection system. However, all kinds of rigidities prevent an immediate adjustment towards the new equilibrium, so that economic activity may be less buoyant in the medium-term. This paper describes these medium-term effects.
The outline of the paper is as follows. In the second section of the paper, we present a brief overview of the nime model, including a non-technical outline of the new equation for the natural rate of unemployment. In the third section, we examine the macro-economic effects of a 1 percentage point cut in the social security contribution rate in the European Union. There we consider two ways to finance the loss of tax revenues.
In the first variant of the third section, we examine the case in which the loss of tax revenues is ex ante financed by an across the board cut in public expenditures. The simulations learn, for instance, that in the long run a 1 percentage point cut in the social security contribution rate reduces the natural rate of unemployment by about 0.4 percentage points in the euro area, thereby unambiguously raising potential output. However, in the medium-term several forces are pulling in a different direction so that the medium-term outlook is less clear-cut. The simulations show that real gdp and the gdp deflator of the euro area are almost unaffected in the first year, indicating that the different forces cancel each other out in the first year. However, the interest rate cut, the expectation of higher future income, and the fall in the producer wage facilitate adjustment, and in subsequent years, real gdp starts to increase, reaching 0.29 percent above the baseline after five years and 0.39 percent after ten years, while the gdp deflator falls from 0.17 percent below the baseline after five years to 0.25 percent after ten years. At the same time, overall employment falls below the baseline during the first three years, mainly due to the loss of employment in the public sector. Afterwards, the growth in private sector employment is strong enough to compensate for the loss of public sector employment. Due to the working of the automatic fiscal stabilisers, the public deficit to gdp ratio and the debt to gdp ratio increase by about 0.3 percentage points in the first year. However, in subsequent years when the measures start to have their full effect, and output and employment increase, revenues increase and outlays decrease, so that as of the sixth year the deficit to gdp ratio becomes smaller than in the baseline. The public debt to gdp ratio starts only to fall below the baseline as of the end of the simulation period, mainly due to the low growth in nominal gdp.
In the second variant of the third section, we consider the case in which the loss in tax revenues is ex ante financed by an increase in the indirect tax rate. As a result, the overall tax burden decreases less than in the previous variant, and the natural rate of unemployment falls only by 0.1 percentage points in the euro area, compared with 0.4 percentage points in the previous variant. The simulations learn, for instance, that total employment in the euro area increases by 0.02 percent in the first year and stays above the baseline afterwards. In the previous variant, total employment fell initially by 0.19 percent, reflecting the strong fall in public employment, and it took three years before total employment rose above the baseline. However, in this variant, total employment is only 0.12 percent above the baseline after ten years, compared with 0.40 percent in the previous variant, reflecting the smaller drop in the natural rate of unemployment. Real gdp of the euro area rises by 0.08 percent in the first year, compared with a 0.03 percent fall in the previous variant, and increases further to 0.12 percent above the baseline after 10 years, compared with 0.39 percent in the previous variant. In the previous variant, the initial fall in public demand triggered immediately a fall in gdp. However, the stronger decrease in the natural rate of unemployment, also allowed for a larger increase in gdp after ten years. Once again, the simulations illustrate the importance of the behaviour of the wages as a determinant in the adjustment process.
In the fourth section, we discuss the simulation results for the variant where the labour participation rate in the European Union is raised by 1 percentage point. This shock increases potential output and raises income. However, the additional supply of labour will not be absorbed immediately. The simulation results of the fourth section show that in the first year real gdp of the euro area increases by 0.50 percent, while the gdp deflator falls by 0.05 percent. This rise in gdp is possible because domestic demand is supported by the expectation of higher future labour income and bya fall in the interest rates, while at the same time external demand is stimulated by the depreciation of the effective exchange rate and the increase in the foreign effective demand. In subsequent years, real gdp increases further reaching 0.91 percent above the baseline after five years and 1.11 percent after ten years, while the gdp deflator falls to 0.37 percent below the baseline after ten years. Total employment increases gradually, and after five years more than half of the additional labour supply has been absorbed. The public deficit to gdp ratio increases initially, primarily because the additional outlays for the increased number of unemployed is higher than the additional revenues generated by higher economic activity. In later years, the public finances improve due to higher tax revenues, and the fall in the outlays for the unemployed and the other dependents, and the fall in interest payments.
Finally, in the appendix, we present some modifications to the nime model, including a change to the specification of the natural rate of unemployment, and the introduction of a new country block for the eu accession countries. The new specification of the natural rate of unemployment is based on the idea that the unemployment rate disciplines the reservation wage aspirations of employees.
Mathematical and Quantitative Methods > Econometric Modeling [C5]
Macroeconomics and Monetary Economics > Consumption, Saving, Production, Employment, and Investment > Employment; Unemployment; Wages [E24]