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STU 04-03 : Special Topic - Personal income tax reform and wage formation in Belgium [Short Term Update 04-03]

The latest update of the FPB’s medium-term outlook for Belgium is pointing towards GDP growth of 2.3% on average from 2004 to 2008. This development can be largely accounted for by domestic demand, whereas the role of (net) exports is expected to be more limited. After moderate growth in 2003, the evolution of private consumption should be more dynamic during the 2004-2008 period, particularly thanks to a favourable development in households’ disposable income (stimulated especially by reductions in personal income tax). The growth in gross fixed capital formation should reach an average of 2.9% during the period 2004-2008, notably reflecting the expansion in business investment. Export growth should be 5.1% on average, compared with growth of 5.6% in our potential export markets: the structural loss of export market share should be confirmed.

Inflation should be below 2% in the medium term, thanks to moderate wage increases compatible with productivity gains, cuts in social security contributions and the extension of production capacity. Employment is expected to show a gradual improvement: an average increase of 34,000 jobs should be seen during the 2004-2008 period. The unemployment rate in a broad sense should decrease from 14.2% by mid-2003 to 12.8% in 2008, a large proportion of the labour expansion being absorbed by growth in the labour force.

Given the present prospects for future economic growth, assuming no policy change but taking into account the most important measures decided within the framework of the 2004 budget, the financing capacity of public administrations should go into deficit in the medium term (0.5% of GDP in 2008). The goal of a positive financing capacity (0.3% of GDP in 2007) is not expected to be reached without additional budgetary measures. Nevertheless, the total public debt to GDP ratio should continue to fall, going down by about 17 percentage points between 2002 and 2008.

The impact of the current personal income tax reform on wages, value added and production is assessed. During the transition phase, the effects will be more modest than in the medium or long run because of both the delayed impact on wages and the gradual nature of the tax cut.

The fiscal reform

The personal income tax reform, which is to be implemented gradually in the fiscal years 2002-2005 (personal income revenue years 2001-2004), was set up as a multi- tier measure, comprising changes in various tax parameters. In addition to the personal income tax reform, the surcharge income tax (‘crisis levy’ / ‘bijkomende crisisbijdrage’ / ‘contribution complémentaire de crise’) was to be phazed out gradually during the 2000-2003 period. When fully introduced, both initiatives will amount to 1.6% of GDP in 2005. As a result, the personal income tax rate is expected to be lowered by 3.12 percentage points in 2005 and beyond, starting with a 0.53 percentage-point cut in 2001 (table 1).

In the federal government’s policy manifesto of October 2000, it was argued that the fiscal reform was intended to help contain the cost of wages and to increase the disposable income of the working population. The manifesto stated that the personal income tax cut would moderate gross wage demands in the central bargaining round that would set wages and other labour market conditions for 2001-2002. Other aspects of the fiscal reform were explicitly designed as incentives to labour supply, particularly at the lower end of the wage distribution. The upward pressure on domestic prices - in response to the rise in purchasing power and induced labour- market tensions - and the resulting adverse effects on international price competitiveness were implicitly assumed to be minor or of limited relevance in view of quantitatively similar tax cutting measures abroad. Importantly, the emphasis on the effects of cutting personal income taxes on wage bargaining - while reductions in social-security contributions (SSCs) were also put in place - reflects the federal government’s belief that the choice between a cut in payroll taxes or SSCs matters when it comes to wage formation. This belief is partially corroborated by economic theory and empirical evidence of the non-equivalence of payroll taxes and SSCs in the short run, despite the long-run equivalence of labour taxes.

Adopting a counter-factual approach, the FPB has used its new macroeconometric labour-market model of the market sector to examine what would happen if the fiscal reform were not implemented. Since the model does not distinguish different wage categories, the wage level specific aspects of the fiscal reform could not be taken into account. Crucially, according to the econometrics of the model, the tax incidence on employers and employees is an intermediary case between zero impact on wages (where employees bear the full burden due to lower take-home wages if taxes are raised) and maximum impact on wages (where employers bear the full burden due to higher wage costs if taxes are raised).

The macroeconomic effects

In the absence of the fiscal reform, the income-tax and hence the wage-wedge would be higher, implying higher equilibrium real wages, lower real take-home wages, and lower real value added and employment in the long run. Unemployment would be higher because of both the general drop in economic activity and the fall in the price of capital relative to labour. The upward pressure on real wages, initiated by the wage-wedge rise, would be strengthened by the rise in labour productivity (which is due to the rise in the capital-labour ratio) and in the replacement rate between the average real unemployment benefit (which is unaffected by assumption) and the average real take-home wage (which would fall). The decrease in labour-market tensions - resulting from the rise in unemployment - would reduce the upward pressure on real wages to some extent. Since - for a given number of unemployed - the number of vacancies that could be scrapped would exceed the fall in the number of jobs, the bottle-neck in matching supply and demand on the labour market would become less severe. The rise in the labour cost - including matching cost - would therefore be less than than the rise in wages. Due to mark-up price setting, the value-added price would follow the rise in domestic factor costs, triggering a rise in consumer prices and prices of investment goods as well.

During the transition to the new long-run equilibrium, short-run real wages would tend to rise due to the push of the higher long-run equilibrium wage rate and because of the direct impact of the higher income tax rate. Nominal wages and hence nominal take-home wages would be propped up by the rise in the price of goods. Initially the negative effects on employment and value added would be modest, but these would become increasingly significant. Aggregate demand would fall as a consequence of the value-added price rise (and the resulting loss of international price competitiveness) and the fall in households’ real disposable income. The fall in households’ real disposable income would be accounted for by the fall in market-sector employment and by the drop in real take-home wages. [More in the publication ...]

STU 4-03 was finalised on December 4th 2003.

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