DP588 | A Cross-Country Analysis of the Tax-Push Hypothesis

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A microeconomic theoretical model shows that two factors - the compensation and progressivity effects - produce the shifting (if any) of tax rates on wage formation. From an analytical viewpoint, they may be positive or negative and of equal or different sign. A microfounded nested macroeconomic wage equation is then tested for nine European countries for the period 1960-88. Three robust regularities seem to emerge from our econometric results. First, in general, small open economies such as Austria, Denmark and the Netherlands have negligible compensation and progressivity effects: to maintain their external competitiveness they fix a real labour cost target independent of tax rates. Second, larger and less open European economies, in contrast, transfer indirect and social security tax rate increases on the real labour cost in the long run, except Italy and the UK; in these greater economies, a rise in the direct tax rate raises the steady-state gross real wage, both where the compensation and the progressivity effects move in opposite directions (as in France, Germany and Sweden), and a fortiori where (in Italy and the UK) the compensation effect is approximately zero, like in very open economies, but the progressivity effect is positive. Third, all European countries show a weakening of tax shifting on the real labour cost between the end of the 1970s and the beginning of the 1980s. This changing attitude on the part of unions usually runs parallel to the introduction of de facto fiscal indexation and a reduction in tax progressivity, which increasingly leads to the fixing of the steady-state wage rate so as to safeguard the country's external competitiveness.