DP1681 | Unemployment, Growth and Taxation in Industrial Countries

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To the layperson, the upward trend in European unemployment is related to the slowdown in economic growth. We argue that the layperson?s view is correct. The increase in European unemployment and the slowdown in economic growth are related because they stem from a common cause: an excessively high cost of labour. In Europe, labour costs have gone up for many reasons, but one is particularly easy to identify: higher taxes on labour. If wages are set by strong and centralized trade unions, an increase in labour taxes is shifted onto higher real wages. This has two effects. First, it reduces labour demand, and thus creates unemployment. Second, as firms substitute capital for labour, the marginal product of capital falls; over long periods of time, this in turn diminishes the incentive to accumulate and thus to grow. Thus high unemployment is associated with low growth rates. The model also predicts that the effect of labour taxation differs sharply in countries with different labour market institutions. We test these predictions on data for 14 industrial countries between 1965 and 1991, and find striking support for them. In particular, labour taxes have a strong positive effect on unemployment only in Europe and not in other industrial countries. The observed rise of about 9 percentage points in labour tax rates can account for a reduction of the EU growth rate of about 0.4 percentage points a year, about one-third of the observed reduction in growth between 1965?75 and 1976?91, and a rise in unemployment of about 4 percentage points.