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Der Open-Access-Publikationsserver der ZBW – Leibniz-Informationszentrum Wirtschaft

The Open Access Publication Server of the ZBW – Leibniz Information Centre for Economics

Boeters, Stefan

Working Paper

Optimal tax progressivity in unionised

labour markets: what are the driving

forces?

ZEW Discussion Papers, No. 09-065

Provided in cooperation with:

Zentrum für Europäische Wirtschaftsforschung (ZEW)

Suggested citation: Boeters, Stefan (2009) : Optimal tax progressivity in unionised labour markets: what are the driving forces?, ZEW Discussion Papers, No. 09-065, http:// hdl.handle.net/10419/28612

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zbw Leibniz-Informationszentrum Wirtschaft Leibniz Information Centre for Economics Discussion Paper No. 09-065 Optimal Tax Progressivity

in Unionised Labour Markets:

What are the Driving Forces?

Stefan Boeters Discussion Paper No. 09-065 Optimal Tax Progressivity

in Unionised Labour Markets:

What are the Driving Forces?

Stefan Boeters

Download this ZEW Discussion Paper from our ftp server:

ftp://ftp.zew.de/pub/zew-docs/dp/dp09065.pdf Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.

Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW.

Non-technical summary In the economic policy debate, income tax progressivity is mostly seen as a means of redistribution. The more progressive the tax, the more redistribution from the rich to the poor. However, high tax progressivity also means high marginal tax rates for those with a high income, which leads to labour supply distortions in this group and, as a consequence, to a lower overall potential for redistribution. Under non-competitive wage formation, there are positive aspects of tax progressivity in the efficiency dimension as well, because tax progressivity lowers the incentives for high wage claims and leads to a downward pressure on non-competitive wages. This

counteracts the labour supply distortions and creates the potential for a free lunch:

simultaneous equity and efficiency gains through higher tax progressivity. I explore the empirical potential for this constellation using a model that includes both wage bargaining and flexible labour supply, so that both sides of the trade-off are captured. It is calibrated to a set of macroeconomic and institutional parameters of large OECD countries, and the optimal degree of tax progressivity is numerically determined.

The most remarkable simulation result is that both at the level of average OECD parameters and for most of the individual countries, optimal tax progressivity is considerably lower than actual progressivity. At the country level, however, we do not get uniform picture. In a few countries optimal progressivity is higher than actual progressivity. The between-country differences can be traced back to differences in the initial conditions. The effect of the initial unemployment rate is particularly strong. The higher initial unemployment, the higher optimal tax progressivity. Another important driver is the general tax level. High taxes in the initial situation lead to a lower optimal level of tax progressivity. The initial level of tax progressivity plays a significant role as well. It affects optimal progressivity through the interaction with labour supply elasticities.

Nicht-technische Zusammenfassung In der wirtschaftspolitischen Diskussion wird die Progressivität der Einkommensteuer vor allem als ein Instrument der Umverteilung gesehen. Je höher die Progression, desto mehr Umverteilung von Reich zu Arm. Ein hoher Grad der Steuerprogression bedeutet jedoch auch eine hohe marginale Belastung für Bezieher hoher Einkommen. Dies führt zu Verzerrungen des Arbeitsangebots in dieser Gruppe, und in der Konsequenz zu einem geringeren Umverteilungsvolumen. Bei nicht-wettbewerblicher Lohnbildung kommt noch ein weiterer Effekt ins Spiel. Eine höhere Steuerprogression hat dann auch in der Effizienzdimension positive Wirkungen, da sie dämpfend auf die Lohnforderungen wirkt und zu niedrigeren Lohnabschlüssen führt. Dies wirkt den Verzerrungen des Arbeitsangebots entgegen und schafft das Potential eines gleichzeitigen Gewinns in sowohl der Effizienz- als auch der Verteilungsdimension. In diesem Papier untersuche ich mit Hilfe eines numerischen Modells, ob dieses Potential für tatsächliche Volkswirtschaften relevant ist. Das Modell beinhaltet kollektive Lohnverhandlungen und flexibles Arbeitsangebot, so dass beide abzuwägende Seiten erfasst sind. Es wird mit Hilfe makroökonomischer und institutioneller Parameter großer OECD-Volkswirtschaften kalibriert, so dass der optimale Grad der Steuerprogression numerisch bestimmt werden kann.





Das wichtigste Ergebnis der Simulationsrechnungen ist, dass sowohl im OECDDurchschnitt als auch für die meisten individuellen Länder die optimale Progression deutlich unter der tatsächlichen liegt. Auf der Länder-Ebene ist das Bild allerdings nicht einheitlich: In einigen Ländern liegt die optimale auch über der tatsächlichen Progression. Die Unterschiede zwischen den Ländern können auf Unterschiede in den Ausgangsbedingungen zurückgeführt werden. Dabei ist der Effekt der bestehenden Arbeitslosigkeit besonder stark. Je höher die Arbeitslosigkeit, desto höher die optimale Steuerprogression. Ein zweiter wichtiger Einflussfaktor ist das allgemeine Steuerniveau. Ein hohes Steuerniveau führt zu einer niedrigen optimalen Progression. Schließlich spielt auch das Ausgangsniveau der Steuerprogression eine Rolle.

Es beeinflusst die optimale Progression durch die Interaktion mit den Arbeitsangebotselastizitäten in der Kalibrierung des Modells.

Optimal Tax Progressivity in Unionised Labour Markets: What are the Driving Forces?

–  –  –

In labour markets with collective wage bargaining higher progressivity of the labour income tax creates a trade-off. On the one hand, wages are lowered and unemployment decreases, on the other hand, the individual labour supply decision is distorted at the hours-of-work margin. The optimal level of tax progressivity within this trade-off is determined using a numerical general equilibrium model with imperfect competition on the goods market, collective wage bargaining and a labour-supply module calibrated to empirically plausible elasticity values. The model is calibrated to macroeconomic and institutional parameters of both the OECD average and a number of individual OECD countries. In most cases the optimal degree of tax progressivity is below the actual level. A decomposition approach shows that the optimal level is increased by high unemployment and by the general tax level.

Keywords: labour taxation, tax progressivity, optimal taxation, collective wage bargaining, unemployment JEL Code: H21, J22, J51, J64, ∗ Stefan Boeters, CPB, P.O. Box 80510, NL-2508 GM Den Haag, e-mail: s.boeters@cpb.nl.

I thank Rob Euwals, Nicole Gürtzgen, Albert van der Horst, Bas Jacobs, Egbert Jongen, Stefanie Schubert and Peter Sørensen for helpful comments on earlier versions of this paper.

1 Introduction Income tax progressivity creates an efficiency trade-off in labour markets with collective wage bargaining. On the one hand, higher tax progressivity can reduce unemployment, which leads to a welfare gain. On the other hand, the individual labour supply decision is distorted, with an associated deadweight loss. In this paper, I calculate the optimal degree of tax progressivity that results from this trade-off, and I try to identify the driving forces for differences between OECD countries.

The focus on efficiency issues in the discussion of the income tax needs explanation. In the economic policy debate, income tax progressivity is mostly seen as a means of redistribution from the rich to the poor. Traditionally, economist have stressed that efficiency must also be considered in this context. High tax progressivity leads to labour supply distortions in the high-income group and, as a consequence, to a shrinking overall potential for redistribution. The derivation of criteria for an optimum in this situation has been one of the early highlights of optimal taxation theory (Mirrlees, 1971; Tuomala, 1990).

Since the 1980s, extensive research into wage forming mechanisms that are not fully competitive has shown that the equity-efficiency trade-off is not clear-cut. There are positive aspects of tax progressivity in the efficiency dimension as well, because tax progressivity lowers the incentives for high wage claims and leads to a downward pressure on non-competitive wages. This counteracts the labour supply distortions and creates the potential of a free lunch: simultaneous equity and efficiency gains through higher tax progressivity. However, this is only a theoretical potential – whether it is relevant to real-world economies remains a question for empirical research.

The trade-off within the efficiency dimension has often be addressed using an analytical approach, but there are hardly any attempts to quantify it. What is the optimal level of tax progressivity that balances the positive effect of lower unemployment through lower wages with the negative effect on labour supply? This is the question I investigate in this paper using a calibrated, numerical general equilibrium model. I adopt the model of collective wage bargaining between a trade union and an employers’ association. This mechanism is dominant in a number of European countries and has most often been chosen to demonstrate the ambiguous effects of tax progressivity theoretically (Hersoug, 1984; Lockwood and Manning, 1993; Holmlund and Kolm, 1995; Koskela and Vilmunen, 1996).

The numerical model includes both wage bargaining and flexible labour supply, so that both sides of the trade-off are captured. It is calibrated to a set of macroeconomic and institutional parameters of large OECD countries and solved for the optimal degree of tax progressivity. This approach is close in spirit to Sørensen (1999), which is, to my knowledge, the only paper in the literature that comes up with a numerically determined optimal degree of tax progressivity. However, Sørensen’s main focus is on the comparison of different mechanisms of wage determination. To provide a sharper focus, he chooses a relatively simple calibration of labour supply, and he fixes the institutional and macroeconomic parameters at stylised values of a typical Western industrialised country. This is where the present paper comes in.

The calibration of labour supply is elaborated, so that it accounts for different empirical indicators: labour supply elasticities of hours of work and participation, and with respect to wages as well as to non-wage income.



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