Shifting the burden of taxation from labour taxes to indirect taxes

1. Shifting the burden of taxation from labour taxes to indirect taxes Werner Roeger Jan in �t Veld European Commission, DG ECFIN

2. Reform taxation policy Direct taxes create distortions Labour taxes distort labour demand and labour supply decisions High unemployment in EU linked to high labour taxation ? Switch to indirect taxes less distortionary?

3. Shift tax burden towards indirecttaxation: the political dimension Lisbon strategy (reduction tax burden low-wage earners) Verhofstadt�s �European pentathlon� Proposal to shift tax burden in EU to indirect taxation (target 40 -> 50% % of total taxation) �Social� VAT (FR)

4. Shift tax burden from labour taxes to indirect taxes Consumption tax can be regarded as a more general income tax (paid by working population and non-working population) Less distortionary regarding labour demand and supply decisions

5. Shift tax burden from direct to indirect taxation Reforms might imply long term gains, but if adjustment takes time, reforms may have short term losses Reforms affect distribution of income (progressivity of personal income tax systems) Does the reform have losers? (do they get compensated ?)

6. Total tax burden (as % of GDP)

7. Share of indirect taxes in total taxation

8. Indirect taxes /Total taxation

9. Indirect taxes /Total taxation

10. Tax reform simulated with QUEST model: Shift the burden of taxation from labour tax to VAT such that share of indirect taxation in total taxation is 40% in each of the member states Reform is budgetary neutral (ex ante): Government expenditure constant Increase VAT = Reduction Wage tax

11. European Commission�s QUEST model : Derived from dynamic optimisation of utility and profits by economic agents, s.t. intertemporal budget constraints Long run: neo-classical growth model, but imperfect competition: mark-ups involuntary unemployment Short run dynamics: Keynesian features, but with theoretical foundations adjustment costs overlapping contracts

12. Country Coverage Structural models : Each of the EU member states US Japan Trade feedback models: 11 other countries/regional blocks

13. Consumption rule based on intertemporal utility maximisation households Two types of households: - PIH/Life-Cycle consumers, whose consumption pattern is based on life-cycle income (H) and financial wealth (F)- Liquidity-constrained households (�rule-of- thumb�) who base their consumption decision on disposable income (Ydis)? share of liquidity-constrained consumption

14. Investment: Neo-classical model of investmentInvestment rule derived from profit optimisation problem s.t. adjustment costs

15. Labour market Wage-setting: Bargaining framework (Pissarides) If there is a successful job match, workers and firms both benefit relative to the alternative state of : being unemployed and only receiving �reservation wage� (workers) having an unfilled vacancy (firms)

16. => Wage costs depend on three factors: - the reservation wage Bt (unemployment benefits, leisure ) - labour productivity Yt / Lt  - labour market tightness (probability unemployed, vacancy costs)  � bargaining strength workers

17. � bargaining strength workers: - � =0 competitive labour market, no bargaining strength of workers- � =1 insider-outsider model, complete bargaining strength workers Staggered wage contracts: Nominal rigidities

18. Scenario 1: B not indexed to PC

19. Scenario 1: B not indexed to PC

20. Distributional effects: after-tax wage income: (1-tl)*W/PC and real benefits: Ben/PC

21. Scenario 2: compensate losers (1)Benefit recipients

22. Scenario 3: compensate losers (2)Benefit and Transfer recipients

23. Sensitivity testing: share of liquidity-constrained consumers

24. Sensitivity testing: share of liquidity-constrained consumers and slower employment dynamics

25. Sensitivity testing: share of liquidity-constrained consumers

26. Higher share of liquidity-constrained consumers and stronger lagged employment demand

27. Scenario 2: B indexed to W/P and PC Scenario 2.2: B constant, indexed to PC

28. Scenario 4: alternative wage setting model Neoclassical model: Maximisation over consumption and leisure => Wage equation:

29. Scenario 4: alternative wage setting model

30. GDP

31. Employment

32. Conclusions: Tax shift to VAT yields positive employment and output effects (more general income tax) Size of effects depends on wages and incomes policies Shifting taxation away from wage earners towards other tax payers ? unemployment benefits, social transfers (pensions), profit and interest income

33. Conclusions (2): This specific reform raises share indirect taxes to 40% Spillovers : positive demand effect But : appreciation euro, and interest rate effect depends on monetary policy assumption Are larger VAT differentials sustainable? (cross-border shopping) Alternative reform: set a similar high VAT rate in all EU countries (difference in tax shares reflected in differences in direct tax rates)

34. Further extensions Test robustness of results to alternative assumptions Compensation to profit and interest income earners Evaluate effects of tax shift in estimated DSGE model with neoclassical labour supply