This paper tests whether the impact of labour taxes on unemployment is symmetric with
respect to increases and decreases in labour taxes. Using a panel of 16 OECD countries over
the period 1970-2005, we estimate a panel unobserved component model to account for the
fact that unemployment rates and labour taxes are non-stationary but not cointegrated. We find a positive impact of tax increases in European and Nordic countries with some evidence that tax decreases have a more moderate impact. For Anglo-Saxon countries, no impact of labour taxes on unemployment is found

Berger, Tino

Everaert, Gerdie

English

Ghent University Academic Bibliography

           FACULTEIT ECONOMIE EN BEDRIJFSKUNDE   TWEEKERKENSTRAAT 2 B-9000 GENT Tel. : 32 -  (0)9 – 264.34.61 Fax. : 32 -  (0)9 – 264.35.92    WORKING PAPER    Is the Impact of Labour Taxes on Unemployment asymmetric?  Tino Berger Gerdie Everaert    July 2008  2008/523        D/2008/7012/32 Is the Impact of Labour Taxes on UnemploymentAsymmetric? ∗Tino Berger† Gerdie Everaert‡July 2, 2008AbstractThis paper tests whether the impact of labour taxes on unemployment is symmetric withrespect to increases and decreases in labour taxes. Using a panel of 16 OECD countries overthe period 1970-2005, we estimate a panel unobserved component model to account for thefact that unemployment rates and labour taxes are non-stationary but not cointegrated. Wefind a positive impact of tax increases in European and Nordic countries but no effect ofdecreasing labour taxes on the rate of unemployment. For Anglo-Saxon countries, no impactof labour taxes on unemployment is found.JEL Classification: C15, C33, E24Keywords: unemployment, labour taxes, asymmetry, unobserved component model1 IntroductionIt is a widespread belief, especially among policymakers, that the increase in labour taxes overthe last decades is one of the prime factors responsible for the increase in unemployment. Conse-quently, the alleviation of the high tax burden on labour has been declared to be one of the primeinstruments to fight high unemployment. This strategy relies on the assumption that the allegedimpact of labour taxes on unemployment is more or less symmetric, i.e. cutting taxes will reduceunemployment as much as its increase induced unemployment to go up. The contribution of thispaper is to test whether the impact of labour taxes on unemployment is symmetric. To the bestof our knowledge, this has not been tested empirically.2 Asymmetries in the labour taxes unemployment trade-offFrom a theoretical point of view there are two reasons for an asymmetric trade-off between labourtaxes and unemployment. First, the insider-outsider distinction (see e.g. Blanchard and Summers,1986; Lindbeck and Snower, 1987) may give rise to an asymmetric response. Briefly, it states that∗We would like to thank Siem Jan Koopman, Freddy Heylen, Lorenzo Pozzi, and Tara Sinclair for useful com-ments and suggestions. We also acknowledge financial support from the Interuniversity Attraction Poles Program- Belgian Science Policy, contract no. P5/21. The usual disclaimer applies†SHERPPA, Ghent University, Tino.Berger@UGent.be, www.sherppa.be‡SHERPPA, Ghent University, Gerdie.Everaert@UGent.be, www.sherppa.be1insiders (those currently employed) are insulated from competition of outsiders (those currentlyunemployed) due to labour turnover costs (i.e. costs associated with hiring, training and firing).As a result, insiders have scope to push wages above the market-clearing level. i.e. they mayuse their privileged position to shift the tax burden to the employer (resulting in higher unem-ployment) in response to an increase in taxes and try to push for higher net wages (instead oflower unemployment) in response to a decrease in taxes. It is often argued that insider-outsidereffects are less strong when unions are centralised (as they are in e.g. the Nordic countries) asthe negative wage externalities will be internalised in a centralised wage setting system. Higherwages in one sector of the economy causes unemployment to rise and consequently imply a fallin output and the taxable base and higher costs for unemployment benefits. These costs how-ever will be paid for mainly by others (Calmfors and Driffill, 1988). Moreover, membership rulesin centralised wage settings are more favourable to the unemployed who typically remain unionmembers. Thus they receive more attention in the wage bargaining process implying that insidershave less incentives to push wages above the market-clearing level (see e.g. Layard et al., 2005;Blanchard and Summers, 1986). Insider-outsider effects in wage formation may therefore be a lessappropriate explanation for potential asymmetries in the labour taxes unemployment trade-off incountries with a centralised wage bargaining system.The second reason for asymmetry are asymmetric labour adjustment costs. Different costs forhiring and firing imply a different speed of adjustment for employment and hence unemploymentin response to a labour market shock. A large literature provides considerably empirical evidencein support of asymmetries in labour demand. Using various different techniques and functionalforms Holly and Turner (2001); Pfann and Palm (1993); Burgess (1992a,b); Hamermesh and Pfann(1996) show that there are asymmetries in labour demand due to asymmetric adjustment costs.3 Data and country groupingOur dataset consists of yearly observations for 16 OECD countries over the period 1970-2005. Theunemployment rate is taken from the OECD Economic Outlook. As a measure of labour taxeswe use an update of the effective tax rates on employed labour from Martinez-Mongay (2003).1In order to take possible heterogeneity of the impact of taxes on unemployment into account,we group countries according to their wage-setting institutions. Following Daveri and Tabellini(2000), Domenech and Garcia (2007) and Berger and Everaert (2007) we classify countries in threedifferent groups. The first group (NORDIC) includes Austria, Denmark, Finland and Sweden.These countries are characterised by strong unions, wage bargaining at a central level and/or ahigh degree of co-ordination. The second group (EUCON) includes Belgium, France, Germany,Italy, the Netherlands, Portugal, Spain and Greece. The third group (ANGLO) includes Japan,Ireland, the US and the UK. In a recent study, OECD (2004), it has been shown that in some1We would like to thank Carloz Martinez-Mongay for providing this dataset. This tax rate has been calculatedwith the so-called Mendoza-Razin-Tezar approach (see Mendoza et al., 1994) using the EU AMECO database.2countries the wage setting institutions changed over time. Particularly Sweden, Denmark andIreland have experienced substantial changes to their wage setting institutions. We take thischanges into account by modifying the country grouping, i.e. Denmark and Sweden are classifiedin the EUCON group from 1985 onwards and Ireland in the NORDIC group from 1990 onwards.Although an asymmetric response to shocks of labour market indicators is well established inthe literature there is no attempt to empirically investigate asymmetries in the labour taxesunemployment trade-off. This is even more surprising if one takes the direct political relevance ofthis question into account. A hint of why this issue did not receive much attention can be seen inFigure 1 which shows the evolution of labour taxes for the 16 OECD countries considered here.Labour taxes steadily increased in most OECD countries until the mid 1990s. Only recently, adecrease in labour taxes can be observed in a number of countries. In Finland, for instance, labourtaxes increased steadily to reach a level of 48% in 1994. Since then they continuously decreasedto a level of 40% in 2005. In the Netherlands labour taxes increased from 32% in 1970 to 43% in1993 and then decreased to a level of 33% in 2005. The picture of increasing taxes until the mid1990s followed by steadily decreasing taxes is not as clear in all countries as it is in Finland andthe Netherlands. Nevertheless, they are far more periods with decreasing taxes after the mid 90sas they are in the 70s and 80s for most of the countries. This fact may explains why the hypothesisof asymmetries in the labour taxes unemployment trade-off has not been tested. However withthe availability of recent data, it is now possible to analyse the response of unemployment todecreasing labour taxes.3Figure 1: Effective tax rates on employed labour for 16 OECD countries (1970-2005)4 Empirical SpecificationEmpirical studies on the determinants of unemployment typically estimate a reduced form unem-ployment equation linking the rate of unemployment to various labour market institutions andmacroeconomic shocks (see e.g. Nickell et al., 2005, for a recent example). One major concernis that observed unemployment rates are found to exhibit unit root behaviour in most OECDcountries over the past four decades. Thus, unless there is a cointegrating relation between unem-ployment and its alleged determinants, standard estimation methods yield spurious results. Usinga panel of yearly data for 16 OECD countries ranging from 1960 to 1995, Berger and Everaert(2006) show that unemployment is not cointegrated with a large set of labour market institutionsand macroeconomic shocks. The finding of no panel cointegration does not imply that there is norelation between unemployment and labour market institutions, though. Economic theory relatesthe equilibrium rate of unemployment to a large variety of factors, some of them being difficult tomeasure or even unobservable, e.g. the reservation wage which is a function of, among others, the4value of leisure. By inducing a unit root component in the residuals, both missing non-stationaryvariables and measurement error in non-stationary variables turn an otherwise cointegrating re-lation into a spurious regression (see Everaert, 2007, for a simulation experiment). To solve thismissing variables problem, Planas et al. (2007) and Berger and Everaert (2007) set up an un-observed component model in which the sum of all missing variables is treated as a latent statevariable and identified through the Kalman filter. Here, we follow Berger and Everaert but extendtheir model to allow for an asymmetry impact of labour taxes on unemployment.Let the total unemployment rate, uit, be the sum of an equilibrium component, u∗it, which isa function of structural factors driving long-run unemployment, and a temporary component, ucit,which we label cyclical unemployment,uit = u∗it + ucit, i = 1, . . . , N, t = 1, . . . , T, (1)where N is the number of countries and T is the number of time series observations. In order toallow cyclical unemployment to exhibit the standard hump-shaped pattern, ucit is assumed to bean AR(2) processucit+1 = φ1ucit + φ2ucit−1 + ηcit, ηcit ∼ NID(0, σ2ηci ). (2)The equilibrium rate u∗it is assumed to be given byu∗it = u∗it−1 + εit, (3)such that εit reflects all factors that induce a permanent shift in the equilibrium rate of unemploy-ment. In order to estimate the impact of labour taxes on u∗it we disentangle εit into the impact oflabour taxes, εtit, and the impact of all other factors, εzit, i.e. εit = εtit + εzit whereεtit = β1∆TAXit + β2Dit∆TAXit, (4)εzit = δεzit−1 + ηzit, ηzit ∼ NID(0, σ2ηzi ), (5)with Dit = 1 if ∆TAXit < 0 and zero otherwise. Thus shocks to the equilibrium rate of un-employment are disentangled into changes in labour taxes which are observed, and all remainingshocks that we treat as unobserved. The impact of labour taxes on uit is measured by β1 and β2.Accounting for a potential asymmetric impact, β1 measures the impact of increasing labour taxeswhereas β2 measures the differential impact of decreasing labour taxes on unemployment. Thusβ1 + β2 measures the effect of decreasing labour taxes on unemployment. If there are asymmetriceffects, one would expect that β1 > β1 + β2. As a pure random walk process for equilibriumunemployment would result in a non-smooth series that is hard to reconcile with the expectedsmooth evolution of the structural characteristics driving equilibrium unemployment, the AR(1)specification in equation (5) allows for a smooth evolution of εzit over time, i.e. the closer δ to onethe smoother εzit.55 Results and DiscussionAfter casting the model given by equation (1)-(5) into state-space form the likelihood can becalculated by a routine application of the Kalman filter and maximised with respect to the unknownparameters using an iterative numerical procedure (see e.g. Harvey, 1989; Durbin and Koopman,2001). 2The estimated parameters are presented in Table 1. For the group ANGLO we do not finda significant impact of labour taxes on unemployment neither for an increase nor for a decreasein taxes. In contrast, there is a significant positive impact of increases in labour taxes on unem-ployment in both the EUCON and the NORDIC group, with the impact being more moderatein the latter. These results confirm earlier studies in the literature which typically do not dis-tinguish between increasing and decreasing taxes. However the majority of previous estimatescovers a period in which labour taxes were persistently increasing. By using more recent data andthus covering the recent decrease in taxes we find that there is clear evidence of asymmetry inthe EUCON and the NORDIC group, i.e. the point estimate of the impact of tax decreases asmeasured by β1 + β2 is considerably lower and not statistically significant different from zero asthe t−test indicates. Although this finding may not be very surprising as insider-outsider effectsand asymmetric adjustment costs can explain this asymmetry, it calls into question the strategyof reducing labour taxes to fight high unemployment.The estimates of δ1 indicate that equilibrium unemployment is smoother than a simple randomwalk. Further, φ1 and φ2 imply that cyclical unemployment exhibit the standard hump-shapedpattern in all country groups. Two LM tests show that we cannot reject the null of no autocorre-lation in any of the three country groups (see bottom Table 1).Table 1: Parameter estimatesANGLO EUCON NORDICβ1 0.01 (0.07) 0.16 (0.04) 0.07 (0.03)β2 -0.23 (0.15) -0.15 (0.08) -0.07 (0.07)φ1 0.87 (0.24) 1.48 (0.06) 1.28 (0.21)φ2 -0.39 (0.25) -0.76 (0.06) -0.71 (0.15)δ1 0.62 (0.16) 0.54 (0.07) 0.54 (0.18)tβ1+β2=0 -0.95 [0.34] 0.02 [0.98] -0.04 [0.97]LMAR 0.10 [0.75] 0.07 [0.79] 0.08 [0.78]LMMA 0.31 [0.62] 0.27 [0.61] 0.28 [0.61]Standard errors are in parentheses. LMAR and LMMA are LM testsfor an AR respectively MA structure in the residuals, tβ1+β2=0 is at-test of no impact to decreasing taxes, i.e. H0 : β1+β2 = 0. P -valuesare in brackets.2The stationary state variables are initialised by drawing from their stationary distributions while a diffuseinitialisation is used for the non-stationary state variables u∗it. Standard errors for the estimates are calculatedby inverting the Hessian matrix. This standard method of inference has recently been shown to be valid even inmodels with integrated series such as the one used here (see Chang et al., ming).6ReferencesBerger, T. and Everaert, G. (2006). Unemployment in the oecd since the 1960s. do we reallyknow? Working Papers of Faculty of Economics and Business Administration, Ghent University,Belgium 06/425, Ghent University, Faculty of Economics and Business Administration.Berger, T. and Everaert, G. (2007). Labour taxes and unemployment evidence from a panelunobserved component model. Working Papers of Faculty of Economics and Business Ad-ministration, Ghent University, Belgium 07/478, Ghent University, Faculty of Economics andBusiness Administration.Blanchard, O. and Summers, L. (1986). Hysteresis and the european unemployment problem.NBER Macroeconomics Annual, 1:15–77.Burgess, S. M. (1992a). Asymmetric employment cycles in britain: Evidence and an explanation.Economic Journal, 102(411):279–90.Burgess, S. M. (1992b). Nonlinear dynamics in a structural model of employment. Journal ofApplied Econometrics, 7(S):S101–18.Calmfors, L. and Driffill, J. (1988). Bargaining structure, corporatism and macroeconomic per-formance. Economic Policy, 3:13–61.Chang, Y., Miller, J., and Park, Y. (forthcoming). Extracting a common stochastic trend: Theorywith some applications. Journal of Econometrics.Daveri, F. and Tabellini, G. (2000). Unemployment, growth and taxation in industrial countries.Economic Policy, 15(30):47–104.Domenech, R. and Garcia, J. R. (2007). 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Is the impact of labour taxes on unemployment asymmetric?

This paper tests whether the impact of labour taxes on unemployment is symmetric with respect to increases and decreases in labour taxes. Using a panel of 16 OECD countries over the period 1970-2005, we estimate a panel unobserved component model to account for the fact that unemployment rates and labour taxes are non-stationary but not cointegrated. We find a positive impact of tax increases in European and Nordic countries with some evidence that tax decreases have a more moderate impact. For Anglo-Saxon countries, no impact of labour taxes on unemployment is found

Is the impact of labour taxes on unemployment asymmetric?

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