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MASTER FILES ROOM C-5E5 0440 This is a Working Paper and the author would welcome any IMF WORKING PAPER comments on the present text. Citations should refer to a Working Paper of the International Monetary Fund, men- tioning the author, and the date of issuance. The views © 1992 International Monetary Fund expressed are those of the author and do not necessarily represent those of the Fund. WP/92/11 INTERNATIONAL MONETARY FUND European Department A Cross-Country Analysis of the Tax-Push Hypothesis Prepared by Fiorella Padoa Schioppa Kostoris * Authorized for distribution by Massimo Russo February 1992 Abstract This paper presents a microeconomic theoretical model of union optimizing behavior which is then used to test the relevance of the tax-push hypothesis for wage formation in nine Western European countries. Two factors-- the compensation and the progressivity effects--are shown by the model to account for the effect (if any) of tax rates on wage formation. A wage equation tested for the period 1960-1988 shows that in general small open economies have negligible compensation and progressivity effects, while in larger economies direct, indirect and social security tax rates are transferred onto the real labor cost. All countries show a weakening of the tax shifting starting at the end of the 1970s or the beginning of the 1980s. JEL Classification Numbers: E24, E62, J51, P52 * The author is Full Professor in Economics at the University of Rome "La Sapienza". This paper was prepared while she was a visiting scholar in the European Department of the International Monetary Fund. The author is very grateful to three brilliant research assistants, Leonardo Felli, Chiara Rossi and Elena Schioppa. She also wishes to thank the country desk economists of the European Department at the IMF and the participants at various seminars where a previous version of this paper was presented for their useful comments. All remaining errors are hers. ©International Monetary Fund. Not for Redistribution - 11 - Contents Page I. Introduction 1 II. A Testable Model of the Average Direct Tax Rate for Nine European Countries 5 III. A Microeconomic Model of Tax Shifting on Optimum Wage Setting 21 1. The compensation effect (of S, T, and flat A) 27 2. The progressivity effect (of a progressive A) 28 3. The effects of a change in A when the average and the marginal direct tax rates vary together 28 IV. A Testable Model of the Wage Setting for Nine European Countries 30 V. The Tax-Push Hypothesis Revisited for Nine European Countries 37 Text Tables 1. Personal Income Taxes in Europe: An Institutional Perspective in 1988 10 2a. Estimates of the Average Direct Tax Rate Equation in Nine European Countries, 1960-88 15 2b. Estimates of the Average Direct Tax Rate Equation in Nine European Countries, 1960-88 17 3a. Estimates of the Wage Equation in Nine European Countries, 1960-88 34 3b. Estimates of the Wage Equation in Nine European Countries, 1960-88 35 4. Long-Run Estimated Semi-Elasticities of the Wage Rate to the Direct Tax Rate in Some Large European Countries 39 Charts 1. Temporal Dynamics of the Average Direct Tax Rate, of the Nominal and Real Wage Rate 8a 2. Estimate of the Wage Equation: Observed and Fitted Values 38a Appendix I. Variables, Definitions and Data Sources 40 References 42 ©International Monetary Fund. Not for Redistribution I. Introduction The main purpose of this paper is to test for nine (Western) European countries the relevance of the tax-push hypothesis for wage formation. To this end, we adopt a microeconomic theoretical model of union optimizing behavior (which generalizes the analysis of Padoa Schioppa, 1990) to derive a macroeconomic, testable model of union wage setting. According to our microeconomic model (see Chapter III), the union optimally chooses the nominal wage so as to maximize an objective function which depends positively on the net real wage and on employment (and on various parameters, the most important of which is the net real reservation wage), under the constraint of the firm's perceived labor demand. Of course, optimality implies that the trade-off between the nominal wage and employment along the firm's labor demand must be the same as the one along the union indifference curve. The latter is a function both of the weight the union assigns to employment relative to the net real wage, and of the progressivity of direct taxation. The relevant progressivity index turns out to be the ratio between the marginal minus the average direct tax rate (the numerator) and 1 minus the average direct tax rate (the denominator); it ranges between 0 and 1. Let us first discuss the importance of the weight assigned by the union to employment relative to the net real wage (i.e., the nominal wage, deflated by the consumer price, net of the average direct tax rate). If given the union's objective function this weight is fixed and independent of fiscal policy, the real labor cost (i.e., the nominal wage, deflated by the product price at factor cost, augmented by social security contributions paid by employers) is necessarily unaffected by the tax wedge (the latter is approx- imated by the sum of the social security, the indirect and the direct tax rates). In this event, assuming that all tax rates are flat--an assumption which will be relaxed later--workers bear the consequences of any increase in the social security tax rate paid by employers, through a decrease in nominal wages. They also lose as consumers as a result of a cut in purchas- ing power when, the nominal wage being unchanged, the direct tax rate rises and therefore the net wage decreases or when the indirect tax rate rises and therefore the consumer price increases. In these circumstances, the compensation effect is said to be zero. If, on the contrary, the weight mentioned above depends on the net real wage, any increase in the tax wedge is fully transferred into a higher real labor cost at the employers' expense, while the workers' net real wage remains unaffected: in this instance, the compensation effect is said to be positive. The most interesting case, however, arises when the weight assigned by the union to employment relative to the net real wage not only depends positively on the net real wage but also negatively on the net real reservation wage. This may well be so because, caring about "relativities," workers are interested, for a given net real wage, in having the lowest net real reservation wage, as the latter is what they would get at full employment in the union's absence. Therefore, downward pressures on the net real wage target arise, ceteris paribus, the lower is the net real reservation ©International Monetary Fund. Not for Redistribution - 2 - wage. Most union utility functions used in the economic literature appear to bear this characteristic, for example the Stone-Geary and the utilitarian union utility function (but not the Dunlop one, where the weight assigned to employment relative to the net real wage is constant). When the union cares about "relativities," three important consequences are observed in the optimal union behavior and therefore in the macroeconomic wage equation. First, wage setting is negatively affected by the unemployment rate, because, ceteris paribus, a higher unemployment rate implies a lower net real reservation wage, hence a lower net real wage target. Second, for a given labor supply, any increase in the tax wedge, lowering the net real reservation wage, reduces the compensation effect. While in the two cases discussed above, the compensation effect could only be either zero or positive, now the compensation effect becomes weaker and may even be negative. Third, the tax wedge is proved to be (in Chapter III) the only relevant fiscal parameter in the wage equation only if all tax rates are flat. While this hypothesis is acceptable for the employers' social security tax rate and for the indirect tax rate, it is unrealistic for the direct tax rate due to income tax progressivity. Therefore, when the weight assigned by the union to employment relative to the net real wage is either constant or only dependent on the net real wage, a higher income tax progressivity leads to reductions, ceteris paribus, of the gross wage target because it makes wage benefits relatively less desirable than employment benefits: the progressivity effect is then said to be negative. I/ By contrast, when the union cares about "relativities" and the weight it assigns to employment relative to the net real wage depends positively on the latter but negatively on the net real reservation wage, the progressivity effect becomes stronger and may even be zero or positive. This is because a counterbalancing factor is (at least partially) at work, as a higher direct tax progressivity affects the net real reservation wage less than the net real wage; this would reduce, ceteris paribus, the distance between the net real wage and the net real reservation wage, thus inducing the union to increase the gross wage target. In sum, two factors determine the (backward or forward) shifting, if any, of tax rates on wages: the compensation effect and the progressivity effect. The former explains wage movements caused by changes in the indirect tax rate, in social security contributions, and also in the direct tax rate to the extent that this may vary in the average at given marginal rate; the latter effect explains wage movements caused by changes in the direct tax progressivity at constant average. The most general theoretical model presented here shows that the compensation and the progressivity I/ It should be noted here that in Padoa Schioppa (1990) a similar case was described as an instance of positive progressivity effect.

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