APPENDIX I: The Simulation Model
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Artus, Patrick, 1995, “Réduction du Coût du Travail Non Qualifié: Un Cadre d’Analyse,” Working Paper, Caisse de Dépôts et Consignations, Service des Etudes Economiques et Financières.
Coe, David T. and Dennis J. Snower, 1996, “Policy Complementarities: The Case for Fundamental Labor Market Reform,” mimeograph International Monetary Fund (March).
Conseil Supérieur de l’Emploi, des Revenus, 1996, et des Coûts, L’Allégement des Charges Sociales sur les Bas Salaires (Paris: La Documentation Française).
Cotis, Jean-Philippe and Abderrahim Loufir, 1990, “Formation des Salaires, Chômage d’“, Equilibre” et Incidence des Cotisations Sociales sur le Coût du Travail,” Economie et Prévision, PP. 92–93 and pp. 97–110.
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Dreze, Jacques H. and Edmond Malinvaud, 1994, “Growth and Employment: The Scope of a European Initiative,” European Economic Review, Vol 38 (PP. 489–504).
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Fullerton, Don, 1982, “On the Possibility of on an Inverse Relationship between Tax Rates and Government Revenues,” Journal of Public Economics (October)
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O’Callaghan, Gary, 1995, “The Taxation of Returns from Personal Savings in France,” Paul Masson, ed., France Financial and Real Sector Issues (Washington: IMF)
Phelps, Edmund S., 1994a, “A Program of Low-wage-employment Tax Credits,” Working Paper No. 55 (New York: Russell Sage Foundation).
Phelps, Edmund S., 1994b, (Cambridge: Harvard University Press).
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Prepared by Caroline Van Rijckeghem.
The United Kingdom, the Netherlands, and Belgium have introduced social security tax exemptions for low-income workers. In the case of the Netherlands and Belgium these exemptions amount to reductions in labor costs of 5 and 10 percent, respectively, at the level of the minimum wage. Germany has focussed on providing temporary exemptions from social security taxes to the long-term unemployed (Conseil Supérieur de l’Emploi, des Revenus, et des Coûts, 1996). See also OECD (1995).
The survey of empirical work in this area by Zee (1996) indicates that there is considerable uncertainty surrounding the magnitude of effects of tax changes (see also below).
Hamermesh (1993) provides an overview of partial equilibrium studies of the effects of social security taxes (pp. 166–182).
More sectors could be introduced should the focus be on consequences of tax reform for individual sectors or for foreign trade.
See, Blanchflower and Oswald (1994) for a good survey of the empirical and theoretical literature on equilibrium wage curves and a formal exposition of various models generating wage curves.
The model developed by Agénor and Aizenman is more suitable for qualitative analysis The model developed in this paper also differs from Agénor and Aizenman in that the long-run equilibrium condition for the rate of return of capital is determined by an interest parity condition, where Agénor and Aizenman rely on the optimality condition for consumption in an intertemporal optimization model of a closed economy The qualitative effects of social security tax reductions are also examined by Artus (1995) in a two-sector, two-factor (skilled and unskilled labor) theoretical model.
The extent to which capital will be taxed under current French proposals for the reform of health care financing is smaller than modeled here. This mitigates the negative long run effects obtained in the simulations of this paper.
In the case of France, the minimum wage covers about 10 percent of employees (Moghadam, 1995), so that the labor supply of low-wage earners can be considered to be elastic.
Minimum wages are adjusted according to three mechanisms. First, a rise of 2 percent or more in the CPI automatically triggers an equivalent rise in the SM1C, second, on July 1 each year, the SMIC is adjusted by half the change in real hourly wages in industry, third, the Government can accord discretionary increases.
This corresponds to the usual result (“Dalton’s Law”) according to which a factor which is provided inelasticically bears the full burden of a tax (in this case, the full benefit of a tax reduction). For a formalization of “Dalton’s Law” of proportionality between incidence and relative elasticities of demand and supply of various factors see Keller (1980), p. 17.
See Johansen (1972), p. 125, for a derivation of the elasticity of factor demand in terms of expansion and substitution effects.
Knowledge of the direct elasticities of substitution (the percent change in relative quantities demanded corresponding to the percent change in relative factor costs) is sufficient, as these correspond to the partial elasticities in the nested CES function, in whose terms the model’s solution is expressed. In partial equilibrium analysis, substitution effects are expressed in terms of Allen elasticities (the percent change in factor demand corresponding to a one percent change in the cost of a factor, at constant output), which are more difficult to calculate from the basic parameters of the production function For a derivation of Allen elasticities from the partial elasticities in the nested CES function, see Keller (1980), pp. 79–84.
The broad-based income tax is close in spirit to both the CSG and RDS Its coverage of capital income is somewhat broader than of the RDS and in particular the CSG The broad-based income tax of the model does not cover unemployment benefits, pensions, or family allowances This is of limited consequence in estimating the effects of the Government proposal for reforming health care financing, as the introduction of the new broad-based health tax on unemployment benefits and pensions will be offset in large part by reductions in social security contributions levied on these incomes. Consumption, labor force participation, and tax evasion are also not modeled.
The references to Smith and Dupuit are from Fullerton (1980).
The tax rate which maximizes revenue is 74 percent in the simulations.
These results are sensitive to the assumed relationship between wages and unemployment. For a discussion of the sensitivity of the finding of self-financing to the assumptions on (a) the relationship between wages and unemployment and (b) the effective unemployment replacement ratio (see the sensitivity analysis below).
Note that in the long run the model can be solved recursively from the factor price frontier. At unchanged income taxes, the required rate of return on capital is constant, so that, given labor costs of unskilled workers as determined by the minimum wage and employer taxes, labor costs of skilled workers follow from the factor price frontier.
Recall that the broad-based income tax covers unskilled workers.
This reflects two factors: higher employment and higher gross wages. As long as (surrogate) labor supply is not fully elastic, a one for one shift from employer taxes to employee taxes (whether income or social security taxes) will lead to higher gross wages. Since gross wages constitute the tax base for both employer and employee taxes, a one for one shift from employer to employee taxes also has a positive effect on the budget. This turns out to account for 80 percent of the shortfall between labor’s share of 0 67 and the required offset in income taxes of 0.37. Twenty percent of the shortfall is accounted for by the increase in employment (which is quite small in the short run because employment has not fully adjusted).
When minimum wages are compensated for higher income taxes, all variables remain essentially unchanged from base-line in the long run. When the unskilled are exempt from the levy of (or increase in) the broad-based income tax, employment and output do expand in the long run, but at the cost of declining employment and net wages of skilled workers. These results are not reported here.
Since one type of employee tax is being replaced by another of smaller magnitude (given taxation of capital), and some of the benefits are shifted to employers, gross wages of the skilled decline, thereby reducing the tax base. This is offset by the effects of higher employment on the budget, so that overall, the required income tax increase just corresponds to labor’s share in value added.
See, for example Fullerton (1980), for work on the relationship between labor supply elasticities and tax revenues in the US.
This assumes that the wage is initially sufficiently below the sum of the reservation wage and the cost to the firm of replacing insiders with outsiders (consisting of severance pay, training costs, and costs which insiders can inflict by withdrawing cooperation from new hires or by striking). See Lindbeck and Snower (1988) for further details.