France: Selected Issues

U.S. shocks explain a large part of French output common components. This paper analyzes the economic implications of two alternative welfare financing reforms: a reduction in payroll taxes funded by an increase in consumption taxes, and the other funded by a new levy on business value added. The importance of financial market constraints and whether the recent mortgage market reform is likely to ease these constraints is assessed. Rechargeable mortgages are attractive and encourage collateralization, but bolder measures are needed to limit legal and other fees.

Abstract

U.S. shocks explain a large part of French output common components. This paper analyzes the economic implications of two alternative welfare financing reforms: a reduction in payroll taxes funded by an increase in consumption taxes, and the other funded by a new levy on business value added. The importance of financial market constraints and whether the recent mortgage market reform is likely to ease these constraints is assessed. Rechargeable mortgages are attractive and encourage collateralization, but bolder measures are needed to limit legal and other fees.

II. Economic Implications of Reforming Welfare Financing22

Objective: The purpose of this paper is to analyze the economic implications of two alternative welfare financing reforms recently debated in France: a reduction in payroll taxes funded by an increase in consumption taxes and a reduction in payroll taxes funded by a new levy on business value added. The paper presents conceptual issues, reviews the existing literature on the economic effects of alternative tax structures, and provides new evidence on the impact of different forms of taxation on unemployment.

Main results: While theory does not provide clear-cut results, evidence suggests that consumption taxes tend to be less distortionary than other forms of taxation, and that a shift from payroll to consumption taxes can have a favorable impact on employment and GDP. The size of this effect depends on a number of factors, notably on whether agents are compensated for their loss of purchasing power. A new tax on firms’ value added, instead, would raise capital taxation, with negative effects on investment, growth, and efficiency.

Policy implications: A shift from employers’ contributions to a consumption VAT would enhance efficiency and would be less distortionary than the status quo or a shift to a tax on firms’ value added. However, when evaluated against the main objective of the shift, namely job creation, the effectiveness of a shift to consumption taxation appears to be limited, largely because of widespread indexation in the French economy. Hence, the preferable avenue would be to finance the cut in employers’ contributions with reductions in expenditure, rather than an increase in other forms of taxation.

A. Introduction

1. Reducing labor costs has been near the top of France’s economic policy agenda since the early 1990s. Key steps in this direction include the creation in 1990 of the Contribution Sociale Généralisée (CSG), a tax falling on all types of income, with all revenues devoted to social security funds, and successive cutbacks in employers’ social security contributions for low-paid workers introduced since the early 1990s.23 Reductions in income taxes and the introduction of an earned income tax credit (Primepour l’emploi) were further measures designed to make work pay.

2. Now further budget neutral cuts in employers’ social security contributions are being considered. While several alternatives have been advanced, two main options on how to finance the reduction are being debated, namely a hike in the existing value-added tax (TVA Sociale), or the creation of a new tax levied on business value added (Cotisation sur la Valeur Ajoutée, CVA).24 The former would imply a shift from labor to consumption taxation, while the latter would result in an increase in profit, and therefore capital, taxation.

3. The purpose of this paper is to analyze the potential economic implications of these alternative reforms and examine, more generally, the effect of different forms of taxation on employment, efficiency, and growth. Section B discusses the conceptual issues related to the two alternative welfare financing reforms. It provides the analytical framework; identifies the main parameters affecting the reform outcome in terms of employment; and points out the effects on consumption, prices, capital accumulation, and competitiveness. Section C presents the evidence on the impact of different forms of taxation on unemployment, growth, and efficiency. After reviewing existing econometric and simulation results, an econometric study on a panel of 15 advanced economies during the period 1970-2004 presents new evidence of the effects of the taxation of consumption, labor, and capital on unemployment. Section D draws the conclusions and policy implications.

Authorities’ Working Group View on Welfare Financing Reform

In the attempt to curtail labor costs and stimulate employment, the French government is considering a budget neutral reform involving a cut in employers’ contributions. The proposal currently under examination is a 2.1 percent reduction in contributions, for a total fiscal cost of 8.5 billion euros.1/

To finance the cut, the government is looking at different alternatives. The two main options are a hike in the existing value-added tax (TVA sociale) or the creation of a new levy on business value added (Cotisation sur la Valeur Ajoutée, CVA)2/ Additional alternatives include: (i) the adjustment of contributions according to the weight of salaries in firms’ value added; (ii) a new tax on firms’ turnover net of the wage bill (“coefficient emploi-activité”); (iii) the elimination of exemptions currently granted to certain forms of labor remunerations (the so-called “niches sociales”, e.g., participations, épargne salariale, and chèque services); and (iv) a new business tax on all labor remunerations, including the niches sociales, and on corporate profits (Cotisation Patronale Généralisée).

The report of the group of experts in charge of assessing the impact of the alternative reforms indicates limited gains in terms of employment from both the CVA and the TVA sociale options. According to their simulations, a cut in employers’ contributions financed by the CVA would create only 28,000 jobs in two years and would have a negative impact on investment (Table 1). In the long run, the effect on employment would be close to zero, while investment and growth would be slightly reduced (Table 2). Financing the cut through an increase in value-added tax (VAT) from 19.6 to 20.8 percent would generate only 23,000 jobs in two years and would reduce consumption. Furthermore, due to social transfer indexation, public expenditure and the deficit would increase. A budget neutral shift from employers’ contribution to VAT would have even more limited gains in terms of employment (Table 1). In the long run, the reform would have a slightly negative impact on investment and output (Table 2).

Table 1.

Results of the Working Group’s Simulations (short term)

Effect of a cut of employers’ contributions by 2.1 percent (percentage changes)

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Scenario based on the assumption that capital depreciation is not deductible from the tax base (CVA brute).

Under this hypothesis, deficit would increase by 0.12 percent of GDP in the first year.

Table 2.

Results of the Working Group’s Simulations (long term)

Effect of a cut of employers’ contributions by 2.1 percent (percentage changes)

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Scenario based on the assumption that capital depreciation is not deductible from the tax base (CVA brute).

The other financing alternatives are also expected to generate only small employment gains. A reform involving an adjustment of contributions according to the weight of salaries in firms’ value added would be difficult to implement because the ratio of wages to value added is highly volatile and only partially correlated with firms’ employment decisions. The macroeconomic impact is expected to be similar to that resulting from the CVA option. Also, the effects of the Cotisation patronale généralisée are likely to be similar to those of the CVA. The coefficient emploi-activité would have a negative impact on investment and growth in the long term (Table 2).3/

1/

A larger decline in employers’ contributions, if financed by a nonprogressive tax, would alter the progressivity of the current contribution system and raise the labor cost of workers close to the minimum wage relative to that of more highly paid workers, thus discouraging employment of the low skilled. Such an effect is considered undesirable, given that the unemployment rate of low-skilled workers is particularly high (12.5 percent in 2005).

2/

The idea of this value-added contribution is not new. It was originally part of the 1995 Juppé project. A first report (Chadelat Report), issued in 1997, was favorable to the tax, while the Malinvaud Report, published in 1998, was critical of such a measure.

3/

The niches sociales option has not been simulated by the working group.

B. The Conceptual Framework

Value-added taxation

4. A value-added tax is imposed on the value that a firm adds to the goods and services purchased from other firms. Depending on the treatment accorded to capital goods, three main types of value-added tax can be distinguished: (i) the consumption-; (ii) the gross product-; and (iii) the income-type value-added tax. Under a consumption value-added tax, the full value of any capital good purchased from another firm is deductible from the tax base in the year of purchase, which implies that capital goods are exempted from taxation. In a closed economy, and in an open economy imposing value-added taxation according to the destination principle, this tax is equivalent to a retail sales tax, and its base is consumption (Shoup, 1969).25 The VAT used in Europe is of this type. Under the gross product value-added tax, capital goods are not exempted from taxation, and depreciation cannot be deducted from the tax base. The base of this type of value-added tax is the sum of wages, profits and depreciation (Shoup, 1969). Under an income type of value-added tax, like under the gross product value-added tax, capital goods are not exempted from taxation; however, depreciation can be deducted from the tax base. The base of this type of value-added tax is the sum of wages and profits (Shoup, 1969). The tax on firms’ value added under consideration in France (Cotisation sur la valeur ajoutée, CVA) would be either a gross product value-added tax (CVA brute), or an income type of value-added tax (CVA nette).

Financing Cuts in Employers’ Contributions With a VAT Hike (TVA Sociale)

Impact on employment

5. In terms of employment, the effects of a reform involving a reduction in employers’ contributions financed by higher consumption taxes depend on the following factors: (i) the response of labor supply to higher consumption taxes; (ii) the response of labor demand to lower employers’ contributions; (iii) whether labor markets are competitive or unionized; and (iv) whether wages are indexed to consumer prices. As discussed below, theory does not provide clear-cut results; the impact of this type of reform on employment is thus an empirical question.

6. A hike in consumption taxes has an ambiguous effect on labor supply.26 In terms of impact on labor supply decisions, a consumption tax is similar to a labor income tax, as they both create a wedge between real gross wages and real post-tax consumption wages.27 Just as in the case of an increase in a labor income tax, a VAT hike could result either in higher or lower labor supply, depending on the net impact of the income and substitution effects.28 In a one-period model, the sign and the magnitude of the labor supply response to changes in the consumption tax are determined by the elasticity of substitution between consumption and leisure. In a multi-period model, they are affected also by the intertemporal elasticity of substitution of leisure, as well as consumption, across different periods, and on whether such changes are perceived as temporary or permanent (Auerbach and Kotlikoff, 1987; and Lucas and Rapping, 1969). Given that these parameters may vary across groups of individuals, countries, and periods, the response of labor supply to changes in consumption taxes remains an empirical matter.

7. In the absence of wage indexation, a cut in employers’ contributions raises labor demand. Consider a firm endowed with the following technology: Y = f(k, 1), with fi>0 and fu<0, where l is labor and k is capital (for the time being assumed to be constant). The firm pays w(l+θ) for each unit of labor, where w is the wage rate and θ is the employer’s contribution.29 A profit-maximizing competitive firm hires labor up to the point where the marginal productivity of labor equals its marginal labor cost. The first order condition fl = w(1 + θ) yields the labor demand function ld=l(w, θ). After differentiating, it is easy to see that with dld/dθ = w/fll < 0. Hence, a decrease in employers’ contribution shifts the labor demand curve outwards.

8. In a perfectly competitive labor market without wage indexation, the employment effect of a revenue neutral cut in employers’ contributions financed by higher consumption taxes is ambiguous. The impact of such a reform depends mainly on the response of labor supply to the change in consumption taxes. Given that labor demand increases in response to lower labor costs, employment would certainly rise if labor supply also increased. If, however, labor supply declined, the final effect on employment would depend on the relative size of the shifts in the labor demand and supply curves.30

9. In an economy with full wage indexation, the same reform is likely to have a positive, but small, impact on employment.31 With full indexation, the price increase caused by higher consumption taxes results in an equal raise in nominal wages. Thus, workers’ net real wages do not change, and labor supply remains unaffected. The labor demand response, on the other hand, depends on two factors: while the cut in employers’ contributions stimulates labor demand, the increase in nominal wages (which translates into higher real wages for the firm, given that producer prices do not change) discourages it. Given that the VAT tax base (consumption) is larger than employers’ contribution base (the wage bill), a given cut in contributions could be financed by a relatively smaller hike in the VAT rate. So, the increase in nominal wages due to indexation is likely to be smaller than the reduction in contributions and, overall, labor costs are likely to decline somewhat, thus marginally stimulating labor demand and employment.

10. In a labor market where wages and employment are determined by the bargaining between trade unions and employers, a cut in employers’ contributions financed by higher consumption taxes has a positive impact on employment. Consider the so-called “right-to-manage” model, where firms and unions bargain over wages, and employment is then freely chosen by the firm so as to maximize profits. As shown in Appendix I, in this setting higher consumption taxes are not translated into higher wages. Given that labor demand increases as a result of lower employers’ contributions, while wages remain unchanged, the reform has a positive effect on employment. This result, however, is based on the assumption that union membership is given, and so labor supply by union members is perfectly elastic. The outcome could be different if, instead, union membership and therefore labor supply, were endogenous.

Other issues arising from the proposed reform

11. Switching from employers’ contributions to consumption taxes implies broadening the tax base from labor income to consumption. Since the consumption tax base is fairly large, a revenue-neutral reduction in contributions could be financed by a relatively small increase in the VAT rate. Given that efficiency losses from distortionary taxation increase more than proportionally with the tax rate, such a shift should reduce the dead-weight loss.32 Furthermore, as the consumption tax base includes those who consume out of capital and transfer incomes (e.g., pensions, social benefits) as well as wage income, the overall tax burden on labor could be reduced, even in conditions when the increased taxation on consumption results in an equivalent increase in nominal wages. If, however, transfer incomes were indexed to the increase in consumer prices resulting from the VAT hike, public expenditure would rise, and, presumably, a budget-neutral shift from payroll to consumption taxes would allow a relatively small cut in employers’ contributions. In this case, labor would continue to largely bear the incidence of taxation.33

12 The cut in employers’ contributions accompanied by an increase in VAT could have an impact on trade. A VAT is often viewed as an aid to international competitiveness, as it is levied on imports, but rebated on exports. If VAT is raised to lower employers’ contributions, domestic producers are expected to gain competitiveness, as, in principle, they could cut their sales prices by the amount of the cost relief. Hence, exporters could benefit from such a move, which would be equivalent to a real exchange rate depreciation. This conclusion, however, is questionable. As discussed above, with wage indexation, the VAT increase, and the accompanying rise in consumer prices, would lead to higher nominal wages, thus somewhat offsetting the decline in labor costs resulting from lower social contributions. Secondly, the argument that VAT taxation favors export performance is considered incorrect by theorists and has not received empirical support.34

13. A VAT increase is likely to unfavorably impact consumption and inflation. The VAT rise would also translate into an increase in prices, whose magnitude would depend on firms’ ability to pass the VAT forward. Whether or not forward-shifting would be inflationary, as opposed to a once-and-for-all change in the level of prices, would depend on a number of factors, including the reaction of wages, the monetary policy stance, and psychological effects (Tanzi, 1983; Tait, 1988). Due to agents’ purchasing power loss, domestic consumption would probably decline in response to a VAT hike, although, shortly before the introduction of the reform, it may increase in anticipation of a higher tax rate.

14. The expected impact of the VAT hike on investment is ambiguous, but it is likely to be small. On one hand, given that capital goods are exempted from VAT taxation, an increase in the latter should not significantly affect investment decisions. On the other hand, since the reform would shift part of the tax burden to the recipients of capital income, investment may decline. The empirical evidence, however, suggests that the consumption taxation base generates more long-run capital formation than wage taxation (Auerbach and Kotlikoff, 1987).

Financing Cuts in Employers’ Contributions with a Tax on Firms’ Valued Added (CVA)

15. The effect of a reduction in employers’ contributions financed by a new levy on firms’ value added hinges crucially on its impact on labor and capital costs. This depends on how the tax base is defined. One important aspect is whether capital amortization, interest payments, and employers’ contributions would be deductible from the tax base. Additional aspects to be considered in assessing the reform are the long-term implications in terms of capital accumulation and firms’ location decisions, the impact on different sectors of the economy, and the effects on international trade.35

16. The reform would imply a reduction in labor taxation and an increase in profit, and therefore capital, taxation. As the new tax on firms’ value added would be either a gross product (CVA brute), or an income type of value-added tax (CVA nette), its base would be the sum of wages, profits, and depreciation in the former case, or the sum of wages and profits in the latter case. In any event, the reform would broaden the tax base for employers’ contributions from wages to wages and profits. Labor would continue to bear part of the taxation burden.

17. With capital virtually fixed in the short run, the change in tax structure would only impact firms’ labor demand, though in the medium to long term, it would affect both labor and capital utilization. To analyze the firm’s problem, suppose that the price of capital is p, firms borrow at the rate r to finance investment, and capital depreciates at rate δ. Assume that social security contributions and interest payments are deductible from the tax base and that the tax deduction for depreciation is αδ, where α can be greater, smaller, or equal to 1.36 The output price is normalized to be equal to 1. Inputs are chosen in order to maximize the following net profit function:37

ΠN=(1-tVA)f(k,l)-wl(1+θ)-rpk-δpk+tVAwlθ+tVArpk+tVAaδpk

where tVA is the tax rate on the firm value added. If social security contributions are not deductible, the term tVAwlθ is equal to zero; if interest payments are not deductible, the term tVArpk is equal to zero; if amortization is not deductible, the term tVAαδpk is equal to zero.

18. In the short run, employment would increase as a result of the reduction in labor taxation. However, the size of this increase would depend on the cut in employers’ contributions, on the tax rate tva, and on whether remaining contributions would be deductible from the tax base. Maximization of the net profit function with respect to l, while keeping capital constant, yields the following first order condition:

fl=[w(1+θ)-tVAwθ]/(1-tVA)

If employers’ contributions are not deductible from the value-added tax base, the term tva in square brackets is zero, and so the marginal cost of labor (the term on the right hand side of the above equation), is higher.

19. Firms’ capital accumulation depends on the tax rate tVA, and on the deducibility of interest and amortization from the tax base. In the medium to long term, firms choose an amount of capital satisfying the following first order condition:

fk=[δp+rp-tVArp-tVAaδp]/(1-tVA)

If amortization is not deductible, the term tVAαδp is equal to zero; if interest payments are not deductible, the term tVArp is equal to zero. In both cases, the marginal cost of capital (the term on the right hand side of the above equation) is higher.

20. Given that a tax on businesses’ value added is a form of capital taxation, in the long run, it could discourage investment and give firms an incentive to relocate abroad. Both theoretical models and empirical research indicate that investment demand is sensitive to capital taxation.38 Since capital is fairly mobile in the medium to long term, the tax on businesses’ value added could result in firms relocating abroad, with a negative impact on employment. This negative effect of the reform probably would not be uniform across all sectors of the economy, as high value-added and capital intensive industries would likely be more penalized than the labor-intensive ones.39

21. A tax on businesses’ value added could also have an impact on trade. Unlike the consumption type VAT tax, this form of taxation follows the origin principle, since it is levied in the country where goods are produced and could, in principle, be less favorable to competitiveness. From a macroeconomic point of view, however, the scant available empirical evidence indicates that origin-based corporate taxation has an initial positive effect on net exports and virtually no effect in the long run (Keen and Syed, 2006).40 From a microeconomic point of view, the effect of the reform on firm competitiveness is likely to vary across the different sectors of the economy.

C. Evidence

Review of the literature

22. The empirical literature based on regression analysis typically assumes that what affects unemployment is the total tax rate, including labor and consumption taxes, and not the individual components. According to this view, income taxes, employers’ and employees’ contributions, as well as consumption taxes are considered substitutes and are expected to have no differential impact on labor cost and employment. Hence, most econometric studies use a measure of the tax wedge combining labor and consumption taxes, without investigating the impact of alternative forms of taxation on unemployment.41

23. Contrary to this widely held view, Daveri and Tabellini (2000) argue that only direct labor taxation (i.e., income tax and social security contributions) matter for unemployment. According to them, only labor taxes drive a wedge between income if employed and unemployed, while consumption taxes hit both employed and unemployed in the same way. Thus, a shift of taxation from labor to consumption would help in reducing unemployment. Additionally, according to Daveri and Tabellini’s model, an increase in capital taxation would not have any impact on unemployment, but a negative effect on the steady state capital stock and per capita income. These propositions are confirmed by their econometric study on a panel of 14 industrial countries over the period 1965–95.42

24. Simulation studies typically conclude that a shift from labor to consumption taxation could be beneficial to employment and growth, but the size of these gains varies across studies (Table 1). According to some simulations based on the EU Commission services’ QUEST II model, in the long run, a reduction of labor taxes by 1 percent of GDP coupled with an increase in consumption taxes of compensating size, would have a positive, nontrivial, effect on employment and GDP. A shift from labor to corporate taxation, instead, would raise employment but reduce GDP (Leibfritz and others, 1997). Other, more recent, simulations with a similar model indicate that the size of the positive impact of a shift from labor to consumption taxation would depend on whether agents are compensated for their purchasing power loss (European Commission, 2000). An experiment conducted by the Belgian Federal Planning Bureau (Bureau Fédéral du Plan, 2006) for the euro area finds limited employment and growth effects of a reduction in social contributions, accompanied by a matching rise in indirect taxes.

Table 1.

Summary of Simulation Results

(Percentage points deviation from baseline)

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Medium-term effect (six years after reform).

Assuming that unemployed and other transfers recipients are not compensated for the increase in consumer prices.

Assuming that unemployed and other transfers recipients are compensated for the increase in consumer prices.

25. A number of papers have investigated, more generally, the impact of alternative forms of taxation on growth and efficiency.43 Simulations of neoclassical growth models indicate that consumption taxes are more efficient than labor taxes, which, in turn, are more efficient than capital taxes (Ballard, Shoven, and Whalley, 1985; Auerbach and Kotlikoff, 1987; Judd, 1987; Matier and Wu, 2000; and Baylor and Beauséjour, 2004).44 This result appears to be confirmed when different tax policies are ranked according to their impact on steady-state output rather than on their efficiency. Results from the endogenous growth literature suggest that tax structure does not affect long-run growth, but it has permanent level effects fairly consistent with the findings obtained by the neoclassical growth literature, although the evidence varies somewhat across countries (Lucas, 1990; Devereux and Love, 1994; Mérette, 1997; Xu, 1997).45

Empirical analysis

26. This section provides new evidence on the impact of different forms of taxation on unemployment. The analysis differs from most of the existing econometric literature, which typically includes among the explanatory variables for unemployment a measure of the tax wedge combining labor and consumption tax, by disentangling the impact of these two types of taxes and assessing the effect of capital taxes on unemployment. The econometric analysis is conducted on a panel of 15 advanced economies46 over the period 1970–2004, thus extending the sample period covered in the existing literature, which typically ends in the mid- to the late 1990s.

27. The dependent variable in the regressions is either the unemployment rate, as defined by the OECD, or the employment rate of the business sector. The main explanatory variables are the average effective tax rates47 on labor, consumption, and capital.48 These are calculated as the ratios between the tax revenues from particular taxes and the corresponding tax bases, using data from the AMECO database, combined with auxiliary information from the OECD databank ‘Revenue Statistics,’ following a method similar to that proposed by Mendoza, Razin, and Tesar (1994).49

28. The control variable set includes the output gap and several indicators of labor market institutions that have been typically used in the literature. These comprise the employment protection index, a measure of unemployment benefit entitlements, and measures of the strength of trade unions (centralization, coordination, trade union density, collective bargaining coverage).50 As these indicators tend to be correlated, they are summarized by their first principal component.51 Given that recent research has shown that unemployment may be affected by the degree of product market competition, the OECD index of product market regulation is also included in some regressions.52

29. The estimation results indicate that labor taxes contribute to higher unemployment or lower business sector employment rates, while consumption and capital taxation do not have a significant effect (Table 2). Indeed, the variable measuring effective labor taxation (LABOR TAX) exhibits a positive and significant coefficient on the unemployment rate and a significantly negative coefficient on the business employment rate, whereas the coefficients of the variables accounting for consumption and capital taxation (CONSUMPTION TAX and CAPITAL TAX, respectively) are not statistically significant.

Table 2.

Regression Results

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Source: IMF staff estimates.

In parenthesis, absolute value of t-statistics. The Breusch-Godfrey LM test detects serial correlations for all the regressions estimated in levels. Therefore, in Equations (1) through (4) and (6), t-statistics are obtained using White period standard errors that are robust to arbitrary serial correlation. *, **, and *** indicate that the coefficient is significant at the 10, 5, and 1 percent levels, respectively.

Principal component summarizing the following variables: employment protection index; unemployment benefit entitlements; measures of strength of trade unions (centralization, coordination, and trade union density).

30. This result is robust to alternative model specification and estimating procedures. The basic model specifications (Equations (1) and (2)) are estimated using OLS and include both country and time effects. Since rising unemployment rates could have forced countries to increase taxes to pay for higher unemployment benefits, Equation (3) is estimated by two-stage least squares, using lagged values of the taxation variables as instruments, to address the possible endogeneity of the right-hand side variables. In Equation (4), lags of the variable measuring capital taxation are included in the model to account for possible delays in the response of unemployment to capital taxation. Given that unemployment and labor taxes have risen at the same time in some countries, in Equation (5), the model is estimated in first differences to cope with the possible problem of spurious correlation.53 In Equation (6), the dependent variable is the employment rate of the business sector. Consistent with the results discussed above, the estimates indicate that labor taxes have a negative and significant impact on employment, while consumption and capital taxes do not have significant effects.

D. Conclusions and Policy Implications

31. This paper analyzes the economic implications of two alternative tax reforms under consideration in France, taking into account, more generally, the effects of different forms of taxation on employment, efficiency, and growth. The main results are as follows:

A reduction in employers’ contribution financed by higher consumption taxes (the TVA sociale hypothesis) is subject to the following considerations:

  • From a theoretical viewpoint, the impact of such a reform on employment is ambiguous and depends on (i) the response of labor supply to higher consumption taxes; (ii) the response of labor demand to lower employers’ contributions; (iii) whether labor markets are competitive or unionized; and (iv) whether wages are indexed to consumer prices.

  • The broadening of the social contribution tax base from labor income to consumption would yield efficiency gains. However, if transfer incomes were indexed, the VAT hike would raise public expenditure. Hence, a budget-neutral shift from payroll to consumption taxes would create scope for only a relatively small cut in employers’ contributions and would only marginally alleviate the taxation burden on labor.

  • Unfavorable effects from the reform could include a negative impact on consumption and an increase in prices. The expected effect on investment is ambiguous and likely to be small. Effects on export performance are debatable.

  • New empirical results presented here confirm that labor taxes have an adverse effect on unemployment or on business sector employment. However, compared to the empirical literature, which lumps labor and consumption taxes together, the estimates do not find significant effects of consumption taxes on unemployment.

  • The literature suggests that consumption taxes are less distortionary than labor and capital taxation.

  • Existing simulations consistently indicate that a shift from labor to consumption taxation could be beneficial to employment and growth, but the size of these gains varies across studies, notably depending on whether agents are compensated for their purchasing power loss.

A reduction in employers’ contribution financed by a new tax on businesses’ value added (the CVA option) is subject to the following considerations:

  • In the short run, employment would rise as a result of the reduction in labor taxation. However, the size of this increase would depend on the cut in employers’ contributions, on the firms’ value-added tax rate, and on whether remaining contributions would be deductible from the tax base. In any event, labor would continue to bear part of the incidence of taxation.

  • As this tax on value added is a form of capital taxation, in the long run, it would discourage capital accumulation and give firms an incentive to relocate abroad, especially for companies operating in high value-added and capital-intensive industries.

  • Several studies find that capital taxation is the most distortionary form of taxation and has a harmful impact on investment and growth.

  • The overall impact on investment would depend on whether amortization and interest payments would be deductible from the tax base.

32. The considerations above suggest the following policy implications:

  • A reform involving a cut in employers’ contributions financed by the CVA would not be very beneficial, as the positive impact on employment would be offset by the detrimental effects on investment, growth, and efficiency.

  • A budget-neutral cut in employers’ contributions financed by a VAT hike would enhance efficiency with respect to the status quo and would be less distortionary than introducing the CVA. However, the impact of such a reform on job creation may be limited, largely because of the widespread indexation in the French economy. In fact, on one hand, social transfers indexation would raise public expenditure, thus creating scope for only a small reduction in contributions. On the other hand, the wage indexation system would offset the labor cost decline resulting from the cut in contributions, thus limiting labor demand expansion.

  • Given these considerations and the fact that the tax burden in France is already high, the preferable avenue is to finance the cut in employers’ contributions with reductions in expenditure rather than an increase in other forms of taxation.

APPENDIX I. Financing Employers’ Contributions Cuts Through Higher Consumption Taxes

Impact of higher consumption taxes on labor supply

A hike in consumption taxes would have an ambiguous effect on labor supply. Consider a consumer whose utility function is

U(c,f)(1)

where c is the composite consumption good, f=I-l is leisure, l is working time, and the maximum number of hours is equal to 1. The consumer’s budget constraint is

(1+t)c=wl+z(2)

where t is the consumption tax, w is the nominal wages, z is unearned income (e.g., inheritance, accumulated wealth), and the consumption price is normalized to be equal to 1. It is easy to see that when z=0, a consumption tax is equivalent to a labor income tax.54 Maximization of (1) subject to the budget constraint (2) yields the first order condition

Uf/Uc=w/(1+t).(3)

Substituting c= (wl+ z)/(l+t) from the budget constraint into (3) and totally differentiating with respect to t and/one obtains the response of labor supply to changes in the consumption tax:

dldt=-dfdt=Uctw-Uft(1+t)-UfUcfw-(1+t)Uff,(4)

which has an ambiguous sign.

In a one period model, the sign and the magnitude of the labor supply response to changes in the consumption tax depend on the elasticity of substitution between consumption and leisure. Consider the case of the CES utility function, which has been largely used in the labor economics literature (e.g., Auerbach and Kotlikoff, 1987); and Pissarides, 1998) and which takes the following form:

U=[βc(γ-1)/γ+(1-β)f(γ-1)/γ]γ/(γ-1)(5)

where γ is the elasticity of substitution between consumption and leisure and β represents the intensity of household preferences for consumption relative to leisure. Inspection of the labor supply function obtained maximizing (5) subject to the budget constraint (2) indicates that the parameter γ plays a very important role in determining the response of labor supply to changes in taxation.55 When z=0, if γ=1, the income and substitution effects on labor supply exactly offset each other, and the labor supply curve is inelastic to the changes in wages and consumption taxes. When γ>1, the labor supply curve is upward-sloping, and an increase in the consumption tax (which is equivalent to a decrease in net wages) yields a reduction in labor supply. When instead γ<1, the labor supply curve has a negative slope, and an increase in consumption tax yields an increase in labor supply.56

Impact of lower employers’ contributions on labor demand

In the absence of wage indexation, a cut in employers’ contribution raises labor demand. Consider a firm endowed with the following technology:

Y=f(k,l)(6)

The production function is increasing and strictly concave in labor (l). Capital (k) is assumed to be constant. The firm pays w(1+θ) for each unit of labor, where w is the wage rate, and θ is the employer’s contributions. Price is normalized to be equal to 1. The first-order condition is:

ft=w(1+θ)(7)

which yields the downward-sloping labor demand function

ld=l(w,θ)(8)

Totally differentiating (7), it is easy to see that

dld/dθ=w/fll<0.(9)

An increase in employers’ contributions shifts the labor demand curve inwards, and the shift is bigger the larger the wage rate is.57

Effects of the reform on employment in a competitive labor market

In competitive markets and in the absence of wage indexation, the effect on employment of a revenue-neutral cut in employers’ contributions financed by an increase in consumption tax is ambiguous. In response to lower labor costs, the labor demand function would shift outwards. If labor supply also rises after the increase in consumption taxes, the labor supply curve would also shift outwards, and employment would certainly increase (Figure 1a). If, however, labor supply declines and the curve shifts inwards, the final effect on employment would depend on the relative size of the shift in the labor demand and supply curves (Figure 1b).

Effects of the reform on employment in a unionized labor market

Consider a labor market where wages and employment are determined by the bargaining process between trade unions and employers. In this so-called “right to manage” model, the firms and the union bargain over wages, and then employment is freely chosen by the firm so as to maximize profits. Following the standard assumption in the labor economics literature (e.g., Booth, 1995 and Atkinson, 1999), the outcome of this process is the generalized Nash bargaining solution. According to this approach, wages are determined by the maximization of the product of each agent’s net gains from reaching a bargain, weighted by their respective bargaining strengths. For the firm, the net gain from reaching an agreement is simply its profit function.58 For the union, it can be shown that the net gain from bargaining is

l[V(w)-V(b)](10)

where V is a utility function such that V’>0, V’’<0, l is union member employment, w is real gross wage, and b is the real gross reservation wage, or the real gross unemployment benefit.59 With consumption taxes, employers and unions choose real gross wages in order to maximize

Πφ×{l×[V(w1+t)-V(b1+t)]}1-φ(11)

where Π is the firm’s profit and φ is a positive number measuring the employer’s bargaining power. When φ = 0, the outcome is the monopoly union model. With a Cobb-Douglas production function of the form Y=kαl(1-α), the first-order condition for the maximization problem above reduces to

G(w)φ1-αα+(1-φ)α-(1-φ)w[V(w1+t)-V(b1+t)]/w[V(w1+t)-V(b1+t)]=0.(12)

Equation (12) defines implicitly the gross real wage agreed upon by the union and the firm as a function of the other parameters of the model. Once wages have been determined by the bargaining process, the firm chooses the number of workers depending on its labor demand function.60

In this setting, an increase in consumption taxes has no impact on gross real wages. This can be seen by specifying an explicit functional form for V. Consider, for example, the following constant relative risk aversion function, which has been largely utilized in the labor market literature:61

V(w1+t)=11-σ(w1+t)1-σV(b1+t)=11-σ(b1+t)1-σ(13)

where σ measures relative risk aversion. If σ=0, the trade union is risk-neutral, and the utility function is linear in wages. In this case, it is evident that the tax rate t disappears from the last term in (12), and the gross real wages is set irrespectively of the tax rate. In other words, any change in the tax rate does not have any impact on gross real wages. If σ is positive, to evaluate the impact of changes in t on w, totally differentiate Equation (12) with respect to t and w.

dwdt=-G/tG/w

and, with the utility function (13),

Gt=(1-φ)w(w1+t)−σ(b(b1+t)−σ(1+t)2-w(w1+t)−σ(1+t)2)(1+t)(-(b1+t)1-σ1+σ+(w1+t)1-σ1-σ)2+(1-φ)w(w1+t)-σ(1+t)2(-(b1+t)1-σ1+σ+(w1+t)1-σ1-σ)-(1-φ)w2σ(w1+t)-1-σ(1+t)3(-(b1+t)1-σ1+σ+(w1+t)1-σ1-σ)=0

Also, in the case of a risk-averse trade union, any change in the tax rate does not have any impact on gross real wages. The rationale for this result is the following: In this model, wage determination depends on the difference between real income when employed and when unemployed. Consumption taxes do not affect wages, as they do not create a wedge between real income when employed and when not employed.

As higher consumption taxes are not translated into higher gross real wage, and labor demand increases as a result of lower employers’ contributions, the reform has a positive effect on employment. The parameter θ does not enter into the wage Equation (12) but only in the labor demand function, which implies that a decrease in employers’ contributions would stimulate labor demand without affecting wages. Therefore, the labor demand curve would shift to the right, while the equilibrium wage remains unchanged. The final outcome would be an increase in employment (Figure 2b).

APPENDIX II: Variable Definitions and Data Sources

Consumption tax: consumption-effective tax rate (in percent of pretax value of final consumption. Source: Martinez-Mongay (2000 and 2003).

Labor tax: labor-effective tax rate (in percent of total labor costs). Source: Martinez-Mongay (2000 and 2003).

Capital tax: capital-effective tax rate (in percent of the gross operating surplus). Source: Martinez-Mongay (2000 and 2003).

Output gap: Deviations of actual GDP from potential GDP as a percent of potential GDP. Source: OECD Economic Outlook.

Employment protection index: index measuring the strictness of employment protection laws. It ranges from 0 (low) to 6 (high). Source: Nickell and others (2003) and OECD (2004).

Measure of unemployment benefit entitlement: The OECD summary measure, defined as the average of the gross unemployment benefit replacement rates for two earnings levels, three family situations and three durations of unemployment. For further details, see OECD (1994), The OECD Jobs Study (chapter 8), Martin (1996), and “Measures of Replacement Rates for the Purpose of International Comparisons: A Note”, OECD Economic Studies, No. 26.

Centralization: index measuring the degree of centralization of the collective bargaining system. It ranges from 1 (decentralized) to 5 (centralized). Source: OECD (2004).

Coordination: index capturing the degree of consensus between the actors in collective bargaining. It ranges from 1 (low) to 5 (high). Source: OECD (2004).

Trade union density: portion of workers who are members of trade unions. Source: OECD (2004).

Collective bargaining coverage: share of workers covered by wage-bargaining agreements. Source: OECD (2004).

Product market regulation: index ranging from 1 (low) to 6 (high). Source: Conway, P., and G. Nicoletti (2006).

Unemployment rate: unemployment as a percentage of the labor force. Source: OECD Economic Outlook.

Employment rate of the business sector: employment of the business sector as a percentage of the labor force. Source: OECD Analytical database, and Economic Outlook.

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22

Prepared by Edda Zoli.

23

Currently 60 percent of the main social security system {régime général) is financed by payroll contributions, 22 percent by the CSG, and the remaining 18 percent by other miscellaneous sources.

24

Box 1 illustrates the different financing options and summarizes the results of the report prepared by the working group set up by the government to evaluate the impact of these alternative reforms.

25

Under the destination principle, consumption taxes are levied where goods are consumed (so that exports are exempt from domestic taxation), whereas under the origin principle, they are levied where goods are produced. The destination system ensures production neutrality, since all firms receive the same producer price from selling in any location, irrespective of their country of residence. Under certain, strong assumptions, however, destination and origin-based taxes are equivalent (Ebrill and others, 2001, pp. 179–182).

26

For a formal derivation of this result, see Appendix I.

27

Under certain circumstances (e.g., in the absence of any form of unearned income, such as inheritance, or when inheritance is taxed at the same rate as labor income), the two taxes are equivalent (Atkinson and Stiglitz, 1980, p. 70).

28

For a discussion of the impact of a change in labor income tax on labor supply, see Atkinson and Stiglitz, 1980, p. 34.

29

The producer output price is normalized to be equal to 1.

31

This case is relevant for France, given that salaries are to some extent indexed. In fact, the minimum wage (SMIC) is formally indexed to the CPI, and changes in the SMIC, in turn, influence other salaries adjustments (DARES, 2006).

32

It is known from the optimal tax literature that the excess burden increases with the square of the tax rate (Auerbach, 1985).

33

This consideration is particularly relevant for France, where pensions and a wide range of family benefits are indexed to the Consumer Price Index (CPI).

34

According to Krugman and Feldstein (1989); and Auerbach (1997), this argument is incorrect except in the very short run, because exchange rates or domestic prices adjust to offset the effect of the VAT tax on the relative prices of domestic and foreign goods. Once prices or exchange rates have adjusted, the valued-added tax will have no effect on imports and exports. From an empirical point of view, recent studies by Desai and Hines (2005) and Keen and Syed (2006) find no evidence of a positive impact of VAT taxation on trade performance.

35

Another issue is the compatibility of a new tax on firms’ value added with EU law. The General Counselor of the European Court of Justice has recently indicated that a similar tax in effect in Italy (the IRAP) is not compatible with the VI directive on the harmonization of the laws of the member states relating to turnover taxes. The Court of Justice has still to make a final pronouncement on the matter.

36

If α=1, it means that fiscal depreciation is equal to true economic depreciation, while α> 1 implies accelerated depreciation.

37

This is based on the assumption that capital can be adjusted to a new desired level at no cost.

38

For a comprehensive and recent survey of the empirical evidence on the effects of taxation on investment, see Hasset and Hubbard (2002).

39

The tax on firms’ value added could also affect corporate financial decisions, depending on whether debt financing is favored relative to equity financing. This issue, however, is probably less relevant from a macroeconomic perspective.

40

Keen and Syed (2006) argue that net exports increase in the short run because a source-based corporate income tax reduces domestic investment, leading to a decline in imports (or a rise in exports) of capital goods.

41

The empirical literature on taxation and unemployment is large. For a recent surveys, see Arpaia and Mourre (2005) and Nickell (2004).

42

Daveri and Tabellini (2000) estimate the impact of labor and consumption taxation in three groups of countries characterized by different trade union systems. They find that labor taxation is harmful to employment especially in countries with strong but decentralized trade unions, while consumption taxes do not affect employment, irrespective of the trade union system.

43

For a survey see Baylor (2005).

44

In this context, efficiency is measured either by the welfare losses arising from a tax or by a marginal excess-burden type concept.

45

Another strand of the endogenous growth literature finds that tax policy can have nontrivial growth effects in the long run (for instance, King and Rebelo, 1990). Unfortunately, to our knowledge, there are no works examining tax ranking in such a context.

46

The sample countries are: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Sweden, United Kingdom, and United States.

47

It would be preferable to use marginal, rather than average, effective tax rates, as the former are more likely to affect agents’ decisions. However, long time series on marginal effective tax rate are not available.

48

The effective tax rates on labor comprise effective rates on labor income tax as well as employees’ and employers’ contributions.

49

These data are regularly constructed for the European Commission Spring and Autumn forecasts and were kindly provided by Carlos Martinez-Mongay. For details and methodological issues, see Martinez-Mongay (2000 and 2003).

50

Variables definitions and data sources are reported in Appendix II.

51

When individual institutional variables, rather than their principal components, are entered in the regressions, the general estimation results are not affected, but the size and significance of the individual labor market indicators are not very robust to alternative model specifications.

52

See, for example, Blanchard and Giavazzi (2003) and Nicoletti and Scarpetta (2005) and the references therein.

53

Panel unit root tests indicate that all the variables are stationary.

54

With a consumption tax, when z=0, the budget constraint (2) becomes (1 + t)c = wl. With a labor income tax tw, the consumer’s budget constraint is c = w(1 - tw)l. The two budget constraints are identical if 1 - tw= 1/(1 + t).

55

The labor supply function is ls=[(w1+t)γ(β1-β)γ(1+t)-z]/[w+(w1+t)γ(β1-β)γ(1+t)]

56

When z is positive and γ<1, the labor supply curve is initially upward-sloping but becomes backward-bending for higher wage levels. An increase in consumption taxes yields an increase in labor supply.

57

This result holds also when capital is flexible.

58

It is assumed that in the case that the firm does not reach a bargain with the unionized workforce, it cannot obtain any worker, and its profits are zero.

59

See Booth (1995), p. 125.

60

A graphical illustration of the model outcome is presented in Figure 2a.

61

See, for instance, Booth (1995); Farber (1978); and Pissarides (1998).