Reductions in employers' social security contributions in a wage norm and automatic indexing régime

The article investigates the possible labour market and fiscal impacts of labour tax reductions within a macroeconometric model that allows for various wage responses to tax policies and to policy-induced price changes. As such, the model captures different institutional settings of wage formation. We consider reductions in employers' social security contributions and fiscal compensation through value added or production taxes in a typically Belgian setting, i.e. a wage norm regime with automatic price indexing of wages. The (quarterly) macroeconometric model we use has been developed as part of a larger project within the European System of Central Banks and is essentially Neo Keynesian in its approach. The equilibrium in the real economy is determined by the supply side, but the short run is determined by demand. Nominal rigidities slow down the adjustment process. One of the key features of the model is its ability to distinguish between 'intrinsic' adjustments (related to delayed responses through costly adjustment processes) and 'expectation' dynamics (related to agents anticipating and incorporating future information into their decision making). Forward looking behaviour is therefore fairly widespread in the model. The model contains two alternatives for wage formation. In the first, wages are determined endogenously as the result of a bargaining process between unions and firms, following a 'right to manage' model. In the second, a wage norm and price indexing regime is mimicked. Two subroutines, determining the degree of price indexing of wages, are available: a 'nominal rule' that keeps nominal wages equal to a reference value an a 'real rule' that targets the real wage. These rules can both concern labour costs or gross wages, depending on the degree of tax shifting from employers to employees. To determine the labour market impact of the tax policy, the reaction of wages to the reduction in employers' social security contributions and to the fiscal compensation measures proves crucial. The more the initial reductions in employers' contributions are used to finance higher gross wages, and the more the inflationary effects of fiscal compensation measures are passed on in wages, the less positive the impact on employment will be. This means that little job creation is to be expected without a special co-ordination effort between all labour market players. Labour tax reductions are by no means a substitute for other labour market reforms.