The employment effects of different regimes of welfare state taxation: An empirical analysis of core OECD countries

Among policy-makers and academics there is a controversial discussion whether the tax mix influences labor market performance in advanced industrialized countries. Many economists argue that the total tax burden rather than the tax-mix matters for aggregate employment, whereas neither the burden nor the mix play major roles in determining unemployment in the long run. This paper aims at combining this literature with an analysis informed by comparative welfare state analysis. It starts with a discussion of standard economic accounts - the incentives literature - and looks for cases where tax-mixes affect labor markets. Then the analysis shifts to a comparative point of view. Contemporaneous welfare states not only differ in terms of social expenditures, but also in the ways they fund these expenditures by various forms of taxation. The paper shows some of the linkages between the tax regime on the one hand, and the regime for social expenditures, and namely social transfers, on the other hand. The tax regime is, however, an imperfect mirror image of social expenditures and has the capacity to shape labor market outcomes. In particular, countries with high payroll and indirect taxation pose more problems for (low-wage) private sector employment than countries relying predominantly on income taxation. Moreover, since all countries have opened up their goods and capital markets, taxation these days should matter more for labor market outcomes than in times when markets were still national in nature. The paper attempts to judge the empirical plausibility of these claims. The empirical estimations generate three tentative results: First, there is some evidence that payroll and indirect taxation is more harmful for labor markets than income taxation. Second, this is particularly true for non-tradables sectors with a low degree of productivity. Third, there is some evidence that the impact of taxation has increased in the last decades. Taken together, the three results add to an explanation why some welfare states in continental Europe have both low employment and high unemployment rates.