The marginal cost of public funds in the EU : the case of labour versus green taxes

One key objective of tax‐based fiscal consolidations which is too often disregarded in publicdebate is to minimise economic distortions. This paper uses a computable generalequilibrium model to gauge these potential distortions by calculating the marginal cost ofpublic funds (MCF) for EU member states. We consider two specific tax categories which areoften proposed as good candidates for efficiency‐enhancing tax shifting policies: labour andgreen taxes. Our analysis suggests that the economic distortions provoked by labour taxesare significantly larger than for green taxes. This result suggests that a green‐taxes orientedfiscal consolidation would be preferred to a labour‐tax oriented one (assuming that both taxincreases would yield the same tax revenues). This holds for all EU member states modelledand despite the fact that potential welfare enhancement through pollution abatement arecancelled‐out. Nevertheless, this result is slightly less strong when one considers thespillover effects between countries, which are more pronounced (in relative terms) for greentaxes. This suggests that the use of green taxes for fiscal consolidation would be moreeffective were there to be close coordination across EU countries. In addition the efficiencylosses associated with labour taxes are also likely to be greater when labour markets are lessflexible (from an efficiency‐wage perspective), a result also found to a small extent for greentaxes. This raises the possibility that undertaking structural reforms (especially in the labourmarket) would help to minimize the efficiency losses entailed by tax‐driven fiscalconsolidations.