Labour market responses to taxes: a structural approach

Department(s)/ Research Infrastructure
Public Economics
Project Status
Current Project
Project Duration
since/from 2015 to 2017
Funded by
In Cooperation with
Thomas Breda (Institut des Politiques Publiques & Paris School of Economics),
Haomin Wang (Institut des Politiques Publiques & Paris School of Economics)
Henrike Junge (DIW)
Jan Hackforth (DIW)
Project Team/Contacts at DIW Berlin

We propose to investigate the long-run impact of taxes on employment, working hours and wages, contrasting these key labour market outcomes in France and Germany. Few studies have considered these margins jointly when assessing tax incidence. In order to do so, we offer to develop a realistic equilibrium model that draws on the most recent contributions in the microeconomic job search literature. It includes frictions (workers and firms do not match instantly), a wage-setting mechanism with bargaining, transitions from unemployment to employment, as well as job-to-job transitions. So far taxes have not been included in these state-of-the-art models, despite their quantitative importance and policy debates on their incidence. The key value-added of the model is to allow us to study jointly the responses of employment, working hours and wages to tax changes, while the standard partial equilibrium approaches are forced to shut down (at least) one of those responses to study the other ones.

The model also offers a natural tool to study together all types of labour market taxes: income tax, corporate tax, payroll taxes and social security contributions. We propose to use within-country variation in tax rates (across time and regions) to estimate the model. The structural model we put forward allows not only a joint estimation of tax effects on the labour market, but also a simulation of potential tax reforms and their welfare effects for different individuals. To this end, we allow individuals to differ in unobserved ability and firms to differ according to unobserved productivity. Since it does not assume that workers in different firms are similar, the model is able to capture the idea that if taxes affect only certain firms, they may also affect only certain types of workers. Using the specific estimated parameters for each country, we can illustrate the importance of taxes in explaining different labour market outcomes in France and Germany. Finally, we discuss potential labour tax reforms and characterize welfare-enhancing tax policies.