Equilibrium Effects of Payroll Tax Reductions and Optimal Policy Design

Abstract

We quantify the unintended effects of a low-wage payroll tax reduction using an equilibrium search model featuring bargaining, worker and firm productivity heterogeneity, labor taxes, and a minimum wage. The decentralized economy is inefficient due to search externalities and labor market policies. We estimate the model using French data and find that a significant reduction in low-wage payroll taxes in 1995 leads to an overall improvement in economic efficiency by increasing employment and correcting existing policy distortions that disincentivize labor force participation. However, the tax reduction, by increasing labor force participation among low-productivity workers and vacancy postings by low-productivity firms, results in negative but minor spillover and reallocation effects due to congestion. We find that the optimal policy mix is a lower minimum wage and lower payroll taxes compared to the policies in place in the early 1990s.