A Numerical Approach to Fiscal Policy, Unemployment and Growth in Europe

Abstract

Europe is faced with serious problems of slow growth and little employment creation. Are the two problems related at all? Our proposed answer is: yes, they are. Building on Daveri and Tabellini (1997), we developed an infinite-horizon model with endogenous growth due to learning-by-doing and unemployment due to monopoly union bargaining in the labor market. In this framework, high labor and capital taxes and unemployment subsidies may in principle reduce employment and growth. The model is then calibrated using actual data from a variety of countries in Continental Europe, which we identify as the closest to our toy model. We run two types of balanced-budget fiscal policy experiments, focusing on their employment and growth effects. First, we separately change tax rates on capital, labor and subsidies, as well as replacement rates, while assuming that the government budget is kept balanced by appropriate changes in lump-sum transfers. Second, we cut labor taxes and adjust capital taxes in order to keep the GDP share of lump-sum transfers unchanged. Our numerical results suggest that, in the absence of binding revenue constraints, reducing labor taxes and unemployment subsidies is beneficial to both employment and growth, while capital taxes are less useful. If revenue constraints are binding, instead, cutting labor taxes is in general ineffective in boosting employment and growth.