Equilibrium unemployment Unemployment and stability Albert van der Horst CPB, The Hague October 29, 2003

Equilibrium unemployment Just a minute  European comparative analysis ► EU enlargement (immigration) ► Tax competition in the European Union ► Regional policy (geographical economics) ► European labor markets ► Competition and harmonization in Europe (a Level Playing Field)  Workshop ► Stability and growth pact (January 9, 2004)

Equilibrium unemployment Outline  Equilibrium unemployment ► our approach ► in Europe ► & structural growth ► versus the EC approach ► & stability and growth pact

Equilibrium unemployment Stable?

Equilibrium unemployment Equilibrium  Equilibrium is central in economic theory ► equilibrium = where we go ► today = where we come from  Unemployment is a persistent phenomenon ► demand = supply fails ► short-run imperfections are insufficient ► seems to be a stable equilibrium

Equilibrium unemployment L W Wage curve Labor demand Labor supply -- u --

Equilibrium unemployment Wage negotiations  Firms prefer low labor income share ► opt for low wages  Workers prefer high wage income ► take into account that unemployment leads to a reduction in income  Negotiations ► => tax shifting & sharing ► role of benefits (replacement rate)

Equilibrium unemployment Wage equation TaxRRw(min)u(-1)Stationary France00,140,25-0,79yes Germany0,730-2,10yes The Netherlands0,130,75-1,07yes Spain0,210,25-0,68yes United Kingdom0,200,05-0,79yes United States0-0,40no

Equilibrium unemployment Labor demand  Firms maximize profits ► Higher wages reduce profits ► Reduction in employment improves profits  Substitution between labor and capital

Equilibrium unemployment  Equilibrium unemployment rate depends on: ► Tax wedge ► Benefits ► Minimum wage rate ► Interest rate

Equilibrium unemployment France and Germany

Equilibrium unemployment The Netherlands and Spain

Equilibrium unemployment United Kingdom

Equilibrium unemployment Labor tax and unemployment  Higher labor tax (1% GDP) ► raises equilibrium unemployment immediately ► raises actual unemployment gradually Jade simulation

Equilibrium unemployment Labor tax and growth  A tax increase ► reduces structural GDP immediately ► reduces actual production gradually ► creates positive output gap (dotted line) Jade simulation

Equilibrium unemployment Structural growth  Y * depends on ► Labor supply ► Labor productivity ► Equilibrium unemployment CPBEC LSLS ProjectionHP filter Y/LHP filter U*U* ‘Equilibrium’‘NAIRU’

Equilibrium unemployment EC Nairu  Alternative approach by the European Commission ► trend estimate ► depend on change in inflation rate ► backward looking

Equilibrium unemployment Labor tax and unemployment (2)  Higher labor tax (1% GDP) ► raises actual unemployment gradually ► raises equilibrium unemployment gradually, but even before the implementation date

Equilibrium unemployment Labor tax and growth (2)  A tax increase ► reduces structural GDP gradually ► reduces actual production gradually ► slightly positive output gap initially (dotted line)

Equilibrium unemployment Meet the EMU-norm  What if a country proposes the EC to improve its budget by raising its labor tax rate (by 1% GDP)  Choice 1: does the EC take negative growth effects into account?  If yes, how? 1) Structural approach: ΔEMU < 1% GDP Positive output gap: ΔEMU(structural) < ΔEMU 2) EC approach ΔEMU < 1% GDP Small output gap: ΔEMU(structural) ≈ ΔEMU

Equilibrium unemployment Towards SGP  The impact of tax changes differ between countries  It is therefore suboptimal to opt for a single fiscal regime