DP4896 Rolling Back the Public Sector - Differential Effects on Unemployment, Investment and Growth

Author(s): Frederick van der Ploeg
Publication Date: February 2005
Keyword(s): fiscal retrenchment, growth, investment, labour market, public employment
JEL(s): D90, E20, E60, H30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4896

The macroeconomic effects of different ways of rolling back the welfare state are analysed. Cutting public spending on market goods induces a lower interest rate, a higher wage, a lower capital stock and a fall in employment. Cutting public employment or the labour income tax rate leads, in contrast, to a lower wage, a higher interest rate and a higher capital stock. Employment rises on impact. If the extra revenues of rolling back the welfare state are handed back via a lower tax rate rather than a lump-sum subsidy, both cutting public employment and cutting public spending on market goods induce an investment boom. Making the tax system less progressive by cutting tax credits and the labour income tax rate induces an investment boom as well. The effects of endogenous growth, adjustment costs for investment and non-Walrasian labour markets on these results are considered as well.