Labour Economics
Fiscal effectiveness

There is widespread agreement that the harmonization of European fiscal systems will entail serious problems, particularly concerning direct taxes, which will largely depend on existing differences between countries' effective tax rates and structures. In Discussion Paper No. 587, Research Fellow Fiorella Padoa Schioppa Kostoris compares the effective tax rates and structures of ten European countries during 1960-88. Direct taxation is the sum of the (approximately flat) employees' social security contribution and (progressive) personal income tax. The effective progressivity of direct taxation is therefore not observable for most of the years and countries studied; the various tax systems may also be very heterogeneous in terms of de facto fiscal indexation, which is again not immediately observable.
Padoa Schioppa Kostoris develops a theoretical model to identify the average taxpayer's effective marginal tax rate and the progressivity and de facto indexation of direct taxation systems, which she tests on the chosen data-set. Her estimates show that the progressivity of direct taxation declined in the 1980s in all the countries except Denmark, Spain and Sweden, and it approached zero in some small open economies. Fiscal indexation has also been widely adopted de facto in the last decade, even though it remains legally prohibited in some countries.
Padoa Schioppa Kostoris also calculates the coefficients of variation of effective social security contributions, indirect tax rates, the tax wedge, average and estimated marginal direct tax rates and the progressivity of direct taxation over time. These indicate that fiscal harmonization is more difficult for direct taxes than for some other forms of taxation because of compensating differences in tax structures. Fiscal harmonization does not seem to be an unrealistic, Utopian goal for Europe in the 1990s, however, since the various countries' effective tax rates and structures appear to have been much closer in the late 1980s than ever before.
In Discussion Paper No. 588, Padoa Schioppa Kostoris derives a macroeconomic model of union wage setting and tests it on data for nine European countries, assuming initially that all tax rates are flat. If the weight the union assigns to employment relative to the net real wage is fixed and independent of fiscal policy, workers bear the consequences of employers' increased social security contributions through reduced nominal wages and rising taxation; the `compensation effect' is then zero. If this weight depends only on the net real wage, however, the employer bears the whole of any increase in the tax wedge, and the compensation effect is positive. If it is also negatively related to the net real reservation wage, a reduction in the latter exerts downward pressure on the target net real wage.
When the union cares about `relativities', increased unemployment implies a lower net real reservation wage and hence a lower net real wage target; while for a given labour supply, any increase in the tax wedge reduces the compensation effect, to the point that it may even be negative. Padoa Schioppa Kostoris then examines the effects of relaxing the assumption of a flat income tax rate. If the relative weight the union assigns to employment depends only on the net real wage, income tax progressivity enhances the relative desirability of employment and reduces the gross wage target; the `progressivity effect' is negative. If this weight also depends negatively on the net real reservation wage, however, this effect can be zero or even positive: higher direct tax progressivity reduces the gap between the net real reservation and net real wages, and the union raises its gross wage target.
Tests of the model on 1960-88 data for nine European countries yield three main results. First, small open economies such as Austria, Denmark and the Netherlands have negligible compensation and progressivity effects and maintain external competitiveness by fixing a real labour cost target independently of tax rates. Second, most larger and less open economies transfer increases in indirect taxation and social security contributions on to the real labour cost in the long run: an increase in the direct tax rate raises the gross real wage. Third, in all the countries considered, tax shifting on to real labour costs reduced in the late 1970s/early 1980s; a change in union attitudes was usually accompanied by the introduction of de facto fiscal indexation and a reduction in tax progressivity. Padoa Schioppa Kostoris concludes from these results that the validity of the tax-push hypothesis does indeed vary significantly across countries and periods and according to the fiscal policies they pursue.

Tax Rates, Progressivity and de facto Fiscal Indexation in Ten European Countries
A Cross-Country Analysis of the Tax-Push Hypothesis
Fiorella Padoa Schioppa Kostoris

Discussion Papers Nos. 587-8, October 1991 (HR)