The major source of this problem was the rise in effective tax rates on labour income, the average rate of which had increased by about 10% between 1965–75 and 1976–91. This could account for a 4% increase in European unemployment, and for a reduction in the EU growth rate of about 0.4 percentage points a year. In Tabellini’s view, therefore, one of the main challenges currently faced by the European Union was to moderate the overall level of taxation and particularly taxes on labour.

Tabellini’s finding that unemployment and the slowdown in growth were related stemmed from the identification of a common cause, namely an excessively high cost of labour. If labour markets are non-competitive, an exogenous increase in labour costs has two effects. It reduces labour demand, thus creating unemployment; and, as firms substitute capital for labour, the rate of return on capital falls over long periods of time. This, in turn, diminishes the incentive to accumulate and thus to grow.

European labour costs had gone up for many reasons, but one was particularly easy to identify: higher taxes on labour. In competitive labour markets, nothing much would happen if taxes went up. The low elasticity of individual labour supply implies that the burden of a tax on labour income would be borne almost entirely by the worker, with little effect on unemployment or on the capital-labour ratio. But if workers are organized in monopolistic unions, then labour taxes are much more distorting. The reason is that unions can succeed in shifting the burden of labour taxes onto firms. In this case, a rise in labour taxes would increase unemployment, increase the capital-labour ratio, and reduce long run growth. Thus, the consequences of labour taxes depend very much on the character of labour-market institutions.

Continental Europe fares very poorly on both counts. Labour markets are highly unionized; and labour taxes have increased substantially. Little wonder, therefore, that unemployment has increased so much and growth has slowed down. In some recent joint research with Francesco Daveri (Universitá di Brescia), Tabellini had made this argument more precise, by testing its validity against the evidence from a panel of 14 OECD countries – some European, some not – over the period 1965–91. The difference between Continental Europe and the other industrial countries had been striking in three respects.

First, Tabellini and Daveri had found a large positive correlation between labour taxes and unemployment in Europe, but not elsewhere. Second, there was strong evidence that higher labour taxes were indeed shifted onto higher gross wages in Europe but again not elsewhere. Third, there had been a much bigger surge in the capital-labour ratio in Europe than in other industrial countries. IMF estimates, for example, suggested that, between 1970 and 1995, the capital-labour ratio had more than doubled in the European Union, whereas it had risen only by 25% in
the United States.

These results had provided the basis for estimating the costs, in terms of reduced growth and higher unemployment, occasioned by higher labour taxes in Europe. The policy implications of these conclusions were straightforward, but highly relevant. In a world with monopolistic trade unions, labour taxes can be as distorting and harmful to growth as capital taxes. Hence the need for moderating the overall tax burden, but especially the burden on labour.