European Economic Perspectives 22

Go Dutch

Policy-makers in the Netherlands are using tax reforms to cut unemployment, stimulate labour supply and still maintain an equitable distribution of income. MIMIC, a model of the Dutch economy, helps them make the trade-offs between these objectives and evaluate which policies will be most effective.

High unemployment is widespread across Europe, especially among the unskilled. At the same time, an ageing population and the low labour force participation of women and the elderly in many European countries imply that the increasing burden of social insurance benefits must be financed by a shrinking pool of workers.

Many solutions have been proposed to these twin problems of high unskilled unemployment and low labour supply. The most drastic ones involve slashing social benefits and minimum wages, but there are others less damaging to the incomes of the low paid and people dependent on benefits. Proposals for fighting unemployment include cutting taxes on low-skilled work, introducing wage subsidies for the long-term unemployed and providing in-work tax benefits. Proposals for raising the quality and quantity of labour supply include cutting marginal tax rates, reducing tax benefits for households where one partner does not participate in the labour force and lowering early retirement benefits.

In a recent CEPR Discussion Paper, Lans Bovenberg, Johan Graafland and Ruud de Mooij use an applied general equilibrium model of the Dutch economy, known as MIMIC, to explore the likely impact of these policies. MIMIC has been developed at CPB Netherlands Bureau for Economic Policy Analysis to help policy-makers investigate the labour market implications of changes in the systems of taxation and social insurance. It combines a rich theoretical framework based on modern economic analysis of labour market imperfections with strong empirical foundations and an elaborate description of the actual tax and social insurance systems in the Netherlands. The institutional detail makes the model especially relevant for policy-making and MIMIC has been used extensively by the Dutch government in designing recent proposals for tax reform.

The simulations Bovenberg and his colleagues have conducted with MIMIC clarify the trade-offs between the various objectives of government policy: reducing unemployment, especially for the unskilled; encouraging the participation of women in the labour force; raising the quality and quantity of labour supply; and maintaining an equitable income distribution. For example, they find that raising the quantity and quality of labour supply calls for lower marginal tax rates, thereby widening the income differentials between low and high labour incomes. But lower marginal tax rates are less effective in reducing unemployment, raising unskilled employment and stimulating female labour supply.

One key to cutting unemployment lies in widening the gap between labour incomes and transfer incomes in unemployment. This may be accomplished through in-work tax benefits, which raise the reward to work compared with relying on social benefits. MIMIC reveals that these tax benefits can reduce unemployment significantly by moderating wage costs and encouraging the unemployed to search more intensively for jobs.

In-work benefits can become even more effective at reducing unemployment if they are targeted at unskilled workers, since the gap between labour income and transfer income is smallest for these workers. Targeting in-work benefits at those with low labour incomes also substantially reduces the tax burden on small part-time jobs, hence encouraging non-participating partners to find work and boosting the participation rate (measured in numbers of people).

But targeting also implies an increase in the marginal tax rate in the income range where in-work benefits are phased out. This adversely affects labour supply measured in hours. The costs and benefits of targeting can be illustrated with the effects of an Earned Income Tax Credit (EITC) simulated by MIMIC. This EITC amounts to 4% of annual labour income phased in up to the statutory minimum wage and phased out between 120% and 180% of the minimum wage.

MIMIC indicates that this policy is effective in cutting unemployment, especially among the unskilled and in raising female participation in the labour force. But breadwinners and single people reduce their labour supply in the face of the EITC, in part due to the higher marginal tax rate in the phase-out range. On balance, the reduction in labour supply dominates the positive effect on the participation rate of partners. Hence, aggregate labour supply measured in hours drops.

Targeting the EITC reveals a trade-off between the goals of raising labour supply (measured in hours) and fighting unemployment. That trade-off can be mitigated by linking the EITC to hourly wages rather than annual incomes. In its white paper on tax reform, the Dutch government suggested just such a policy: workers who earn the hourly minimum wage and hold a full-time job are eligible for the full EITC, but the credit is reduced proportionally for workers who work less than a full-time job.

Comparing an EITC that depends on annual incomes and one that depends on hourly wages indicates another trade-off, that between increasing the participation rate of partners and reducing the rate of unskilled unemployment. The latter kind of EITC is more effective in cutting unskilled unemployment because, with the same budget for tax relief, more tax benefits can be provided to full-time workers with low hourly wages. As less benefits accrue to small part-time jobs with hourly wages above the minimum wage, the instrument is less effective in raising the labour force participation of women.

There is a further EITC-related trade-off between the quality and quantity of labour supply. Compared with an EITC that depends on annual incomes, an EITC that depends on hourly wages enhances the quantity of labour supply in hours because additional hours do not reduce the credit. But the latter also does more serious harm to the quality of labour (in terms of human capital) since the marginal tax rate on a higher hourly wage increases more substantially, thus damaging the incentives for training.

An alternative instrument for fighting long-term unemployment is a marginal labour subsidy. MIMIC simulations indicate that hiring subsidies for the long-term unemployed are effective in fighting unskilled unemployment. Moreover, in contrast to the targeted EITC, such subsidies do not raise the marginal tax rate. Accordingly, they neither reduce labour supply nor harm the incentives to accumulate human capital. Instead, the long-term unemployed who find jobs are able to restore some of the human capital they lost during prolonged unemployment.

But despite the substantial decline in unskilled unemployment that these subsidies will bring, according to MIMIC, a hiring subsidy does not pay for itself. This is primarily because of the large dispersion in the productivity distribution of the long-term unemployed, which implies that only relatively small numbers of the long-term unemployed become employable through the subsidy. In addition, some of the long-term unemployed would have found jobs without the subsidy. They also crowd out some job opportunities for the short-term unemployed.

Bovenberg and his colleagues conclude that while the Dutch tax reforms are showing some success, there are no magic solutions: no single policy can combat unskilled unemployment, stimulate female labour force participation and raise the quality and quantity of labour supply. Governments must set priorities among their objectives when deciding whether to cut marginal tax rates, widen the income gap between after-tax unskilled wages and unemployment benefits and reduce the tax burden on small part-time jobs.

This article reviews research reported in ‘Tax Reform and the Dutch Labour Market: An Applied General Equilibrium Approach’ by Lans Bovenberg, Johan Graafland and Ruud de Mooij, CEPR Discussion Paper No. 1983 (September 1998). Bovenberg is at Tilburg University and a Research Fellow in CEPR’s Financial Economics, International Macroeconomics and Public Policy programmes; Graafland and de Mooij are at CPB Netherlands Bureau for Economic Policy Analysis.

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