Strategic fiscal policies in Europe: Why does the labour wedge matter?

• Published in: European economic review Vol. 91; pp. 15 - 29
• Main Authors: Langot, François, Lemoine, Matthieu
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01-01-2017; Elsevier
• Subjects: Economics and Finance; General equilibrium model; Humanities and Social Sciences; International trade; Labour wedge; Optimal taxation; D51; International trade; Optimal taxation; F42; H21; Labour wedge; General equilibrium model
• ISSN: 0014-2921; 1873-572X
• DOI: 10.1016/j.euroecorev.2016.09.005

Most European countries suffer from a structural weakness in employment and competitiveness. Can an optimal tax system reinforce European countries in this respect? In this paper, we show that fiscal competition can be a welfare improving second best solution if the labour wedge is sufficiently large. Indeed, a sufficiently large labour wedge calls for an expansion of the production set in both countries, thus increasing global opportunities. For a small labour wedge, this would not be the case, because the terms-of-trade externality would call for a fiscal policy that exacerbates a non-cooperative behaviour between countries. In a two-country world, we show that the symmetric Nash equilibrium can be Pareto-efficient, if employment subsidies are financed by a consumption tax. This is not the case when the former are financed by tariffs.