Pay roll taxes do not have a net negative impact on the economy

Conclusion: In this paper, a two-sector overlapping-generations model of investment in fixed capital with endogenous labor-leisure choices has been developed with the scope of reconsidering in a rich environment the causal association between payroll taxation and the main macroeconomic variables. Neoclassical closed and small-open economies with the capital- and consumption-good decomposition have been considered. The effects of the payroll tax cuts on manhours, wealth formation, and economic growth under diversified financing schemes have been at the center stage of the investigation. In understanding the relationship between labor taxes and the macroeconomic equilibrium, the article has tried to consider, in particular, the separate and possibly contrasting effects of the various fiscal components on labor supplied. Two general budgetary strategies accompanying the reductions of labor taxation have been studied, one in which the drop in the tax revenues is balanced through the compensatory reduction in government expenditure, and one in which the structure of distortionary taxation is modified in a revenue-neutral form; in each of the two general financing regimes, we have explored a variegated constellation of sub-cases. As in a two-sector life-cycle economy, the structure of demand and the financing regimes of the tax shift matter, the type of government expenditure that is compensatorily accommodated has profound implications for the consequences of the labor tax reforms; obviously, the type of distortionary taxation used to balance the government budget has strong implications too. In economies where a consumption good is produced alongside an investment good, the real price of the capital good plays a crucial role in the functioning of the economy and the sectoral transmission of payroll tax shifts; in fact, such a price accomplishes the dual role of being an asset price and therefore reconciling the asset market equilibrium, on the one side, and equilibrating the good markets, on the other. Surprisingly, we discovered that there are cases in which a payroll tax cut is an ineffective instrument to influence labor hours in the stationary state, while in general (with the only exception of a compensatory hike in capital taxation) such a shock is benign for nonhuman wealth formation. As labor supplied ultimately depends on the worker take-home wage relative to (income from) private and social wealth, the neutrality of payroll taxes for hours worked is obtained in those cases in which (income from) nonhuman wealth and the household wage change by the same proportion. Steady state neutrality is, however, always accompanied by short-run changes in labor supply, disappearing asymptotically. The cases of long-run invariance of hours worked, which depend upon the financing regime that accompanies the labor tax shift, are more likely to occur in the small-open economy than in the closed one. Some principles of public finance can be drawn from the differential payroll tax analysis of two-sector life-cycle economies. First of all, a qualitative equivalence in terms of the resource allocation between welfare entitlement and wealth tax financings of labor taxation emerges in the small-open economy. This equivalence does not hold for the closed economy, where the two types of budgetary schemes remain clearly distinct as long as the payroll tax effects are concerned. Second, government expenditure on the consumption good and consumption tax accommodations represent equivalent financing schemes in both closed and small-open economies. Third, also in the two-sector (like in the single-sector) setup, taxing nonhuman wealth in a closed economy or in a small-open economy is totally different. Hence, the macroeconomic implications of wealth tax financing differs substantially in the two cases. In fact, while in the closed economy, a labor tax cut accompanied by a hike in the wealth tax exerts adverse effects on the capital stock, nonhuman wealth and manhours, in the small-open economy such a payroll tax reduction spurs capital and nonhuman wealth formation, but is long-run immaterial for hours supplied. Furthermore, financing procedures based on public expenditure on the capital good or government labor adjustment are basically equivalent for the macroeconomic equilibrium, except for the disparate effect exerted on labor hours used in the capital-good sector. As the analysis of the paper has some limitations, it could be extended in several directions. First, our results have been obtained under the hypothesis that the capital-good-producing sector is labor-intensive. The case of a reversed assumption on sectoral factor-intensities should be investigated to detect the robustness of our findings.32 Second, we have ignored the role of government debt dynamics. This omission is particularly relevant as in our demographic setup Ricardian debt neutrality does not hold. The macroeconomic implications of a debt-financed payroll tax cut are very sensitive to the budget rules adopted to guarantee government solvency. Fiscal rules that arrest the explosion of public debt can contemplate either the automatic reduction of one type of government expenditure or the automatic increase of alternative tax rates when the issuance of debt takes place. Therefore, in our two-sector models, government debt financing of payroll tax reductions would imply several experiments according to the different solvency rules assumed. The consideration of government debt financing would be an important extension of the paper analysis. Third, as the rise in payroll taxes in many European countries in the last decades has been the result of population ageing (which led to the expansion of the social security systems, mainly organized on a “pay-as-you-go” basis), a life-cycle model with retirement would be required to properly discuss the macroeconomic implications of pension reforms aimed at alleviating the tax burden on labor. Unfortunately the Blanchard–Yaari model does not consider retirement; however, it could be easily amended to incorporate mandatory retirement, as done in Hoon and Phelps (2004). Finally, there is another important extension of our two-sector analysis that is worth exploring: the case of a labor market with structural unemployment. This modification, which is interesting per se for reconsidering all the experiments discussed in the paper, has also the advantage of making it possible to investigate in a dynamic general equilibrium context payroll tax cuts financed by reductions in unemployment benefits. Such a proposal for reforming the welfare state, largely debated in academic and political circles, has been mainly discussed through partial equilibrium frameworks.33