Unemployment, growth and taxation in industrial countries

To the layman, the upward trend in European unemployment is related to the slowdown of economic growth. We argue that the layman's view is correct. Th e increase in European unemployment and the slowdown in economic growth are related, because they stem from a common cause: an excessively rapid growt h in the cost of labour. In Europe, labour costs have gone up for many reas ons, but one is particularly easy to identify: higher taxes on labour. If w ages are set by strong and decentralized trade unions, an increase in labou r taxes is shifted onto higher real wages. This has two effects. First, it reduces labour demand, and thus creates unemployment. Secondly, as firms su bstitute capital for labour, the marginal product of capital falls; over lo ng periods of time, this in turn diminishes the incentive to invest and to grow. The data strongly support this view. According to our estimates, the observed rise of 14 percentage points in labour tax rates between 1965 and 1995 in the EU could account for a rise in EU unemployment of roughly 4 per centage points, a reduction of the investment share of output of about abou t 3 percentage points, and a growth slowdown of about 0.4 percentage points a year.