Structural Tax Reform and the Cyclical Behaviour of the Labour Market

Abstract

In this study, we quantitatively examine the consequences of structural tax reform in a real business cycle model with frictional unemployment and distor- tionary tax rates which are increasing in taxable labour income. The parameters of the labour tax schedule are estimated using U.S. data. We find that the cycli- cal implications of a reduction in the progressivity of the tax system critically depend on whether agents internalise the effects of their actions on the marginal tax rate. Hours per worker unambiguously become more volatile upon the removal of tax progressivity but unemployment fluctuations become more volatile only when agents do not internalise the slope of the tax schedule. Labour market instability therefore need not necessarily constitute a cost of tax reform to policy authorities who care about macroeconomic stability. The consequences of tax reform for expansionary fiscal stimulus are also considered.