Essays on the Macroeconomic Effects of Taxation

This dissertation examines the effect of labour and consumption taxes on economic performance and distributional issues. To study these, I first use a Keynesian-type macroeconometric model whereas in the second and third essay I use a dynamic general equilibrium model with heterogeneous agents. In the first essay, I examine the effect of labour taxation on employment and growth. I also analyze the effect of other fiscal policy instruments, e.g. the effect of public spending. The focus here is on the fiscal policy shocks that are balanced for the government budget. The analysis will be performed with a macroeconomic model (EMMA) developed at the Labour Institute for Economic Research. The model is Keynesian in the short run but the long-run steady state of the model is determined by the supply side of the economy. The parameters of the model are mostly estimated from the Finnish macro data. The study finds that a one percentage point decrease in the income tax rate which is financed by increasing government debt improves GDP by 0.58 and employment by 0.25 per cent in the long run. Also, a one percentage point decrease in the income tax rate which is neutralized for the government budget by reducing public purchases produces a long-run increase in GDP and employment of a similar magnitude, even though its short-run effect on both variables is negative. The second essay analyzes the effects of tax reform that shifts tax burden from labour to consumption. This also implies that we need to deal with the issue of progressivity of labour taxes. Even though this kind of tax policy change has recently gained popularity, its positive effects are debatable while the offsetting effect of a consumption tax on labour supply makes the net output change rather ambiguous. In order to examine these issues, I build a dynamic general equilibrium model with heterogeneous agents. The model is calibrated to fit certain characteristics of the Finnish economy, especially labour market features, using both micro and macro data. In addition to output and employment effects, I am particularly interested in the tax reform’s effect on income and wealth distribution. First, I find that eliminating progressivity in labour taxation increases output via increase in capital accumulation that comes, however, in expense of slightly more inequality. Then, tax reform that replaces progressive labour taxes with a flat-rate consumption tax leads to a significant rise in capital accumulation, a negligible change in labour supply and gross labour income distribution, but a relatively considerable increase in wealth concentration. In the third essay, I examine the distributional and employment effects of the Finnish labour tax changes in the period 1996-2008. The motivation for the topic comes from the following. The labour income taxes in Finland decreased considerably during the period 1996-2008. At the same time the Finnish economy grew rapidly. Nevertheless, there was another coincidental trend in this period: a rapid rise in inequality. The rise in inequality was particularly fast also when compared internationally, as noted by OECD in its two reports. Thus, the study aims to answer to what extent labour income tax reductions between 1996 and 2008 contributed to this trend in inequality. The study also examines how much more employment was achieved owing to the labour tax reforms. To answer these questions, I have built a dynamic general equilibrium model with heterogeneous agents. The model has been calibrated to fit the Finnish economy. The model is based on the similar framework as the model used in the second essay of the dissertation but the progressive taxes are now explicitly included in the model structure. The study finds that the labour income tax cuts fractionally raised the Gini coefficient for net labour income. They also increased the concentration of wealth. The employment gains due to the reforms have been modest, but nevertheless significant.