Budget-Neutral Labor Tax Wedge Reductions: A Sumulation-Based Analysis for the Euro Area

Budget-neutral tax wedge reductions rank high in the policy agenda of several EMU member states. Using a New Keynesian DSGE model of a monetary union with a search-andmatching market structure and a fiscal bloc containing a wide range of taxes and disaggregated government spending, we evaluate the macroeconomic and welfare effects of reducing the firms' and workers' labor tax rates under alternative financing instruments. Overall, a tax wedge reduction is beneficial in terms of both welfare and output. While financing the labor tax wedge reduction by an increase in consumption taxation yields most favorable output effects, financing it by a reduction in government spending is more welfare enhancing, as the latter does not imply a policy-induced increase in private consumption costs. We also show that, when there exists an extensive and intensive labor margin, a reduction in the workers' and not the firms' burden can be most beneficial.