Working Paper: CEPR ID: DP4896
Authors: Frederick van der Ploeg
Abstract: The macroeconomic effects of different ways of rolling back the welfare state are analysed. Cutting public spending on market goods induces a lower interest rate, a higher wage, a lower capital stock and a fall in employment. Cutting public employment or the labour income tax rate leads, in contrast, to a lower wage, a higher interest rate and a higher capital stock. Employment rises on impact. If the extra revenues of rolling back the welfare state are handed back via a lower tax rate rather than a lump-sum subsidy, both cutting public employment and cutting public spending on market goods induce an investment boom. Making the tax system less progressive by cutting tax credits and the labour income tax rate induces an investment boom as well. The effects of endogenous growth, adjustment costs for investment and non-Walrasian labour markets on these results are considered as well.
Keywords: Fiscal retrenchment; Growth; Investment; Labour market; Public employment
JEL Codes: D90; E20; E60; H30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cutting public spending on market goods (H40) | lower interest rate (E43) |
| cutting public spending on market goods (H40) | higher wage (J31) |
| cutting public spending on market goods (H40) | lower capital stock (E22) |
| cutting public spending on market goods (H40) | fall in employment (J63) |
| cutting public employment (J45) | lower wage (J31) |
| cutting public employment (J45) | higher interest rate (E43) |
| cutting public employment (J45) | higher capital stock (E22) |
| cutting public employment (J45) | increase in employment (J68) |
| lower tax rate from rolling back welfare state (H29) | investment boom (E22) |
| cutting public employment and cutting public spending on market goods (J45) | investment boom (E22) |
| cutting tax credits and labor income tax rate (H31) | investment boom (E22) |
| fall in public employment (J68) | rise in private wealth (D31) |
| rise in private wealth (D31) | increase in private saving (D14) |
| increase in private saving (D14) | increase in investment (E22) |
| excess labor released from public sector (J45) | push up wages (J39) |
| excess labor released from public sector (J45) | lower interest rate (E43) |
| push up wages (J39) | reduce saving (E21) |
| reduce saving (E21) | lower capital stock (E22) |