Working Paper: CEPR ID: DP5431
Authors: Nikola Bokany; Andrew Hughes Hallett
Abstract: It is widely accepted that in order to improve the economic position of the EU relative to the USA certain structural reforms need to be undertaken, mainly in the labour market. However few EU countries have undertaken such reforms. The reason lies in the fact that those reforms are going to be costly in terms of economic performance, unemployment and hence the cost of financing them - at least in the short term. Blanchard and Giavazzi (2003) develop a model based on imperfect competition in both product and labour markets in order to show the impact of deregulation on the economy. However they do not consider the question of how to finance such reforms or overcome the short run costs, a key consideration if the short run costs are large relative to the long run gains. We extend their model by including the effects of another inevitable source of imperfections: distortionary taxation - not only the most likely candidate for reform, but also the most likely instrument for financing the restructuring process. By extending the model in this way we can establish formally that reforms imply significant short run costs as well as long run gains; that (political opposition apart) the financing of such reforms will be the main stumbling block. We come to a number of conclusions which reverse the Blanchard and Giavazzi results; and find that, in addition, the composition of the reform package matters, as does the distribution of the tax burden. This model therefore supplies new results on the design and sequencing of reforms.
Keywords: structural reform; wage bargains; short vs long runs; substitutability
JEL Codes: J58; H23; E24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| structural reforms (E69) | significant short run costs (D24) |
| significant short run costs (D24) | likelihood of reform implementation (D78) |
| fiscal discipline (E62) | difficulty of undertaking structural reforms (E69) |
| distribution of the tax burden (H22) | incentives for reform (E69) |
| structure of taxation (H20) | success of reform efforts (P11) |
| taxation and market regulation (G18) | outcomes of structural reforms (E69) |