Working Paper: NBER ID: w9349
Authors: Wouter J. Den Haan
Abstract: This paper develops a model with multiple steady states (low tax and low unemployment versus high tax and high unemployment) in which equilibrium selection is not conditioned on a sunspot variable. Instead, large temporary shocks initiate unavoidable transitions from one steady state to another. Tax policies have huge effects in some cases. In particular, it is possible that the transition to the high-unemployment steady state after a negative shock can be avoided if the government borrows to finance unemployment benefits, and in some cases it is even possible that a credible permanent tax cut would force the economy out of the high-unemployment steady state. The model is used to explain the high European unemployment rates in the 80's and 90's. The paper argues that the increase in unemployment during the 70's played a key role because it led to an increase in the obligation to pay unemployment benefits. The implied tax burden was so big that the transition to the highunemployment regime was the unique equilibrium outcome.
Keywords: No keywords provided
JEL Codes: D50; C62; E24; E62; J64
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large temporary shocks (E32) | transition from low-unemployment steady state to high-unemployment steady state (J64) |
| increased unemployment (J65) | higher government liabilities for unemployment benefits (J65) |
| higher government liabilities for unemployment benefits (J65) | higher tax burdens (H22) |
| higher tax burdens (H22) | exacerbate transition to high unemployment (J64) |
| borrowing to finance unemployment benefits (J65) | avoid transition to high unemployment (J68) |
| credible permanent tax cut (H29) | force economy out of high-unemployment regime (E69) |