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The World Economy

The World Economy (2009)


doi: 10.1111/j.1467-9701.2009.01211.x

Corporate Tax Policy and


Unemployment in Europe:
An Applied General Equilibrium
Analysis
Leon Bettendorf 1, Albert van der Horst2 and Ruud A. de Mooij3
1

Erasmus University Rotterdam, Tinbergen Institute and CPB, 2CPB Netherlands Bureau
for Economic Policy Analysis and 3Erasmus University Rotterdam, CPB, Tinbergen Institute,
Netspar and CESifo

1. INTRODUCTION

ESEARCH on corporate taxation and research on unemployment are two


very distinct fields. On the one hand, several studies have tried to explain
the high and persistent levels of unemployment in Europe on the basis of distortive institutions (see e.g. Nickell et al., 2005). On the other hand, there has
emerged a large literature on corporate taxation, focusing on distortions in
investment, location and international profit shifting (see e.g. Srensen, 2006).
There is only little research, however, on the labour market implications of corporate taxation, and virtually no papers on corporate taxes and unemployment.
Yet, corporate taxes may well contribute to involuntary unemployment through
their impact on labour demand. This paper aims to fill this gap in the literature
by analysing the impact of corporate taxation on unemployment in the context
of an imperfect labour market model.
Previous studies that have analysed the relationship between corporate taxes
and employment have typically assumed a perfect labour market. For instance,
Gordon (1986) explores corporate taxation in a model where capital is mobile
internationally while labour is not. The open economy is small and takes the
world interest rate as given. The corporate tax raises the cost of capital, which
reduces capital demand. Given the exogenous after-tax rate of return to capital,

The authors would like to thank an anonymous referee for suggestions to improve the paper.
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workers suffer from this because less capital reduces the marginal product of
labour and, therefore, the before-tax wage. Consequently, the incidence of the
corporate income tax falls on labour. As the labour market clears, the corporate
tax only distorts labour supply.
Phelps (1994) has emphasised the role of the real interest rate in explaining
equilibrium unemployment. A higher interest rate is expected to shift the labour
demand curve inwards, thereby contributing to Europes unemployment problem. Broer et al. (2000) and van der Horst (2003) have taken up this idea and
empirically analyse the impact of the real interest rate on the equilibrium rate
of unemployment in a number of European countries. Their results suggest that
this is indeed important. Although these papers have not explicitly dealt with
corporate taxation, their results imply that an increase in the cost of capital
matters for unemployment.1
This paper analyses the relationship between corporate taxation and unemployment in an applied general equilibrium model for the European Union,
called CORTAX, that is designed for analysing corporate tax policies. This
framework allows for a detailed analysis of the channels in which corporate
taxation affects unemployment and how the imperfection on the labour market
influences the rest of the economy (like consumption, investment, production
and welfare). The second issue is the classification of countries for which the
relation between corporate taxes and unemployment is relatively strong or
weak; on what country characteristics does this relationship depend? The third
question we investigate in this paper is how corporate tax differs in its impact
on unemployment from alternative taxes on labour income or consumption.
The applied general equilibrium model adopts a union bargaining framework to explain equilibrium unemployment on the basis of several institutional variables. The CORTAX model encompasses various distortions of
corporate taxation, including the marginal investment distortions, international
spillovers from foreign direct investment and profit shifting by multinationals,
and distortions in the financial structure of companies.2 The model is inspired
by the OECDTAX model developed by Srensen (2001). That model has been
used for the welfare analysis of corporate tax reform and corporate tax
harmonisation in Europe and the OECD (see Srensen, 2001, 2002, 2004a,
2004b). OECDTAX also contains an imperfect labour market. However, compared to the analyses presented by Srensen, we focus more on labour market

1
In their empirical analysis of the impact of taxation on unemployment, Daveri and Tabellini
(2000) find that labour taxes partly explain high unemployment rates, whereas consumption taxes
exert no significant effect. Corporate taxes are not included in their regressions.
2
A previous version of CORTAX has been used to explore the welfare effects of tax rate competition and tax base consolidation in the EU; see Bettendorf et al. (2006) and van der Horst et al.
(2007). That version of CORTAX does not contain imperfections on the labour market.

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performance and unemployment and the precise mechanisms that drive these
impacts.
On an imperfect labour market, a reduction in the demand for labour caused
by an increase in corporate taxes will not be fully accompanied by a reduction
in labour supply. Indeed, labour unions will resist the reduction in wages
needed to equate labour supply and demand. Country variation in the sensitivity of unemployment to corporate taxation depends on the initial distortiveness
of the corporate tax system high distortions will be aggravated and lead to a
strong unemployment response and on the openness of the economy in a
quite complicated way. Multinationals may respond to a higher corporate tax
by means of profit shifting or FDI. Profit shifting will become less attractive in
low-tax countries (raising their tax rate unilaterally) multinationals will
respond by reducing FDI which exerts an upward pressure on unemployment.
Multinationals in high-tax countries will optimally employ the profit-shifting
opportunities, which implies that the FDI and unemployment response in open,
high-tax countries will be limited. Finally, the paper shows that in comparison
with labour income and consumption taxes, corporate taxes will be less harmful
for unemployment but exert a larger welfare loss.
Our analysis is closely related to the recent theoretical contribution by
Keuschnigg (2008). He investigates the impact of corporate taxation on the
welfare state, with labour market imperfections stemming from search frictions
and wage bargaining. He argues that it is unlikely that the corporate tax can be
used to finance an advanced welfare state as it worsens the overall fiscal stance
by increasing unemployment. We confirm the link between corporate taxation
and unemployment, in an applied framework for 17 European economies.
The analysis of this paper may have important policy implications. For
instance, to the extent that increases in the cost of capital contribute to high
structural unemployment rates, European countries may find it attractive to
pursue policies that reduce taxes at the margin of new investment. Recent
developments in European corporate tax policy, however, suggest that a number of countries have been reducing their corporate tax rates along with a
broadening of their tax bases perhaps in response to the forces of tax competition. Such policies have raised, rather than reduced, marginal effective tax
rates. Indeed, computations of marginal effective tax rates by the Institute for
Fiscal Studies reveal that the cost of capital has increased during the past
decade in Finland, Spain and Italy. By raising the cost of capital, tax competition may have contributed to the high structural unemployment problems in
these countries.
The rest of this paper is organised as follows. Section 2 discusses the main
properties of the CORTAX model. Section 3 shows simulations with CORTAX
on corporate tax policies. Finally, Section 4 concludes.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ


2. CORTAX: AN AGE MODEL FOR THE EU

CORTAX is an applied general equilibrium model for the European Union


designed for simulating corporate tax policies.3 The model is inspired by the
OECDTAX model of Srensen (2001). CORTAX contains 17 EU countries:
the 15 old member states (with Belgium and Luxembourg joined) and the three
largest new member states (Czech Republic, Hungary and Poland). In this section, we discuss the features of CORTAX in more detail. Technical details are
provided in Appendix A.
a. Households
Following the standard overlapping-generations model of Diamond, households are assumed to live for two periods.4 Household decisions on consumption and leisure are derived from the maximisation of lifetime utility. An
individual only supplies labour when young (i.e. the first period), taking into
account that he will be unemployed for a fraction of his time. Young households receive wage income (after taxes), unemployment benefits and lump-sum
transfers. This income is allocated over consumption (including taxes) and
savings. Savings are invested in a mix of bonds and stocks, which are assumed
to be imperfect substitutes. Households retire in the second period. Their
consumption is financed by capital income (net of taxes), pure profits and
lump-sum transfers.
The calibration of the household model is based on data for 2002. For
each country, the model thus reproduces consumption shares, employment (in
hours) and unemployment rates in that year. Values for the main parameters
are given in Table A1. Labour supply decisions are governed by the standard
income and substitution effects. The uncompensated elasticity of labour supply is set at 0.2, which is based on a meta analysis of existing estimates
(Evers et al., 2005). The income elasticity is set at 0.05. In the sensitivity
analysis, we look at an uncompensated labour supply elasticity of 0.4 instead
of 0.2.
b. Firms
CORTAX distinguishes between two types of firms: domestic firms and multinationals. A domestic firm operates in the home country. A representative
3
A detailed description of the structure and parametrisation of the model can be found in Bettendorf and van der Horst (2006).
4
Dividing active life in two parts means that a period spans 40 years. We want to express the
variables in annual terms while keeping the model tractable. We therefore impose that behaviour is
the same in each year of the period when young and when old.

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multinational headquarter is located in each country. Multinationals own one


subsidiary in each foreign country.5 Firms are assumed to maximise the value
of the firm. Production in each firm uses three primary factors: labour, capital
and a location-specific factor (e.g. land). Labour is internationally immobile so
that wages are determined on national labour markets. Capital is assumed to be
internationally mobile so that the return to capital after source taxes is given
for each country on the world capital market. This fixed return to capital
implies that the user cost of capital depends on country-specific corporate
taxes, which thus affect investment behaviour. The location-specific factor is
supplied inelastically and is internationally immobile. Its return, being a rent, is
subject to corporate tax. Income from rents earned by subsidiaries accrues to
the parent country. Accordingly, countries can partly export the tax burden
abroad through the corporate income tax.
Firms finance their investment by issuing bonds and by retaining profits
(issuing new shares is excluded). The equity capital of a subsidiary, defined as
foreign direct investment (FDI), is provided by its parent. The optimal financial
structure of companies depends on the difference between the cost of debt
financing (deductible for corporate taxation) and the required return on equity.
The latter is determined by the marginal equity holder, which is assumed to
live in the home country. As a consequence, the required return on firms
equity depends on the personal income tax on equity. As debt financing is taxfavoured in corporate tax systems, extreme debt positions are avoided by specifying a financial distress cost that increases in the debt ratio of a company.
Production in a subsidiary needs in addition an intermediate input that is
provided by its parent company. A headquarter can charge a transfer price
for these inputs that deviates from an arms-length price. In particular, with
separate accounting, a multinational has an incentive to shift profits to lowtax countries by setting an artificially low transfer price. Profit shifting
remains bounded by specifying convex costs arising from manipulated transfer pricing.
Maximisation of the value of the firm gives the demand for labour and capital, where the marginal productivity of labour equals gross wages, and that of
capital equals the cost of capital c:
@Y
w;
@L

@Y
c:
@K

Given a CES production function with substitution elasticity r < 1, an


increase in the cost of capital implies a reduction in the demand for capital and
5
The location decision of a subsidiary is thus not modelled. In the absence of entry costs, multinationals only decide on the size of their subsidiaries.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

labour. A simplified representation shows that the cost of capital depends on


the corporate tax (cf. equation A15):
1  sA
r d;
2
1s
where s is the corporate tax rate, A denotes the tax deductions, r is the gross
return on capital, and d is the economic depreciation rate. Given that A < 1, an
increase in the tax rate implies an increase in the cost of capital.
The calibration of the firm sector is summarised in Table A2. The capital
and labour parameters in the production functions are determined by countryspecific labour income shares. The amount of the location-specific factor used
by subsidiaries is calibrated from data on bilateral FDI stocks.
The substitution elasticity between capital and labour is set at 0.7. A number
of empirical studies, however, report lower values (de Mooij, 2005). We therefore perform a sensitivity analysis on the substitution parameter with a value of
0.35.
c

c. Unemployment
Real producer wages are determined by a right-to-manage model that gives
rise to an empirically testable wage equation. The model reflects a process
between employers and a trade union who bargain over wages, while the
employer determines employment. Owing to monopoly power, the trade union
is able to claim a share of profits, thereby driving wages above the marketclearing level. This gives rise to involuntary unemployment.6 As in van der
Horst (2003), the fall-back position of the union contains not only unemployment benefits (which are indexed to after-tax wages), but also income from
informal activities such as household production and black-market activities.
The value of these informal activities is untaxed and depends on consumer
prices and labour productivity. Using this set-up, we get the following linearised wage equation:


w
Y
1 sc
b ln rr  cu;
3
ln ln a ln
py
L
1  sl
where w/py is the real producer wage, Y/L stands for labour productivity, sc is
the value-added tax, sl denotes the labour income tax, rr stands for the net

6
The right-to-manage approach has also been adopted in applied general equilibrium models for
the OECD by Srensen (2001) and for Germany by Boehringer et al. (2004). In his theoretical
model, Keuschnigg (2008) adopts a different approach including search frictions and wage bargaining, in which the division of rents between workers and firms is still a driving force in determining
unemployment.

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replacement rate, and u is the unemployment rate.7 Expression (3) suggests that
a higher labour productivity proportionally raises the real producer wage.
A higher unemployment rate tempers the wage claim of unions, in particular if
their bargaining power is weak. The institutional variables, such as direct and
indirect taxes and the replacement rate, are expected to raise the wage rate. They
thus exacerbate labour market imperfections and raise the equilibrium rate of
unemployment. The positive impact of the tax variables on producer wages is
generally referred to as real wage resistance. It means that the incidence of labour
and value-added taxes is shared across workers and firms. Based on the average
estimate for four European countries by van der Horst (2003), we set a 0.5 and
c 1.5.8 We perform a sensitivity analysis on real wage resistance by considering a 0.25. The semi-elasticity for the unemployment rate would correspond
to an ordinary elasticity of 0.1 if evaluated at an unemployment rate of 6.7 per
cent. A value of 0.1 is reported as a consensus estimate from the literature in, for
example, Blanchflower and Oswald (2006). To illustrate the relevance of this
parameter, we also show the effects under c 3, which would correspond to an
elasticity of 0.1 if the unemployment rate were 3.3 per cent.
d. Government
Tax revenues consist of source-based taxes on corporate income9 and residence-based taxes on labour income, dividends, capital gains, interest income
and consumption. The expenditure side contains government consumption,
unemployment benefits, interest payments on public debt and lump-sum transfers. Government behaviour is exogenous. We keep government consumption
and public debt constant as fractions of GDP.
The corporate tax base is defined as the value of output (for a headquarter
including the value of intermediate inputs supplied and for a subsidiary minus
the value of intermediate inputs used), minus wage costs, interest payments on
debt, and tax allowances. Tax allowances capture more than fiscal depreciation
7
Graafland and Huizinga (1999) distinguish between average and marginal income taxes and find
that the marginal tax exerts a negative impact on wages in the Netherlands. This result is also found
for other European countries; see e.g. Srensen (1997) for an overview. Intuitively, high marginal
taxes make it attractive for trade unions to reduce wage demands, since the government takes a
larger share of it in the form of taxes. Thus, unions opt for higher employment and lower wages.
The empirical results of Graafland and Huizinga, however, suggest that this effect is small
compared to the positive impact of the average income tax on wages.
8
The empirical estimates provide sufficient information for adopting country-specific coefficients.
The replacement rate is constant in our analysis as we index unemployment benefits to the after-tax
wage it therefore does not play a role in the tax reform.
9
The focus on this pure regime can be motivated by the observation in Devereux (2004) that
Although in many countries the legal basis of taxation is on a residence basis, in practice the vast
bulk of the international taxation of company equity income is on a source basis.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

and are specified proportional to the capital stock. Country-specific corporate


tax rates and tax allowances are presented in Table 1. Statutory tax rates are
taken from Devereux et al. (2002), except for the new member states (Finkenzeller and Spengel, 2004). The first column in Table 1 shows that statutory tax
rates range from 12.5 per cent in Ireland to 39.6 per cent in Germany (in
2002). The rate of tax allowances is calibrated so as to reproduce marginal
effective tax rates (METR) reported by Devereux et al. (2002) (see the third
column of Table 1). Thereby, we take the METR for domestic firms for the
case where 25 per cent of a new investment is financed with debt and 75 per
cent with equity.10 The allowance rates thus identified are presented in the second column of Table 1. It suggests that Portugal, Italy and Greece feature relatively narrow tax bases, while Ireland and Germany feature relatively broad tax
bases. Note that in countries with a narrow tax base, the METR is typically
small as the corporate tax is largely a tax on rents, rather than a tax at the margin of new investment. In contrast, countries with a broad tax base, like Germany and the Netherlands, feature a higher initial METR. In Ireland, the
METR is relatively low due to a low corporate tax rate, not because of a narrow tax base. The last two columns in Table 1 show the labour and consumption tax rates, which represent effective taxes computed from tax revenue data
of the OECD (the labour tax includes social security contributions). Both rates
matter for the distortions of labour and value-added taxes, which will be analysed in Section 3c.
e. Welfare
We compute the compensating variation to measure the welfare effects of
taxation. The compensating variation is equal to the transfer that should be provided to households to maintain their utility at the pre-reform level. Hence, a
positive compensating variation implies a welfare loss, i.e. an excess burden
from taxation. The compensating variation (CV) can be approximated by the
following three terms:
CV sl DYl  1  sl DYnl  w  w DL;

where sl denotes the share of labour-related income, (1 ) sl) is the share of


non-labour income, w is the actual wage rate, and w* is the opportunity cost of
leisure due to rationing in labour supply. DYl, DYnl and DL reflect changes in,
10

This is lower than the observed debtequity ratio, which is about 2/3. Our choice, however,
ensures that we obtain reasonable values for tax allowances. In particular, our calibration avoids the
so-called taxation paradox, implying a negative marginal effective tax rate (see e.g. Srensen,
2002). Our calibration, however, implies that the model does not reproduce observed values for the
corporate tax to GDP ratios. Indeed, our calibration implies an average ratio of 2.6 per cent while
the actual number is 3.0 per cent.

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TABLE 1
Tax Systems in Europe (2002)
Corporate Rate of
Marginal Effective Labour Consumption
Tax Rate Tax Allowances Tax Rate
Tax Rate Tax Rate
Austria
Belgium/
Luxembourg
Czech Republic
Germany
Denmark
Spain
Finland
France
United Kingdom
Greece
Hungary
Ireland
Italy
Netherlands
Poland
Portugal
Sweden

AUT 34.0%
BLU 34.0%
CZE
DEU
DNK
ESP
FIN
FRA
GBR
GRC
HUN
IRL
ITA
NLD
POL
PRT
SWE

28.0%
39.6%
30.0%
35.0%
29.0%
35.4%
30.0%
35.0%
17.7%
12.5%
38.3%
34.5%
19.0%
33.0%
28.0%

7.7%
6.1%

6.2%
8.0%

38.7%
38.1%

24.7%
22.9%

6.9%
5.0%
7.1%
7.7%
5.7%
7.6%
5.7%
10.0%
5.2%
5.0%
10.0%
5.8%
5.5%
8.4%
7.8%

6.1%
12.4%
6.3%
6.2%
8.1%
6.5%
8.4%
3.6%
5.1%
3.4%
4.0%
9.6%
5.2%
5.1%
4.9%

35.3%
34.1%
34.1%
27.9%
38.2%
38.2%
21.3%
25.6%
32.6%
16.8%
34.1%
30.7%
25.0%
24.2%
46.2%

23.8%
19.6%
47.5%
16.6%
35.0%
22.4%
19.7%
21.2%
33.2%
33.3%
17.3%
28.1%
21.1%
25.8%
36.4%

respectively, labour-related income, non-labour-related income and employment. The first two terms on the right-hand side of (4) reflect the change in
aggregate income. Labour-related income consists of wages and unemployment
benefits. Non-labour income consists of capital income (including rents) and
lump-sum transfers. The income term captures the welfare effects associated
with tax distortions in labour supply and investment. The last term on the
right-hand side of (4) captures the distortion induced by imperfections on the
labour market.
f. Miscellaneous
Equilibrium must hold on each market. On the labour market, wages are set
above the market-clearing level according to equation (3). This leads to equilibrium unemployment. On the goods market, we assume perfect competition
and a tradable homogeneous good. Hence, countries cannot exert market power
on world markets so that the terms of trade is fixed. The goods price acts as a
numeraire. On asset markets, bonds of different origins are perfect substitutes
and they can be freely traded on world markets. Accordingly, the return to
these assets is fixed for an individual country. The same holds for equity. Debt
and equity are, however, imperfect substitutes. The current account equals the
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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

change in the net foreign asset position for each country (including rest of the
world), due to Walras law.

3. SIMULATING CORPORATE TAX REFORM WITH CORTAX

This section uses CORTAX to explore the steady-state impact of an increase


in the corporate tax on labour market performance and welfare in different
European countries. The simulated increase in the corporate tax yields an
ex ante revenue of 0.5 per cent of GDP in each country. We adjust the lumpsum transfers to the old generation to balance the government budget ex post,
i.e. after behavioural responses. We start in Section 3a with a discussion of the
EU-average effects of corporate tax reforms with perfect and imperfect labour
markets. Section 3b considers the same tax change for each country unilaterally, and focuses on the country variation. Finally, Section 3c compares the
corporate tax with labour and value-added taxes.
a. Perfect or Imperfect Labour Markets
To raise a revenue of 0.5 per cent GDP, the necessary average corporate tax
increase in the EU is 8 percentage points. The economic effects for the EU on
average are reported in Table 2.
The corporate tax affects the economy via a number of channels, irrespective
of the labour market perfection. First, it increases the cost of capital, which
raises marginal production costs and exerts a negative output effect on capital
TABLE 2
EU Effects of an Increase of the Corporate Tax Rate

Corporate tax rate


Lump-sum transfer
Cost of capital
Wage rate
Labour supply
Labour demand
Unemployment
Capital
Production
Consumption
Compensating variation

Imperfect

Perfect

Dif

8.0
0.1
0.2
)1.2
)0.2
)0.4
0.2
)2.9
)1.2
)1.2
0.6

8.0
0.2
0.2
)1.2
)0.2
)0.2
0.0
)2.7
)1.0
)0.9
0.4

0.0
0.0
0.0
0.0
0.1
)0.2
0.2
)0.2
)0.2
)0.2
0.1

Note:
Dif is the difference between simulations with the imperfect and perfect labour market. All variables are
percentage changes from base case, except for the corporate tax rate, cost of capital and unemployment
(percentage points) and compensating variation and transfers (%GDP).

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and labour demand. Second, the higher cost of capital induces substitution from
capital to labour in production. This renders the negative impact on capital
larger, but partly offsets the negative effect on employment. The strength of
this latter effect depends on the substitution elasticity between capital and
labour. In particular, if the substitution elasticity would be equal to one, the
substitution effect would precisely offset the adverse output effect so that
employment would remain unchanged. With smaller substitution, however, the
output effect dominates so that employment falls. In our calibration, we use a
substitution elasticity of 0.7. Accordingly, employment falls by 0.2 per cent in
the perfect-labour market model. For capital demand, output and substitution
effects work in the same direction. As a result, capital demand falls by 2.7 per
cent. Third, the sharp decline in capital reduces labour productivity and, therefore, wages. This induces households to substitute leisure for consumption
since the uncompensated wage elasticity is positive. Indeed, we see that labour
supply falls by 0.2 per cent.
The corporate tax raises unemployment in an imperfect labour market by 0.2
percentage points. Figure 1 illustrates the intuition. It plots combinations of
unemployment and real producer wages according to two equations in the
model: wage setting and labour demand. According to the wage-setting curve,
there is a negative relationship between wages and unemployment. The position
of this curve depends on labour taxes and value-added taxes in the presence of
real wage resistance: higher taxes shift the curve outward, i.e. the equilibrium
from A to B. The labour demand curve does not directly depend on unemployment. Rather, real producer wages can be expressed as a function of labour
productivity and the cost of capital. In Figure 1, it is therefore represented by
the horizontal line. A higher labour productivity will shift this curve upward.
In Figure 1, the corporate tax directly shifts the demand curve as it raises the
FIGURE 1
Labour Market Equilibrium
Real
wage
Wage
setting

Labour demand

B
C

Unemployment

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cost of capital and reduces labour productivity. By moving the curve downward, the equilibrium moves from A to C, i.e. it raises the unemployment rate.
Table 2 confirms the intuition that corporate taxation in an imperfect labour
market raises unemployment, but does not additionally affect the wage rate.
Labour supply is slightly changed, but labour demand falls by 0.4 per cent
instead of 0.2 per cent. This stronger reduction in employment explains the
stronger responses of investment, consumption and GDP.
The second row in Table 2 shows that, while the ex ante revenue of the corporate tax increase is 0.5 per cent of GDP, the ex post impact is much smaller
due to the erosion of the tax base, not only of corporate profits, but also of
labour income and consumption.
The corporate tax causes a sizeable welfare cost, despite the fact that it is
partly a non-distortionary tax on pure profits. Indeed, the compensating variation equals 0.6 per cent of GDP with an imperfect labour market. With a taxto-GDP ratio of 0.46, this comes down to a deadweight loss of 130 eurocents
per euro of revenue. This welfare cost is the result of three effects. First, there
is a distortion in production efficiency. The corporate tax raises the cost of
capital, thereby distorting the input mix in production by reducing the capital/
labour ratio. Second, to the extent that the incidence of the corporate income
tax is shifted onto labour in the form of a lower wage, it exacerbates distortions
in labour supply. Finally, the corporate tax raises involuntary unemployment
and, therefore, tightens the rationing on the labour market.
(i) Sensitivity analysis
Table 3 shows the impact of the corporate tax increase under alternative
parameter values. First, we set the substitution elasticity between capital and
labour at 0.35 instead of 0.7. This reduces substitution from capital to labour in
response to the higher cost of capital. Less substitution means that employment
falls more, namely by 0.7 per cent instead of 0.4 per cent. As a result, the
unemployment rate increases by 0.5 per cent, compared to 0.2 per cent in the
benchmark. The welfare cost expands to 0.8 per cent of GDP, which is caused
by the larger increase in unemployment.
Next, Table 3 shows the impact of the corporate tax if the uncompensated
elasticity of labour supply (ell) is 0.4 instead of 0.2 in the EU on average. It
reinforces the adverse labour supply effect in response to the lower wage and
magnifies the labour supply distortion. It does not, however, affect the change
in the unemployment rate. The compensating variation increases in light of the
larger distortion in labour supply.
Finally, Table 3 shows the implications of a doubling of the semi-elasticity
of unemployment in (3). If the feedback of the unemployment rate on wages is
stronger, this mitigates the increase in the unemployment rate on account of
the corporate income tax. In terms of Figure 1, the wage-setting curve becomes
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CORPORATE TAX AND UNEMPLOYMENT

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TABLE 3
Sensitivity Analysis

CIT rate
Transfer
CoC
Wage
L-supply
L-demand
Unemployment
Capital
GDP
Consumption
CV

Substitution Labour/
Capitala

Elasticity Labour
Supplyb

Imperfection Labour
Marketc

imp

pfct

dif

imp

pfct

dif

imp

pfct

dif

8.0
0.1
0.2
)1.2
)0.1
)0.7
0.5
)1.9
)1.1
)1.4
0.8

8.0
0.2
0.2
)1.2
)0.3
)0.3
0.0
)1.5
)0.7
)0.9
0.4

0.0
)0.1
0.0
0.0
0.2
)0.4
0.5
)0.4
)0.4
)0.5
0.3

8.0
0.1
0.2
)1.2
)0.3
)0.6
0.2
)3.0
)1.3
)1.4
0.6

8.0
0.1
0.2
)1.2
)0.4
)0.4
0.0
)2.9
)1.2
)1.1
0.5

0.0
0.0
0.0
0.0
0.0
)0.2
0.2
)0.2
)0.2
)0.2
0.2

8.0
0.1
0.2
)1.2
)0.2
)0.3
0.1
)2.8
)1.1
)1.1
0.5

8.0
0.2
0.2
)1.2
)0.2
)0.2
0.0
)2.7
)1.0
)0.9
0.4

0.0
0.0
0.0
0.0
0.0
)0.1
0.1
)0.1
)0.1
)0.1
0.1

Notes:
For explanation see Table 2. CoC: cost of capital; GDP: gross domestic product; CV: compensating variation.
a
Lower substitution between labour and capital (rkl 0.35 instead of 0.7).
b
Stronger responsiveness of labour supply to wages (ell 0.4 instead of 0.2).
c
Stronger responsiveness of wages to unemployment (c 3.0 instead of 1.5).

steeper, which implies that a shift in the labour demand curve yields a smaller
effect on unemployment. Also the compensating variation in the imperfect
labour market is smaller. Hence, stronger market forces induced by excess
labour supply will help to mitigate the distortionary effect of corporate
taxation.11
b. Country by Country
Does the observation that the corporate tax raises unemployment in the
European Union hold for each member state? In the previous section we saw
that an average corporate tax increase in EU countries of 8.0 percentage points
is needed to raise a revenue of 0.5 per cent GDP. Owing to different tax bases,
the corporate tax increase differs across countries: it ranges from 5.8 per cent
for Germany to 12.1 per cent for Greece. The economic effects are reported in
Table B1, where we have investigated unilateral tax policies in each country.
Here, we focus on the implications for the labour market and welfare.
Figure 2 presents the effects on labour supply, employment and unemployment in all 17 countries. Figure 3 reports the effects on the compensating
variation. The countries in both figures are ranked according to their initial
11
A change in the coefficient of real wage resistance a does not affect the impact of corporate taxes
on unemployment, as long as the wedge is unchanged.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ


FIGURE 2
Changes on the Labour Market after Unilateral Increase in sp
(% of base case labour supply)
0.4

0.2

0.0

0.2

0.4

0.6

Labour supply
Employment
Unemployment
LD

EU
D

BR
G

FI

BL

P
AU
T
D
N
K
FR
A

ES

CZ

PO

IT
A
SW
E
H
U
N
PR
T

IR

L
RC

0.8
(Ordering based on METR)

FIGURE 3
Compensating Variations from Unilateral Increase in sp
(%GDP)
1.0
Perfect
Imperfect
Difference
0.8

0.6

0.4

0.2

0.0
IRL GRC ITA SWE HUN PRT POL CZE ESP AUT DNK FRA BLU FIN GBR NLD DEU
(Ordering based on METR)

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CORPORATE TAX AND UNEMPLOYMENT

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METR (the one that applies to domestic firms), i.e. we start on the left with
the country that features the lowest initial METR. The reason is that the initial
METR determines in an important way the distortionary effect of corporate tax
increases. Indeed, if the initial METR is close to zero, e.g. due to generous fiscal allowances, corporate taxes induce negligible distortions at the margin of
new investment as they largely bear on rents. If the initial METR is large, in
contrast, corporate taxes exert large investment distortions at the margin.
The corporate tax raises the cost of capital, especially if the corporate tax
base is broad. Indeed, the METR rises by between 1 per cent in Italy and
Greece and 3.5 per cent in Belgium/Luxembourg (see Table B1).12 The higher
cost of capital reduces output and induces substitution from capital to labour.
On balance, employment falls in all countries, which is shown in Figure 2.
Substitution from capital to labour reduces labour productivity, thereby also
reducing wages. This harms the incentives for labour supply. However, as pure
profits (and for some countries also lump-sum transfers) decline as well, households also face a negative income effect. This induces them to raise labour
supply. In most countries, the first effect dominates so that labour supply
contracts (see Figure 2). In all countries, the drop in employment is larger
than the reduction in labour supply so that unemployment expands. The rise
in unemployment runs between 0.08 per cent in Greece and 0.35 per cent in
Ireland.
Figure 3 reveals a positive compensating variation, reflecting the marginal welfare cost of the corporate tax. The compensating variation runs between 0.3 per
cent of GDP in Greece to more than 1 per cent in Belgium/Luxembourg. Figure 3
also compares the model of the imperfect labour market with a version of the
model that features a perfect labour market. The difference shows that labour
market imperfections raise the welfare cost of the corporate tax in all countries.
Figures 2 and 3 show that there is substantial variation among countries. This
can be explained by two main factors. First, countries differ with respect to the
rise in the cost of capital. For instance, the cost of capital in Italy and Greece
rises by only 1 per cent. This is because the narrow tax base in these countries
renders the higher corporate tax only slightly distortionary at the margin of new
investment. Countries starting from a broader tax base face a more substantial
rise in the cost of capital. For instance, the cost of capital in Ireland and
Germany rises by 2.5 per cent, in the Netherlands by 3 per cent and in Belgium/
Luxembourg by 3.5 per cent. Figures 2 and 3 indicate that the unemployment
effects and the welfare costs tend to rise with the initial value of the METR.
In Figure 3, we observe exceptionally large welfare costs for Ireland,
Belgium/Luxembourg and the Netherlands. This can be understood by
12

A higher marginal effective tax rate is associated with a higher cost of capital. Hence, we use the
terms interchangeably.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

international spillover effects. Indeed, these three countries are relatively open in
terms of hosting a large share of foreign capital within their borders. Accordingly, a higher corporate tax exerts a relatively large effect on profit shifting
and/or foreign direct investment. Whether a multinational responds to a higher
corporate tax rate by means of profit shifting or FDI depends on the initial corporate tax rate. In particular, if the initial corporate tax rate is low compared
to other countries (such as in Ireland, Hungary and Poland), multinationals will
have already exhausted most of the opportunities for profit shifting. This is due
to the convex cost of manipulating transfer pricing, which renders the marginal
cost of further shifting of profits high. A moderate increase in the corporate tax
rate will then not exert a big change in transfer pricing policies. Instead, the multinational will respond by reducing FDI. This happens to Ireland, Hungary and
Poland. Indeed, Table B1 reveals that these countries lose a considerable amount
of FDI due to the higher corporate tax. This causes a relatively large reduction in
employment and, therefore, a relatively large increase in unemployment.
In countries with a high or moderate corporate tax rate, the response by multinationals is different. Indeed, a higher corporate tax rate may create new
opportunities for profit shifting as the marginal cost of manipulating transfer
prices is still small. This opportunity to shift profits implies that multinationals
can largely escape the higher corporate tax rate. Accordingly, they do not cut
back on FDI. As a result, open countries with moderate to high statutory
corporate tax rates, like the Netherlands, Belgium/Luxembourg, Portugal, Italy
and Greece, see a relatively small effect on FDI.13 The drop in employment
and the increase in unemployment are, therefore, also relatively small. The substantial amount of profit shifting does, however, erode the corporate tax base in
these countries, thereby reducing public revenue. The corporate tax increase
thus allows only for a small increase in lump-sum transfers, ex post. In
Belgium/Luxembourg and the Netherlands, tax revenue even declines so that
lower lump-sum transfers are necessary to balance the government budget.
Figure 3 shows that the welfare cost of the corporate tax is relatively large
for open economies. Hence, the distortions associated with the international
spillovers render corporate taxes distortionary, irrespective of whether initial
corporate tax rates are low or high. In low-tax countries like Ireland, spillovers
typically exacerbate real distortions through FDI, which also show up in a relatively large increase in unemployment. In high-tax countries like Belgium/Luxembourg and the Netherlands, spillovers occur through profit shifting. While
the associated unemployment effects are small in these countries, the erosion
of the corporate tax base renders the welfare cost of the tax relatively high.
13

The figures in Table B1 reflect inward FDI. For Belgium/Luxembourg, this effect is relatively
large. However, outbound FDI by headquarters rises only slightly so that the aggregate loss in
foreign-owned capital is still small compared to other countries.

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In the previous discussion, we have shown how the openness of a country


matters for its own unemployment and welfare effects. Now, we briefly illustrate
how unilateral tax policies spill over to other countries, in particular if bilateral
FDI relations are strong. Figure 4 shows how the unemployment rate in Ireland
and the United Kingdom responds to tax policies in other countries. We choose
these countries for being interrelated, where for one (Ireland) foreign direct
investment is huge and for the other domestic investments are much more
important. The conclusions drawn from this graph extend to other countries. In
general, both countries benefit from a tax increase in other EU member states.
In particular, unemployment in Ireland declines in response to a corporate tax
increase in the UK, the Netherlands, Italy and Germany. The reason is that
foreign multinationals expand their subsidiaries (and therefore employment) in
Ireland, in response to a higher tax in the parent country. The corresponding
response in the UK is much smaller for two reasons. First, because employment
of subsidiaries constitutes a relatively small part of total employment. Second,
because the corporate tax rate is higher in the UK, which makes this country
less attractive for foreign multinationals to escape their higher domestic tax burden. In exceptional cases (like Irish multinationals investing in the UK), a tax
increase may raise unemployment in other countries, because the multinational
FIGURE 4
Unemployment Response of Ireland and the United Kingdom to Unilateral Increase
in sp in Other Countries
0.02
Ireland
United Kingdom
0

0.02

0.04

0.06

0.08

IRL GRC ITA SWE HUN PRT POL CZE ESP AUT DNK FRA BLU FIN NLD DEU GBR
(Ordering based on METR, except GBR)

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

cuts down overall investment in all countries in response to the higher domestic
tax. Overall, corporate taxation in one country tends to reduce unemployment in
countries with which the bilateral investment relations are strong.
c. Comparing Corporate with Labour and Consumption Taxes
This section compares the unilateral corporate tax increase from the previous
section with an increase in labour and value-added taxes. For each tax, we consider an ex ante revenue of 0.5 per cent of GDP in each country. As tax bases
differ across countries (see Table 1), the increase in tax rates differ as well. On
average in Europe, the labour tax rate is raised by 0.8 per cent, with a spread
between 0.74 per cent and 0.94 per cent. The average increase in the valueadded tax is 1.1 per cent, with a range between 1 per cent and 1.4 per cent.
Figures 5 and 6 show the effects on unemployment and the compensating variation. In the figures, countries are ranked according to their initial METR.
Tables B2 and B3 present the effects on other variables as well.
Figure 5 shows that the corporate tax is the least distortive for unemployment in most countries, while the labour tax raises the unemployment rate
most. This conclusion depends crucially on the parametrisation of real wage
resistance in the wage equation (3), where a is currently set at 0.5. Would a be
smaller, then labour income taxes and value-added taxes exert a smaller effect
FIGURE 5
Changes in Unemployment Rate in Unilateral Scenario (percentage points)
0.5

0.4

0.3

0.2

0.1
Corporate
Labour
Consumption
0.0
IRL GRC ITA SWE HUN PRT POL CZE ESP AUT DNK FRA BLU FIN GBR NLD DEU
(Ordering based on METR)

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FIGURE 6
Compensating Variations in Unilateral Scenario (%GDP)
1.0
Corporate
Labour
Consumption
0.8

0.6

0.4

0.2

0.0
IRL GRC ITA SWE HUN PRT POL CZE ESP AUT DNK FRA BLU FIN GBR NLD DEU
(Ordered based on METR)

on the producer wage. Accordingly, output and employment fall less substantially and, as a result, the unemployment rate increases less and the compensating variation will be moderated. Empirical studies are highly inconclusive
about the importance of real wage resistance. Moreover, they suggest that
country differences are enormous. For instance, Tyrvainen (1995) finds the following values for a: 1.0 for Germany and Finland, 0.4 for France and 0 for
Sweden. Van der Horst (2003) finds 0.7 for Germany, 0.2 for Spain and the
United Kingdom, 0.1 for the Netherlands and 0 for France. Graafland and Huizinga (1999) arrive at a 0.6 for the Netherlands. Given this considerable dispersion in estimates for a, the ranking of corporate versus other taxes with
respect to their unemployment effect is highly uncertain. It is interesting to see,
however, how the three taxes are ranked with respect to welfare, even under
the relatively strong real wage resistance.
Figure 6 suggests that the value-added tax is least distortionary in terms of
welfare and the corporate tax is most distortionary for most countries.14 On the
14

An important reason for this result is the assumption that countries raise their tax unilaterally
and experience adverse profit shifting. If all countries were to raise the corporate tax simultaneously, the welfare losses would be moderated.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

one hand, the corporate tax is relatively costly because it distorts the production
mix. On the other hand, the value-added tax and the labour income tax are relatively costly because they cause larger distortions on the labour market. Thereby,
the value-added tax is somewhat more efficient because it partly acts as a tax on
rents received by households, which renders it more efficient than the labour
income tax. On balance, Figure 6 shows that corporate taxes are typically more
distortionary at the margin in countries with a high METR (i.e. countries on the
right-hand side of Figure 6) and in countries that suffer from severe international
spillovers, like Ireland, Belgium/Luxembourg and the Netherlands. Labour
income taxes are more distortionary, however, in countries with a low METR
and a high initial labour income tax, such as Sweden.

4. CONCLUSION

This paper explores the impact of corporate taxes on unemployment in a


general equilibrium model that is calibrated for the European Union. We find
that, by increasing the cost of capital, corporate taxes raise equilibrium unemployment. The magnitude of this effect declines with the substitution elasticity
between labour and capital in production and the responsiveness of wages to
unemployment. It rises with the initial marginal investment distortion associated with the corporate tax system. A broader tax base renders the corporate
tax more distortionary for marginal investments, which magnifies the labour
market effects of corporate tax increases.
The analysis reveals that corporate taxes are more costly for welfare in
European countries that are relatively open in terms of hosting a large share of
multinational companies. In particular, with openness corporate taxes create
relatively large distortions in multinational decisions such as foreign direct
investment and international profit shifting. If spillovers work primarily through
foreign direct investment, like in Ireland, corporate taxes hurt welfare especially via exacerbating unemployment. This is because multinationals have
largely exploited the opportunities for profit shifting because of a low initial
corporate tax rate in combination with convex cost of the manipulation of
transfer prices. If spillovers operate primarily through profit shifting, like in
Belgium/Luxembourg and the Netherlands, corporate taxes exert smaller effects
on unemployment. This is because multinationals can largely escape the higher
corporate tax by exploiting new opportunities for profit shifting. This reduces
the need for reducing their foreign investments in these countries. Still, the
welfare costs of corporate taxes are large also under profit shifting because of
the substantial erosion of the corporate tax base.
Compared to labour and value-added taxes, we find that corporate taxes are
less harmful in terms of labour market performance. Labour supply drops less
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CORPORATE TAX AND UNEMPLOYMENT

1339

since part of the corporate tax is borne by the owners of the firm who receive
pure profits. Unemployment rises more only under the assumption of relatively
strong real wage resistance. This effect is subject to considerable empirical
ambiguity. Yet, even though the corporate tax causes smaller labour market
distortions, it induces larger welfare costs in many European countries due to
distortions in production efficiency. It holds in particular for the open economies Ireland and the Benelux, where international spillovers make corporate
taxes relatively distortionary.

APPENDIX A: THE CORTAX MODEL

This section provides a condensed description of CORTAX. For a detailed


derivation we refer to Bettendorf and van der Horst (2006).
a. Households
The overlapping-generations framework follows the standard Diamond
model. Its instantaneous utility v depends on consumption c and leisure ^l:
1

al

vi s ci s1al Al s^li s1al ;

A1

where i {y, o} denotes the young and old generation, l 1  ^ly is labour
supply with ^lo 1 and al is the weight of leisure. We assume a unit intratemporal substitution elasticity between consumption and leisure.
Let t be the current and t + T be the next period (of 40 years). Lifetime
utility is:


1
1 o
11=ru
11=ru
y
v t
v t T
;
A2
Ut
1  1=ru
q
where ru denotes the intertemporal elasticity of substitution and q is the rate of
time preference. The budget equation is:


 ^l  1 sc cy t
wtl
try t bu wtu1
 T
1
po t T tr o t T  1 sc co t T:

qs

A3

Wage income equals w(1 ) sl)l, where w denotes the gross wage rate, sl is
 w1  sl the after-tax wage rate. A fraction u
the tax rate on labour and w
of the labour force 1  ^l is unemployed. Unemployment benefits are assumed
to be a fraction bu of net income. When young, total income, consisting of
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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

 unemployment benefits and lump-sum transfers try, is divided


wage income wl,
between consumption cy including taxes sc and savings. Households of the old
generations receive transfers tro, the pure profits accruing to location-specific
capital po and they dissave.
The portfolio consists of bonds and stocks, which are perceived as imperfect
substitutes. Bonds of different origin are, however, considered perfect substitutes. The same holds for domestic and foreign equities. Capital income is
assumed to be only taxed in the country of residence. Dividends, capital gains
and interest income from bonds are taxed at the rate sd, sg and sb, respectively.
The following net rates of return to bonds (rb) and equity (re) apply:
rb ^rwb 1  sb
re Vt 1  sd Divt 1  sg Vt1  Vt ;
where ^rwb is the world return on bonds, V is the value of the firm and Div
denotes dividends.
Maximising (A2) subject to (A3) yields the familiar first-order conditions for
consumption and labour supply.
b. Firms
Three types of firms are active in each country: pure domestic firms, headquarters of multinationals and subsidiaries of foreign multinationals. Firm types
are represented by the superscripts d, m and f, respectively.
(i) Domestic firms
The marginal investor maximises the present value of the representative
firm, which is equal to the discounted stream of dividends. The gross return on
equities in period t consists of dividends and capital gains:
d
^rwe Vtd Divdt Vt1
 Vtd ;

A4

where ^rwe is the world rate of return on equity, V d is the value of the firm and
Divd the distributed profits. Dividends follow from a cash flow restriction:
d
b d I d dd K d dd K d : A5
^rwb cdb;t Ktd Pdt sdp P
Divdt Ytd wt Ldt db;t
t
t
b;t1 t1
b;t t

The first element is production:


d

Y d Ad VAd av

with 0 < av < 1


d

Ad A0 xd N y 1av ;

A6

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CORPORATE TAX AND UNEMPLOYMENT

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where Y d denotes total output, Ad the output contribution of the fixed factor,15
VAd value-added and adv the share of value-added in production. The exogenous
fraction of the fixed factor that is in use by domestic corporations is denoted
by xd. Value-added is a CES function of employment Ld and capital Kd:
"
# drdv
d
d
rv 1
rdv

VAd A0 advl Ld

advk K d

rv 1
rd
v

rv 1

A7

where adv is a share parameter and rdv is the substitution elasticity between
labour and capital.
The second ingredient for the expression of dividends is the determination
of the debt ratio. Investment can be financed by issuing bonds or by retaining
profits (issuing new shares is not considered). The gross world rates of return
on bonds and equities are denoted by ^rwb and ^rwe , respectively. First, an interior
solution for the financing mix is obtained by assuming that both debt and
equity financing are extremely costly at the corner:
cib dbi v0 1  dbi 1eb dbi eb  cib;0

i d; m; f

with v0 ; eb > 0; A8

where dbi is the firms debtasset ratio and cib is the cost of financial distress
per unit of capital. This cost represents the output which is lost as financial
decisions distract managers from productive activities. The third element of
dividends is corporate taxation. We assume that corporate income is only taxed
in the source country:16
f
sdp i sm
p i sp j; i sp i:

A9

b d of corporate taxation is defined as:


The tax base P
b d Y d  wLd  d d rwb K d  dt Dd ;
P
b

A10

where d is the debt ratio, rw is the return on bonds, dt is the depreciation rate of
capital for tax purposes and Dd the stock of depreciation allowances.17 When
exponential depreciation is allowed for tax purposes, the accumulation of depreciation rights is similarly specified as the accumulation of physical capital:
fiscal : Ddt1 Itd 1  dt Ddt
15

A11

Each country is endowed with a stock of a fixed factor, named location-specific capital. Its
return is denoted Pd.
16
The focus on this pure regime can be motivated by the observation in Devereux (2004) that
Although in many countries the legal basis of taxation is on a residence basis, in practice the vast
bulk of the international taxation of company equity income is on a source basis. He also states that
only a small amount of revenue is raised in the residence country.
17
Notice that the tax base includes fixed-factor income, which justifies a positive corporate tax
rate.

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L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ


d
economic : Kt1
Itd 1  dk Ktd ;

A12

where I d stands for investment and dk for the real depreciation rate. Corporate
b d.
taxes are equal to sdp P
Profit maximisation yields the familiar first-order conditions, of which we
only present the conditions for labour and capital:
@Y d
w
@Ld

A13

@Y d
cd ;
@K d

A14

where we define the user cost of capital cd and the marginal cost of finance rd as:
cd 

rd dk
sdp dt re dk

1  sdp 1  sdp re dt

r d  dbd rwb 1  sdp bb 1  dbd re cdb 1  sdp ;

A15
A16

where re is the return on equity.


(ii) Multinational company
The multinational company is modelled along the same lines as the domestic
firm. We only show the key differences.18 First, subsidiaries need intermediate
inputs (from their parent) in production:
f

Y f j Af j A0q Q jaq VAf jav

with 0 < aq avf < 1;

A17

where Y f denotes total output, Af the output contribution of the fixed factor,
Q the intermediate input and VAf value-added.
The price of intermediate inputs can be manipulated. When the tax rate on
profits differs between both countries, transfer pricing might be attractive to
shift taxable profits between the jurisdictions. However, charging a different
price than the real cost (i.e. pq 1) involves a type of organisational cost. The
cost arising from a distorted transfer price is assumed to be:
cq
)

18

jpq  1j1eq
1 eq

with eq > 0

A18

@cq
signpq  1jpq  1jeq :
@pq

For the details we again refer to Bettendorf and van der Horst (2006).

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c. Imperfect Labour Market


Wage bargaining involves the maximisation of the following Nash function;
see Graafland et al. (2001, Ch. 7) and van der Horst (2003):
1g
;
max G GgE GU
w

A19

where GE and GU denote the surpluses from employment for firms and unions
respectively, and g is the relative bargaining power of employers.
The benefits from labour for firms (on average) are:
GE

va w

l
py

A20

where va is value-added (so we assume that the surplus depends on production


net of intermediate inputs and net of fixed income), py the producer price. The
utility for the union depends on employment and the surplus of households
from working over non-work:

1m
w
e m
^
;
A21
GU l 1  tl  w
pc
^ as given, i.e. as
where we assume that unions take the reservation wage w
being independent of the wage rate. The solution to the Nash game is:
w h1

^
py y
pc w
:
h2
l
1  tl

A22

^ is specified. First, it is assumed to depend on


Next, the reservation wage w
the return to unemployment times the probability of being unemployed. Second, unemployed workers have a probability of finding another job, at the aver Finally, unemployed workers may (choose to) enjoy leisure
age wage rate w.
^ 0 ). Formally,
(with return w
^ j
w


ubu w 1  uw
1  j^
w0 :
pc

A23

The following (linearised) wage equation can be deduced from equations (A22)
and (A23):
ln

w
y
ln n1 ln K n2 ln bu  n3 u;
py
l

where K  1 tc =1  tl is the wedge.

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A24

1344

L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ

d. Government
The government budget has to be balanced:
gy dg iYi sl iwiLi sc iC y i Co i
h
i
X
b f j; i
b d i P
b m i
P
sp i P
j6i
X
X
X
^r Bi; j
sd i
Divi;
j

s
i
DVi;
j

s
i
g
b
j
j
j wb
xg iYi tr y iN y i tro iN o i ^rwb dg iYi
bu i1  sl iwiui1  ^liN y i;

A25

where N y,o is the size of the young and old generation and countries are
indexed with i and j. The third line represents taxes on dividends, interest
income and capital gains. Expenditures include transfers to households, unemployment benefits, government consumption and debt, where the latter are
assumed to be a fixed fraction xg respectively dg of GDP.
e. Equilibrium
In equilibrium, the markets for goods, labour, debt and equity clear, which
implies that the balance of payments holds.
f. Key Parameters and (Semi-)Elasticities
TABLE A1
Key Parameters and (Semi-)Elasticities for Households
Population growth
Real return on bonds
Real return on equity
Rate of time preference

0.5%
2.0%
4.0%
1.0%

Elasticities of substitution
Intertemporal
Intratemporal (consumption-leisure)
BondsEquity

0.5
1.0
4.0

Implied (semi-)elasticities
Labour supply to wage
Labour supply to income
Savings to interest rate

Min.
0.11
)0.08
0.29

Max.
0.31
)0.02
0.65

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TABLE A2
Key Parameters and (Semi-)Elasticities of Production
Technological growth
Economic rate of depreciation
Income share of location-specific capital
Income share of intermediate inputs in subsidiaries

1.5%
5.0%
2.5%
10.0%

Elasticity of substitution
Labour-capital

0.7

Implied semi-elasticities
Capital stock to statutory CIT
Incoming FDI to statutory CIT
Debt to statutory CIT
Incoming transfer price to statutory CIT

Min.
)0.46
)1.87
0.23
0.74

Max.
)0.11
)0.57
0.38
2.15

APPENDIX B: SIMULATIONS WITH CORTAX


TABLE B1
Unilateral Increase of the Corporate Tax Rate

AUT
BLU
CZE
DEU
DNK
ESP
FIN
FRA
GBR
GRC
HUN
IRL
ITA
NLD
POL
PRT
SWE

metr

ls

fdi

gdp

tro

cv

2.23
3.47
1.71
2.53
2.50
1.80
2.32
1.94
2.88
0.96
2.13
2.53
1.05
2.97
2.17
2.31
2.14

)0.92
)1.36
)1.09
)1.43
)1.06
)1.01
)1.30
)1.04
)1.06
)0.44
)1.23
)1.64
)0.61
)1.32
)1.09
)0.67
)0.88

)0.27
)0.09
)0.36
)0.46
)0.20
)0.34
)0.39
)0.23
)0.34
)0.09
)0.48
)0.79
)0.02
)0.08
)0.47
)0.13
)0.17

)0.09
0.13
)0.14
)0.17
0.01
)0.12
)0.13
)0.02
)0.12
0.00
)0.23
)0.43
0.11
0.17
)0.22
0.00
0.01

0.17
0.21
0.21
0.26
0.20
0.19
0.24
0.19
0.20
0.08
0.23
0.35
0.11
0.24
0.21
0.12
0.16

)2.57
)3.79
)2.39
)3.46
)2.80
)2.37
)3.05
)2.41
)3.25
)1.09
)2.90
)3.71
)1.21
)3.25
)2.82
)2.29
)2.36

)7.68
)10.09
)7.24
)3.96
)6.92
)5.42
)5.98
)4.91
)8.17
)4.25
)10.33
)14.33
)0.17
)5.10
)10.33
)5.69
)8.40

)1.06
)1.92
)1.17
)1.51
)1.20
)1.09
)1.40
)1.04
)1.23
)0.44
)1.40
)2.31
)0.48
)1.37
)1.27
)0.83
)1.06

0.05
)0.16
0.08
0.02
0.01
0.11
0.02
0.06
0.15
0.08
0.08
0.31
0.04
)0.16
0.10
0.09
0.02

0.52
1.02
0.43
0.78
0.68
0.52
0.66
0.58
0.63
0.30
0.47
0.63
0.45
0.95
0.45
0.46
0.52

Notes:
metr: marg. eff. tax rate of domestic firms; w: wage; l: employment; ls : labour supply; u: unempl. rate;
k: capital stock; fdi: inward FDI; tro : lump-sum transfers; cv: CV.
All variables are percentage changes from base case, except for metr and u (% points) and cv and
tro (%GDP).

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1346

L. BETTENDORF, A. VAN DER HORST AND R. A. DE MOOIJ


TABLE B2
Unilateral Increase of the Labour Tax Rate

AUT
BLU
CZE
DEU
DNK
ESP
FIN
FRA
GBR
GRC
HUN
IRL
ITA
NLD
POL
PRT
SWE

wedge

ls

fdi

gdp

tro

cv

1.33
1.26
1.39
1.27
1.29
1.15
1.44
1.34
0.97
1.12
1.35
1.15
1.30
1.19
1.08
0.99
1.54

0.03
0.03
0.03
0.03
0.02
0.03
0.03
0.03
0.02
0.03
0.03
0.03
0.03
0.02
0.02
0.02
0.03

)0.82
)0.77
)0.75
)0.80
)0.67
)0.71
)0.83
)0.78
)0.58
)0.73
)0.75
)0.69
)0.82
)0.67
)0.66
)0.55
)0.84

)0.38
)0.33
)0.27
)0.36
)0.22
)0.29
)0.33
)0.31
)0.26
)0.33
)0.30
)0.30
)0.37
)0.28
)0.24
)0.21
)0.31

0.42
0.40
0.45
0.41
0.41
0.37
0.46
0.43
0.31
0.36
0.43
0.37
0.41
0.38
0.35
0.32
0.50

)0.80
)0.75
)0.73
)0.78
)0.66
)0.69
)0.81
)0.76
)0.57
)0.71
)0.73
)0.67
)0.80
)0.65
)0.64
)0.54
)0.81

)0.73
)0.70
)0.66
)0.70
)0.60
)0.62
)0.73
)0.69
)0.52
)0.64
)0.66
)0.61
)0.72
)0.60
)0.58
)0.49
)0.74

)0.79
)0.74
)0.72
)0.77
)0.65
)0.68
)0.80
)0.76
)0.57
)0.70
)0.72
)0.66
)0.79
)0.65
)0.64
)0.53
)0.81

0.04
0.02
0.05
0.04
)0.01
0.07
0.01
0.03
0.12
0.08
0.05
0.13
0.06
0.06
0.06
0.08
)0.02

0.56
0.57
0.51
0.55
0.60
0.47
0.60
0.56
0.45
0.49
0.52
0.46
0.52
0.50
0.46
0.44
0.67

Notes:
w: wage; l: employment; ls: labour supply; u: unemployment rate; k: capital stock; fdii: inward FDI;
gdp: GDP; tro : lump-sum transfers; cv: CV.
All variables are percentage changes from base case, except u (% points) and cv and tro (%GDP).

TABLE B3
Unilateral Increase of the Consumption Tax Rate

AUT
BLU
CZE
DEU
DNK
ESP
FIN
FRA
GBR
GRC
HUN
IRL
ITA
NLD
POL
PRT
SWE

wedge

ls

fdi

gdp

tro

cv

0.84
0.89
1.07
0.92
0.94
0.92
0.98
1.03
0.84
0.86
1.05
0.93
0.99
0.92
0.90
0.80
1.02

0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.01
0.02

)0.51
)0.54
)0.58
)0.58
)0.49
)0.57
)0.56
)0.61
)0.52
)0.57
)0.60
)0.56
)0.63
)0.52
)0.56
)0.46
)0.55

)0.23
)0.23
)0.21
)0.26
)0.16
)0.24
)0.22
)0.24
)0.23
)0.26
)0.24
)0.25
)0.28
)0.22
)0.21
)0.18
)0.20

0.27
0.28
0.34
0.29
0.30
0.29
0.31
0.33
0.27
0.28
0.34
0.30
0.31
0.30
0.29
0.26
0.33

)0.50
)0.53
)0.57
)0.56
)0.48
)0.56
)0.54
)0.59
)0.50
)0.55
)0.58
)0.54
)0.61
)0.51
)0.54
)0.45
)0.53

)0.46
)0.50
)0.52
)0.51
)0.44
)0.50
)0.49
)0.53
)0.46
)0.50
)0.53
)0.50
)0.55
)0.47
)0.49
)0.41
)0.49

)0.50
)0.52
)0.56
)0.56
)0.48
)0.55
)0.54
)0.59
)0.50
)0.55
)0.58
)0.54
)0.60
)0.50
)0.54
)0.44
)0.53

0.17
0.12
0.09
0.12
0.10
0.13
0.12
0.11
0.17
0.12
0.08
0.21
0.12
0.14
0.07
0.12
0.10

0.37
0.41
0.39
0.40
0.44
0.37
0.41
0.44
0.38
0.37
0.40
0.37
0.39
0.38
0.37
0.35
0.45

Notes:
w: wage; l: employment; ls : labour supply; u: unemployment rate; k: capital stock; fdi: inward FDI;
gdp: GDP; tro : lump-sum transfers; cv: CV.
All variables are percentage changes from base case, except for u (% points) and cv and tro (%GDP).

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1347

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