Unleashing Potential:

Model-Based Reform Benchmarking

for EU Member States
Philipp Pfeiffer, Janos Varga, Jan in ’t Veld
European Commission, DG ECFIN
Bank of Romania
November 2023

The views expressed here are solely those of the authors and do not necessarily reflect the views of the EC
 Model-based analysis of structural reforms
Model-based analysis can complement empirical estimates, which face
difficult identification challenges
• Can capture macroeconomic dynamics, feedback effects and clear transmission
channels.
• Enable consistent evaluation of broader macroeconomic results, e.g. impacts on trade,
fiscal deficits, employment, etc.
• Synergy between reform areas and inter-country interactions

Challenges:
• Structural reform measures do often not directly correspond to model variables (contrary to
e.g. standard fiscal policy measures)

• Need to proxy the measures in this case by their economic substance (using “satellite” tools)
=> TFP, mark-ups
Related literature on structural reforms
• Reduced-form regression: OECD framework described in Égert and Gál
(2018), OECD-Going for growth (2015)
- Typically links structural reforms to determinants of potential GDP, (TFP, employment,
investment → production function approach)
- Lacking comprehensive analysis of transmission channels

• Model-based: simulate stylised reforms:

• unit shocks (e.g 1 pps, 1%),
• average “typical” reforms,
• benchmarking (closing gaps)
QUEST-RD: Roeger et al. (2008), Varga and in ’t Veld (2013, 2014), Pfeiffer et al. (2023)
GIMF: Barkbu et al. (2012), Lusinyan and Muir (2013)
- Quantify a more comprehensive set of transmission channels and reforms
- Difficulty in quantifying the measures and mapping onto model variables
The paper in a nutshell
• Stylised assessment of the scope for reforms:

• We quantify the potential macroeconomic impact of structural reforms in the

EU Member States employing a benchmarking approach, closing half the
observed gaps in structural indicators.

• Focus on five policy areas: i.) market competition and regulation; ii.)
taxation; iii.) skills and education; iv.) labour markets; and v.) R&D

• Simulation results from a rich multi-country model with semi-endogenous

growth find significant potential gains in employment and output.

• We find considerable synergies and spillovers across reforms and countries

• And assess the sensitivity to alternative assumptions on technology

dynamics.
Modelling structural reforms
Overview of model structure
 QUEST-RD model
• Includes a detailed structure for each of the 27 MS & rest of the world:
• Based on our workhorse QUEST (DSGE) model: optimising households and firms (rich
second-round effects)

• Key features

• Rich set of entry points for structural reform indicators (regulation, taxation, benefits)
• R&D endogenously determines aggregate productivity
• Three types of labour (low-, medium-, and high skilled) allows shedding light on
education and skill-specific labour market policies
• International linkages
 QUEST-RD model
• Typical GE models have exogenous technological progress

• QUEST-RD features endogenous technological progress:

• Technological progress is a consequence of purposeful investments.
• Investors and innovators react to changes in underlying market structure
• Linking the process of technological change to the underlying market structure to
address policy questions
• Long-run features make the model suitable to address the economic impact of
reforms
• Product market reforms (mark-ups), human capital, female participation, tax
structure ...
• Endogenous growth helps explain slow recoveries (Cozzi et al., 2021)
QUEST-RD building blocks
Economy populated by:

Households Final goods producing firms

Low|Medium|High Monopolistic competition
skilled

Intermediate goods
R&D institute producing firms
Monopolistic competition

Monetary authority Fiscal authority

Central Bank Government
QUEST-RD building blocks
Final goods Mark up Household

Mark up
Credit frictions
Tangibles

Intermediate goods Research

Credit frictions
Intangibles
Entry Barrier
Subsidies

Entrants Regulation Government

→ simulation design
Households
• Not-liquidity constrained (Ricardian) households
• access to financial and capital markets

• buy new patents of designs produced by the R&D sector

• rent the designs to intermediate goods producers

• Liquidity-constrained households
• no access to financial and capital markets

• consume their current wage and non-wage income (transfers, benefits)

• Both households supply three skills: low-, medium-, and high-skilled

(𝑝𝑜𝑝𝐿 , 𝑝𝑜𝑝𝑀 , 𝑝𝑜𝑝𝐻 population shares)
 Final goods sector
Aggregate final output 𝑌𝑡 is CES aggregate of the varieties 𝑌𝑗,𝑡 , each produced using :

• 𝐴𝑡 varieties of intermediate inputs (𝑥𝑚,𝑡 ):

𝛼 𝐴𝑡 𝜃 1−𝛼 /𝜃
𝑌 𝛼
𝑌𝑗,𝑡 = 𝐴0𝑡 𝐿𝑗,𝑡 − 𝐹𝐶𝐿 ‫=𝑚׬‬0 𝑥𝑗,𝑚,𝑡 𝑑𝑚 𝐾𝐺𝑡 𝐺 -𝐹𝐶𝑌

• in a monopolistically competitive market

with final goods mark-up 𝜎𝑑 Τ 𝜎𝑑 − 1 1 𝜎𝑑 /(𝜎𝑑 −1)
(𝜎𝑑 −1)/𝜎𝑑
𝑌𝑡 = න 𝑌𝑗,𝑡 𝑑𝑗 ,
0

• aggregate of three skill types (𝐿𝑌𝑡 ): 𝜇

1 1−𝜇 1 1−𝜇 1 1−𝜇 1−𝜇
𝑌 𝐿 𝜇 𝐿 𝑀 𝐻𝑌 𝐻𝑌 𝜇
𝐿𝑗,𝑡 = (𝛬 ) 𝜒 𝐿 𝐿𝑗,𝑡 𝜇 + 𝑀 𝜇
(𝛬 ) 𝜒 𝑀 𝐿𝑗,𝑡 𝜇 + 𝐻𝑌 𝜇
(𝛬 ) 𝜒 𝐿𝑗,𝑡

• exogenous productivity ( 𝐴0𝑡 )

• public capital enhances private productivity (𝐾𝐺𝑡 )

11
Intermediate goods sector
Monopolistically competitive firms
• enter the market by licencing a design from domestic households
• make an initial payment (𝐹𝐶 𝐴 ) to overcome administrative entry
barriers
• (tangible) capital inputs are also rented from the household
sector
• entry occurs until the PDV of profits covers the entry cost

12
Research institute
Innovation corresponds to the discovery of new designs:
𝜙
∆𝐴𝑡 = 𝜐𝐴𝑡−1 (𝐴∗𝑡−1 )𝜓 (𝐿𝑅𝐷
𝑡 ) 𝜆
−𝛿 𝐴
𝐴𝑡−1
• invents in new designs (∆𝐴𝑡 )
• building on the accumulated stock of domestic knowledge (𝐴𝑡 )
• and foreign knowledge (𝐴∗𝑡−1 )
• R&D sector hires high-skilled labour (𝐿𝑅𝐷
𝑡 ) → trade-off with final goods sector

• can receive wage-subsidies (𝑠 𝑅𝐷 )

• 𝜙<0 “fishing out” ; 𝜙>0 “standing on shoulders”; 𝜙=1 endogenous growth
13
Fiscal & monetary authorities

Government expenditures:
• government purchases (𝐺𝑡 ) and investment (𝐼𝐺𝑡 ).
• nominal transfers consist of general social transfers and pension payments

𝑇𝑅𝑡 = trsGDPtN + ෍ 𝑃𝐸𝑁𝑆𝑅𝑅 𝑠 𝑊𝑡𝑠 𝑁𝑃𝑡55−64,𝑠

Other Social transfers 𝑠∈ 𝐿,𝑀,𝐻
Pension payments

• unemployment benefits linked to net wages

𝐵𝐸𝑁𝑡 = ෍ 𝑃𝑂𝑃𝑡𝑠 𝐵𝐸𝑁𝑅𝑅𝑡𝑠 𝑊𝑡𝑠 1 − 𝑁𝑃𝑡𝑠 − 𝐿𝑠𝑡

𝑠∈ 𝐿,𝑀,𝐻

14
cont.
Fiscal & monetary authorities
Government revenues:
• taxes on consumption (𝑡 𝑤 ) and on labour (𝑡 𝐶 ) and capital income.
• lump-sum taxes (𝑇𝑡 ) control the debt-to-GDP ratio
Monetary policy:
• Taylor-rule: central banks have a constant inflation target and also responds
to the output gap
• euro area members do not have independent Taylor-rule:
ECB sets the interest rate based on inflation and output gap in the euro area

15
28-region model

• Trade links all 28 (EU+RoW)

economies.
• Consider trade in final
goods
• Accounts for rich bilateral
spillovers of R&D stock
Calibration I

• Country-specific macroeconomic variables based on national

accounts, fiscal and trade data.
• Eurostat data for the breakdown of national accounting items
• Trade openness, bilateral trade from FIGARO
• Labour supply side, employment rate, inactivity rate, skill-
composition from Labour Supply Survey
• Regulation, competition: Product market reform indicators
(OECD), Doing Business database (WB)
Calibration II

• Taxation: Taxation trends (TAXUD)

• Support to R&D (OECD)
• Structural and behavioural parameters follow the
literature (Burgert et al. 2020)
• Knowledge production technology:
Bottazzi and Peri (2007)
Structural indicators and
reform benchmarking
Assumptions on reform implementation
Distance to frontiers in structural indicators
 Structural indicators and reform benchmarking
Structural reforms in
• market competition and regulation,
• tax structure
• labour market participation (pension reform), unemployment benefit generosity
• quality of human capital, skill structure, and R&D expenditure
Quantification: gradual closure of the gap with the 3 best EU performers
by 50%
• avoiding unrealistic/unattainable targets
• not actual reform measures
• implementation lags may be longer than assumed
Mapping structural indicators into the model
Measure Mapping Model counterpart Timing
assumptions

Market Product market regulation: mark-up Indirect 𝜎𝑑 Τ 𝜎𝑑 − 1 1 pp/y

competition and Entry costs (%): fixed costs entry Direct 𝐹𝐶 𝐴 5 ys
regulation barriers
Tax reforms Tax shift from labour to consumption Direct 𝑡 𝑐 /𝑡 𝑤 5 ys
tax
Skill enhancing Share of high-skilled (%) Direct 𝑝𝑜𝑝𝐻 /𝑝𝑜𝑝 45 ys
reforms Share of low-skilled (%) Direct 𝑝𝑜𝑝𝐿 /𝑝𝑜𝑝 45 ys
PISA score – quality of education Auxiliary 𝐴0 5+45 ys
elasticity

Labour market Non-participation (%, 25-55ys): Direct 𝑁𝑃 𝑠 20 ys

reforms Male and female
Elderly non-participation (%, 55- Direct 𝑁𝑃55−64,𝑠 20 ys
64ys):
Benefit replacement rate (%) Direct 𝐵𝐸𝑁𝑅𝑅 𝑠 5 ys

R&D measures R&D subsidy (% GDP): wage subsidy Direct 𝑠 𝑅𝐷 5 ys

Costs and fiscal policy assumptions
• No direct budgetary expenses/savings, except for R&D subsidies, and
savings from reductions in benefit replacement rates and from
pension reforms (participation 55-64)
• But all reforms indirectly impact the budget
• Tax-rule inactive for the first 50 years, targets debt-to-GDP ratio in the
long run
• Nominal transfers (excl. pensions, unemployment benefits) are
indexed to nominal GDP
• Government investment and purchases are constant as a share of
GDP
Macroeconomic effects of
structural reforms
• Effects by reform areas
• Spillover and synergies
• Sensitivity analysis
 GDP effects by Member States
Simultaneous implementation of all reforms, GDP (% difference)
45.0

40.0
5 ys
35.0
20 ys
30.0 LR

25.0

20.0

15.0

10.0

5.0

0.0
RO IT EL BG HR CY SK FR BE AT EA EU27 MT HU ES LU PL SI LV PT DE LT CZ IE DK NL FI EE SE
Break-down of long run effects (GDP %) across countries
45

40

35

30

25

20

15

10

0
RO IT EL BG HR CY SK FR BE AT EU27 MT HU ES
-5

25

20

15

10

0
LU PL SI LV PT DE LT CZ IE DK NL FI EE SE

-5

Bars: reform per MS. Red dot: all reforms per MS: Black dot: all reforms in all 27 MS
 GDP effects by reform areas
EU aggregate
Short run:
25

• tax reforms
20 • Market competition/
regulation
15 • labour market reforms

10 Medium to long run:

5
• skill enhancing reforms
• PISA
0
• R&D subsidy
5 years 10 years 15 years 20 years LR

Bars: reform per MS. Red dot: all reforms per MS: Black dot: all reforms in all 27 MS
Spillovers and synergies – EU aggregate
25
• Demand spillovers : growth-enhancing
reforms → higher exports demand
20 • Competitiveness effects: higher
productivity, improvement competiveness
→ by definition opposite effects across
15 countries (e.g Fadinger et al 2023)
• Synergies across reform areas within a
10 country are also relevant. E.g. reforms
that raise the share of high-skilled
workers also increase the effectiveness
5 of R&D-enhancing policies (and reducing
entry barriers for innovative activities).

0
5 years 10 years 15 years 20 years LR
Employment effects by reform areas
EU aggregate
• Mainly driven by those
10

reforms that boost labour

8
force participation
6 • Also shifting from low- to
medium skills, due to a
4
lower steady-state
unemployment rate for
2
medium-skilled workers
0 • LR employment effect less
than half GDP effect, i.e
-2
5 years 10 years 15 years 20 years LR
large productivity effect in
LR
 Demand effects by reform areas
EU aggregate
Consumption Investment
18 18

16 16

14 14

12 12

10 10

8 8

6 6

4 4

2 2

0 0

-2 -2
5 years 10 years 15 years 20 years LR 5 years 10 years 15 years 20 years LR
 …. but large gaps remain. Income differences are the result of a
complex interplay of various factors, e.g
• managerial practices
• differences in education levels and
skills more broadly than PISA
• quality of private and public capital
• integration in the global economy
• tax competition
• immigration and attraction of global
talent,
• property rights, the rule of law
• historical and geographical factors
• …

Catching-up and diffusion of technology can lead to further convergence in GDP per capita
 Sensitivity I: R&D effects: declining research productivity
Ideas harder to find & Additive growth
Implied Foreign
𝜙
• ∆𝐴𝑡 = 𝜐𝐴𝑡−1 (𝐴∗𝑡−1 )𝜓 (𝐿𝑅𝐷 𝜆 𝐴
𝑡 ) −𝛿 𝐴𝑡−1
𝜷𝑹𝑫 spillover 𝜓
(EU-27) included
∆𝐴𝑡 −𝛽 𝑅𝐷 Benchmark 0.56 yes
• = 𝜐𝐴𝑡−1 𝐿𝑅𝐷
𝑡
𝜆
− 𝛿𝐴
𝐴𝑡−1 Ideas getting harder to find (Bloom et al. 2020) 1.8 no
Additive growth (Philippon, 2022) 1 no
Sensitivity II : upskilling
Stylised directed technical change
𝜇
1 1−𝜇 1 1−𝜇 1 1−𝜇 1−𝜇
𝑌 𝐿 𝑀 𝐻𝑌
• 𝐿𝑗,𝑡 = (𝛬𝐿𝑡 )𝜇 𝜒 𝐿 𝐿𝑗,𝑡 𝜇 + (𝛬𝑀
𝑡 )
𝜇 𝜒 𝑀 𝐿𝑗,𝑡 𝜇 + (𝛬𝐻𝑌
𝑡 )
𝜇 𝜒 𝐻𝑌 𝐿𝑗,𝑡 𝜇

Stylized variant of (endogenous) directed technical change

in which firms adjust their production technology in line with the skill
distribution:
• Production share time-varying and responding directly to changes in
relative skills supply:
𝑧
𝑝𝑜𝑝𝑡
𝛬𝑡𝑧 =
𝑝𝑜𝑝𝑡

=> Changes in the skill structure lead to adjustment in technological

environment: Gains could be even larger.
Sensitivity II : upskilling
Stylised directed technical change
𝜇
1 1−𝜇 1 1−𝜇 1 1−𝜇 1−𝜇
𝑌 𝐿 𝑀 𝐻𝑌 𝑝𝑜𝑝𝑡𝑧
• 𝐿𝑗,𝑡 = (𝛬𝐿𝑡 )
𝜇 𝜒 𝐿 𝐿𝑗,𝑡 𝜇 + (𝛬𝑀
𝑡 )
𝜇 𝜒 𝑀 𝐿𝑗,𝑡 𝜇 + (𝛬𝐻𝑌
𝑡 )
𝜇 𝜒 𝐻𝑌 𝐿𝑗,𝑡 𝜇 , 𝛬𝑡𝑧 =
𝑝𝑜𝑝𝑡
Conclusion
Key findings
Final remarks
Key findings
• We have quantified the potential effects of ambitious supply-side reforms
with a model-based benchmarking approach.
• EU GDP level potentially increasing by over 20% by closing half of the gap
with top performers in all Member States.
• Competition and regulation, tax and labour market reforms have the most
significant short to medium-term effects, closing gaps in human capital
yields substantial gains in the long run.
• The benefits of reforms may take time to materialize, delays in addressing
these gaps can hinder countries' catch-up efforts.
• Reforms also create positive spillover effects in the long run, increase
growth potential beyond national actions.
Final remarks
• Effects of reforms can further be dependent on:
• Implementation speed
• Fiscal policy assumptions
(reduced gov. debt ratio creates space to reduce tax burden)
• Compensation payments to mitigate distributional impacts (unemployment benefit
and/or transfer recipients)

• Stylised assessment of the scope for reforms,

• We assume substantial improvements in the indicators without specifying
the precise details of the reforms (reform design, associated costs,
execution process)
• Not of concrete real-world reform measures (tend to be less ambitious)
Unleashing Potential:
Model-Based Reform Benchmarking for EU Member States

Pfeiffer, P., Varga, J. and in ’t Veld, J. (2023),

“Unleashing Potential: Model-Based Reform Benchmarking for
EU Member States”,
ECFIN Discussion Paper 192, July 2023.
https://economy-finance.ec.europa.eu/system/files/2023-07/dp192_en_1.pdf
 Thank you

© European Union 2020

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 Distance to frontiers in structural indicators
AT BE BG CY CZ DE DK EE EL ES FI FR HR HU IE IT LT LU LV MT NL PL PT RO SE SI SK Best
3
Market PMR indicator 1.44 1.69 1.93 1.80 1.30 1.08 1.02 1.29 1.56 1.03 1.37 1.57 1.43 1.32 1.38 1.32 1.19 1.68 1.28 1.54 1.10 1.45 1.34 1.86 1.11 1.29 1.52 1.05
competition
Market Entry costs (%) 10.4 6.7 7.4 7.0 7.3 8.9 1.2 1.9 2.6 7.3 4.3 1.8 11.4 6.2 2.4 17.0 1.9 4.2 3.0 11.3 5.0 20.7 3.6 5.7 2.6 2.2 6.8 1.6
regulation
Tax reform Labour to 2.1 2.0 0.8 1.1 1.7 2.3 1.7 1.2 1.1 1.9 1.5 2.0 0.7 1.2 1.4 1.9 1.4 2.0 1.1 1.0 1.7 1.2 1.2 1.2 2.1 1.4 1.6 0.8
consumption tax
revenue ratio
Skill enhancing Share of high- 8.5 9.0 5.5 6.6 6.5 7.7 11.2 7.7 5.3 6.5 11.3 6.1 5.5 5.6 10.7 3.9 7.3 9.8 5.1 7.6 11.0 6.7 7.9 5.6 12.7 7.5 4.1 11.7
reforms skilled (%)
Share of low- 14.4 21.3 17.5 17.5 6.2 13.4 18.5 9.8 23.2 38.7 9.9 19.6 14.2 15.0 16.3 37.8 5.0 20.7 8.8 44.8 20.4 7.4 47.8 21.0 13.9 11.2 8.6 6.2
skilled (%)
PISA score 491 500 427 438 495 500 501 526 453 482 516 494 472 479 505 477 480 477 487 459 502 513 492 428 503 504 469 518

Labour market Non-participation

reforms (%, 25-55ys):

- low-skilled 17.5 22.2 26.2 13.7 20.1 21.2 22.1 21.8 13.9 13.0 21.5 17.5 20.8 19.6 23.3 20.8 28.5 12.9 20.0 13.6 17.6 26.2 9.5 23.2 15.2 15.0 27.5 11.8

- medium-skilled 6.9 19.6 18.1 20.4 17.2 16.2 13.9 17.4 27.8 17.8 17.6 15.3 22.9 20.6 31.2 27.7 14.9 22.5 17.3 21.7 15.4 24.8 8.7 27.6 11.6 11.4 18.9 5.3

- high-skilled 5.9 6.3 4.6 7.5 10.3 6.9 4.0 7.4 5.1 7.0 5.8 5.0 4.6 9.4 6.5 10.9 3.5 5.7 5.5 5.0 4.7 6.4 3.5 3.8 3.5 3.5 11.2 3.5

Elderly non-
participation
(%, 55-64ys):
- low-skilled 20.7 24.9 14.1 17.6 18.3 11.6 13.1 9.6 22.3 14.9 17.2 21.8 35.8 18.5 19.4 18.7 8.8 23.5 9.6 18.8 16.2 24.7 15.3 16.3 8.9 29.3 19.7 9.1
- medium-skilled 9.7 8.3 7.1 5.7 6.6 6.4 5.4 5.7 9.5 5.5 6.8 8.7 11.8 8.6 5.5 6.2 7.4 9.2 7.1 4.0 5.2 11.8 3.5 10.8 3.6 11.1 8.4 3.7

- high-skilled 4.1 3.6 4.6 1.9 2.9 3.1 1.4 3.6 4.0 3.4 2.9 2.6 3.1 3.0 2.8 2.9 3.5 3.2 5.1 2.8 2.5 3.4 2.7 5.2 1.7 2.5 3.6 1.6
Benefit 67.6 56.6 32.5 50.5 37.7 51.5 60.7 41.9 40.7 41.9 59.7 49.9 39.2 30.0 62.3 48.0 45.2 57.3 58.0 51.5 48.0 46.9 39.1 33.2 66.0 59.8 40.1 48.7*
replacement rate*
(%)

R&D measure R&D subsidy (% 0.19 0.21 0.00 0.00 0.05 0.00 0.03 0.00 0.01 0.03 0.00 0.28 0.00 0.05 0.18 0.16 0.03 0.00 0.00 0.03 0.15 0.02 0.20 0.01 0.01 0.10 0.03 0.23
GDP)
Romania: closing half the gaps
Romania: closing half the gaps
Reform areas RO Target GDP % relative to baseline
5 years 10 years 15 years 20 years LR
Market competition PMR index 1.86 1.05 1.6 2.0 2.3 2.6 3.0
Market regulation Entry costs 5.71 1.65 0.0 0.0 0.0 0.0 0.1
Tax reforms Tax shift from labour to consumption tax 1.18 0.84 0.1 0.2 0.2 0.2 0.2
Skill enhancing reforms Share of high-skilled 5.6 11.7 0.3 0.7 1.1 1.5 4.0
Share of low-skilled 21.0 6.2 0.2 0.4 0.7 0.9 2.1
PISA score 427.8 518.3 0.9 2.2 3.4 4.8 13.7
Labour market reforms Non-participation (25-55ys): 0.5 1.1 1.7 2.3 2.9
- low-skilled 23.2 11.8
- medium-skilled 27.6 5.3
- high-skilled 3.8 3.5

Elderly non-participation (55-64ys): 0.6 1.4 2.2 3.1 3.9

- low-skilled 16.3 9.1
- medium-skilled 10.8 3.7
- high-skilled 5.2 1.6
Benefit replacement rate 33.2 48.7 0.0 0.0 0.0 0.0 0.0
R&D measure R&D subsidy 0.01 0.23 0.1 0.5 0.7 0.8 1.0
Total, sum of shocks 4.4 8.4 12.4 16.1 30.9
Total, incl. spillovers, full simulation 4.5 8.9 13.5 18.2 40.6
Total, no spillovers 4.4 8.7 12.9 17.0 34.0
Spillovers=Total, incl. spillovers, full simulation-Total, no spillovers 0.0 0.3 0.7 1.2 6.6