Progressive Taxation, Wages and Activity in a Small Open Economy.

Recent tax reforms in the OECD area have aimed at reducing the progressivity of the labour income taxation. The present analysis seeks to evaluate the effects of such reforms both theoretically and empirically for the case of Denmark. The theoretical general equilibrium model contains a dual labour market with imperfect competition in the market for white collar workers. Both the wage and the number of working hours is subject to bargaining between a local union of blue collar workers and the firm. This implies that the theoretical effect of a reduction in progressivity on the wage rate of blue collar workers is indeterminate. The empirical estimates show a positive effect. For the white collar workers the theoretical effect on the wage rate of a reduction in the progressivity is negative. This result is confirmed by the empirical estimates. Thus the analysis shows that for Denmark the effects on activity of general reductions in the progressivity of the labour income tax are mixed.