Tax and Welfare Reforms : Stabilisation and Incentives Effects

Reforms aiming at lowering the tax burden and cutting social benefits may boost efficiency and output, and improve market adjustment to shocks, but, by reducing the size of automatic stabilisers, may also imply less cyclical smoothing. This would be problematic in EMU given the loss of national monetary autonomy. This paper argues that the alleged trade-off between efficiency/flexibility and stabilisation depends on the typology of shocks affecting the economy. While higher taxes and benefits stabilise output in the event of demand shocks, if the initial tax burden is high, they may have destabilising effects in the event of supply shocks. As to inflation, very high taxes are destabilising thereby increasing the likelihood of a policy conflict with the central bank. Numerical simulations show that European countries – especially very open ones – may well have a tax burden above the threshold beyond which perverse output stabilisation effects in the event of supply shocks occur. Hence tax reforms may not only improve efficiency, but, if supply shocks prevail, also enhance cyclical stabilisation