The Impact of Taxes on Employment and Economic Growth in Industrialized Countries

Looking at economic trends in industrialized countries during the time frame 1965 to 1995, there has been an upward trend in unemployment, which appears to be related to the slowdown of economic growth. However, the relation between unemployment and a slowing growth pattern stems from an external variable: a rapid increase in the cost of labor. There are many factors behind the rise of labor costs, but the most significant reason is from higher taxes being placed on labor. Increasing labor taxes have two primary effects on employment and growth. First, the demand for labor is decreased as the cost rises, therefore creating unemployment. Second, because the cost of labor rises, firms will begin replacing labor with capital until the marginal product of capital falls, diminishing the incentive for investment and growth. The empirical evidence found in this paper proves this theory is accurate as a 10 percentage point increase in the tax rate on labor increase the unemployment rate by 5.3 percentage points and decreases growth by 2.1 percentage points.