The Welfare State and Competitiveness

In all modern industrial countries, redistributive expenditures are a larger component of the government budget than consumption of goods and services. In this paper, we use a general equilibrium, two- country model with exportables, importables and nontradables to study redistribution across different types of agents in a world characterized by the presence of labor unions and distortionary taxation. We show that an increase in transfers to, say, retirees, financed by distortionary taxation, can generate a loss of competitiveness (defined as an increase in relative unit labor costs for tradable goods), an appreciation of the relative price of nontradables, and a decrease in employment in all sectors of the domestic economy. The same qualitative effects would also obtain in the case of an increase in transfers towards the unemployed even if financed by non-distortionary taxation. Moreover, all these effects of labor taxation depend in a nonlinear way on the degree of centralization of the wage setting process in the labor market. We then estimate the effects of labor taxation on unit labor costs and the relative price of nontradables in a sample of 14 OECD countries. We find considerable empirical support for the model.