A Question from France

The Wall Street Journal (subscription required) describes a recent policy idea from France:

The government's latest proposal is to reduce the amount companies contribute to the state-run health-care and pension systems, which is based on the size of their work forces. To make up for the lost income, it would raise France's value-added tax.

Here is a good question for discussion: If a government reduces a payroll tax and raises a consumption tax, how does the tax shift affect the economy?

Here are my tentative answers:

1. The Labor-Leisure Decision. The shift does not alter the tax distortion between leisure and consumption. Both consumption taxes and payroll taxes distort that margin. The tax is collected at a different place (at the store rather than at work), but the disincentive to work is roughly the same.

2. The Saving Decision. Neither tax distorts the decision about consuming today versus consuming in the future. So the tax shift does not affect the incentive to save.

3. Distributional Effects. The shift may have some distributional effects--in particular, on the old versus the young. The old have already paid taxes on their wage income and now will have to pay taxes again when they consume out of savings. The young would seem to benefit by this shift of the tax burden to older generations. If the young have higher propensities to save than the old, this distributional effect could raise aggregate saving.

4. Short-run Macro Disequilibrium. Assuming the pretax price of goods is given by world prices, the after-tax price of goods in France will rise with the new sales tax. Nominal wages will rise as well, so that the after-tax real wage will be approximately unaffected. The transition to higher prices and higher nominal wages may not be instantaneous, so there may be some short-run macroeconomic effects (as was studied in this 1986 paper by Poterba, Rotemberg, and Summers). In particular, if nominal wages are slow to adjust to their higher level, the real wage will be temporarily lower than its equilibrium level, and this would tend to stimulate employment for a while.

Update: My colleague Emmanuel Farhi emails me:

I was reading your blog today. Encouraged by Olivier Blanchard, I actually wrote a note with Ivan Werning on the French reform under consideration. The note is attached, but is in French (we passed it on through Olivier to various people in the French government). We make all the points you are making, and a couple additional ones:

- A lot of non-traded goods and services are exempt from VAT. So the reform would [depress] consumption of traded goods and services relative to non-traded goods and services.

- Payroll taxes are highly progressive for wages between the minimum wage and 1.6 times the minimum wage. The reform would hurt those people, as the VAT is linear and not progressive.

- A lot of empirical studies find that a part of the VAT - up to 15% of the VAT - falls directly on firms and is not transmitted to consumer. This is called "VAT remanence" in French. Hence a VAT increase represents an increase in the tax on capital (investment).

- There is a lot of VAT fraud in Europe, that basically involves creating an ad-hoc firm that is supposed to go bankrupt with VAT liabilities.

- For many people, income comes from transfers from the government in one form or another. In France, this is true of pensions, unemployment benefits etc. Most of these transfers are indexed on inflation. So the reform would be neutral for them. A big question, given the importance of the public sector in France, is civil servant's wages.

Thanks, Emmanuel, for those insights.

I am puzzled by one thing: Why is a young, productive, untenured economist like you wasting time reading this blog?