The Impact of Tax, Product and Labour Market Distortions on the Phillips Curve and the Natural Rate of Unemployment

Most people accept that structural and labour market reforms are needed in Europe.

However few have been undertaken. The usual conjecture is that reforms are costly in

economic performance and costly to finance. Blanchard and Giavazzi (2003) and

Spector (2004) develop a general equilibrium model with imperfect competition to

show the impact of labour or product market deregulation. We extend that model to

combine both reforms, and include the costs of financing them, the conflict between

long run gains and short run costs, and to allow for reforms of distortionary taxation.

We also extend the model to explain the natural rate of unemployment and non-wage

employment costs, to show the impact of reform on the short and long run Phillips

curve parameters. We find that structural reforms imply short run costs but long run

gains (unemployment rises and then falls, while wages move in the opposite way);

that the long run gains outweigh the short run costs; and that the financing of such

reforms is the main stumbling block. We also find that the implications for welfare

improvements and employment generation are quite different: tax reforms are more

effective for welfare, but market liberalisation for employment.