Rafael Domenech and Jose Ramon Garcia

This paper considers the financing of productive public goods and social benefits through different types of taxes in a model with unemployment. We incorporate unemployment, caused by the wage-setting behaviour of a monopolistic union, in a neoclassical growth model which integrates a quite detailed structure of taxes used to finance productive public expenditures and social transfers and parameterizes the inefficiency of government to transform taxes into public goods or transfers. The main conclusion is that the relationship between unemployment and labour taxes critically depends on the degree of government efficiency and the unions' perception on how wages affect the welfare state. If unions internalize that transfers and social benefits are closely related to labour taxes, they do not pressure for higher wages in response to higher taxes. This result offers an alternative explanation to the lack of a positive correlation between unemployment and labour taxes in most OECD countries and periods, whereas the empirical evidence for 21 OECD countries support the effects on unemployment rates of the interaction between taxes and government inefficiency.

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