Labor Tax Reforms, Cross-Country Coordination, and the Monetary Policy Stance in the Euro Area: A Structural Model-Based Approach

We evaluate the effects of permanently reducing labor tax rates in the euro area (EA) by simulating a large-scale open-economy dynamic general equilibrium model. The model features the EA as a monetary union, split into two regions (home and the rest of the EA, or REA), the United States, and the rest of the world, region-specific labor markets with search and matching frictions, and public employment. Our results are as follows. First, a permanent reduction in labor tax rates in the home region would have stimulating effects on domestic economic activity and employment. Second, reducing labor tax rates simultaneously in both home and REA would have additional expansionary effects on the home region. Third, the short-run macroeconomic effectiveness of the EA-wide tax reduction is enhanced if the EA monetary policy is accommodating.