Differentiated payroll taxes, unemployment, and welfare

This paper investigates the impact of payroll taxes on unemployment and welfare in a two-sector economy characterised by imperfect competition in product and labour markets. The two sectors differ in market competitiveness. It turns out that only the relative tax pressure affects unemployment and welfare. Unemployment can be reduced by having the less competitive sector pay higher taxes. Moreover, differentiated payroll taxes will, in general, improve efficiency. Which sector to tax relatively more is, however, not clear. The government faces a tradeoff in the sense that unemployment is reduced only at the expense of reduced efficiency in the output mix. (C) 1998 Elsevier Science S.A. All rights reserved.