Tax Progression, Structure of Labour Taxation and Employment

According to a widely held popular belief, a pure increase in tax progression decreases work effort, increases wages and is thus bad for employment under competitive labour markets. This paper studies the effects of labour taxes in a general equilibrium model of two countries with monopoly unions, where wages are not determined by equality of the demand for and supply of labour. It is shown that increased domestic tax progression, which keeps government tax revenue unchanged, decreases both the domestic and foreign wages and thus raises employment in both countries. Moreover, a revenue neutral restructuring of labour taxation from employers to workers in the domestic country is good for employment in both countries, when the income tax base is smaller than payroll tax base. But when the income tax base is equal to the payroll tax base, a revenue neutral restructuring of labour taxation has no employment effect in either country.