Welfare Reform in European Countries: A Microsimulation Analysis

Abstract

This paper estimates the welfare and distributional impact of two types of welfare reform inthe 15 (pre-enlargement) member countries of the European Union. The reforms are revenueneutral and financed by an overall and uniform increase in marginal tax rates on earnings.The first reform distributes the additional tax revenue uniformly to everybody (traditionalwelfare) while the second reform distributes tax proceeds uniformly to workers only (in-workbenefit). We build a simple model of labor supply encompassing responses to taxes andtransfers along both the intensive and extensive margin. We then use EUROMOD todescribe current welfare and tax systems in European Union countries and use calibratedlabor supply elasticities along the intensive and extensive margins to analyze the effects ofthe two welfare reforms. We quantify the equity-efficiency trade-off for a range of elasticityparameters. In most countries, because of large existing welfare programs with high phaseoutrates, the uniform redistribution policy is undesirable unless the redistributive tastes of thegovernment are extreme. The in-work benefit reform, on the other hand, is desirable in a verywide set of cases. We discuss the practical policy implications for European welfare policy.

Keywords: labour supply, redistribution, welfare reform

JEL Classification: H20