Solving the unemployment puzzle in Europe

Abstract

High unemployment is a problem in most European countries. The starting point of this article is that structural problems in the labour market and economic disincentives due to benefit and tax systems are the main reason why Europe faces severe unemployment. Many suggestions have been made to solve the problem, but few countries have succeeded in fighting unemployment. This paper points out that Denmark has succeeded in fighting unemployment with a battery of instruments primarily structural in kind. Along the same lines, Europe also has to structure tax and benefit systems to make work pay. Especially high Net Replacement Rates at the lower end of the wage distribution create disincentives to work and reforms need to be implemented to make the benefit system more employment friendly. One suggestion - which this paper discusses - is to introduce an employment-conditional scheme through the tax system - the so-called Earned Income Tax Credit (EITC). The EITC improves employment opportunities for low skilled workers by strengthening incentives to work without reducing benefit entitlements. This is achieved by introducing a tax credit given to low income people with a job. Simulations suggest that the EITC can improve employment although it is not a 'free lunch'. Distortions arise from financing the EITC and from the withdrawal of the tax credit.