How Do Laffer Curves Differ Across Countries?

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 1048 May 2012 How Do Laffer Curves Differ Across Countries? Mathias Trabandt and Harald Uhlig NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge from the Social Science Research Network electronic library at www.ssrn.com.

I How Do La(cid:11)er Curves Di(cid:11)er Across Countries? Mathias Trabandta, Harald Uhligb,c aMathias Trabandt, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, D.C. 20551, USA bHarald Uhlig, Department of Economics, University of Chicago, 1126 East 59th Street, Chicago, IL 60637, USA cNBER, CEPR, CentER, Deutsche Bundesbank Abstract We seek to understand how La(cid:11)er curves di(cid:11)er across countries in the US and the EU-14, thereby providing insights into (cid:12)scal limits for government spending and the service of sovereign debt. As an application, we analyze the consequences for the permanent sustainability of current debt levels, when interest rates are permanently increased e.g. due to default fears. We build on the analysis in Trabandt and Uhlig (2011) and extend it in several ways. To obtain a better (cid:12)t to the data, we allow for monopolistic competition as well as partial taxation of pure pro(cid:12)t income. We update the sample to 2010, thereby including recent increases in government spending and their (cid:12)scal consequences. We provide new tax rate data. We conduct an analysis for the pessimistic case that the recent (cid:12)scal shifts are permanent. We include a cross-country analysis on consumption taxes as well as a more detailed investigation of the inclusion of human capital considerations for labor taxation. Keywords: La(cid:11)er curve, taxation, cross country comparison, debt sustainability, (cid:12)scal limits, quantitative endogenous growth, human capital and labor taxation JEL Classi(cid:12)cation: E0, E13, E2, E3, E62, H0, H2, H3, H6 IThis version: May 4, 2012. We are grateful to Roel Beetsma and Jaume Ventura for useful discussions. Further, we are grateful to Alan Auerbach, Alberto Alesina, Axel Boersch-Supan, Francesco Giavazzi, Laurence Kotliko(cid:11) and Valerie Ramey for useful comments and suggestions. The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as re(cid:13)ecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System. Email addresses: mathias.trabandt@gmail.com (Mathias Trabandt), huhlig@uchicago.edu (Harald Uhlig)

1. Introduction We seek to understand how La(cid:11)er curves di(cid:11)er across countries in the US and the EU-14. This provides insight into the limits of taxation. As an application, we analyze the consequences of recent increases in government spending and their (cid:12)scal consequences as well as the consequences for the permanent sustainability of current debt levels, when interest rates are permanently high e.g. due to default fears. We build on the analysis in Trabandt and Uhlig (2011). There, we have characterized La(cid:11)er curves for labor and capital taxation for the U.S., the EU-14, and individual European countries. In the analysis, a neoclassical growth model featuring \constant Frisch elasticity" (CFE) preferences are introduced and analyzed: we use the same preferences here. The results there suggest that the U.S. could increase tax revenues considerably more than the EU-14, and that conversely the degree of self-(cid:12)nancing of tax cuts is much larger in the EU-14 than in the U.S. While we have calculated results for individual European countries, the focus there was directed towards a comparison of the U.S. and the aggregate EU-14 economy. This paper provides a more in-depth analysis of the cross-country comparison. Furthermore, we modify the analysis in two important dimensions. The model in Trabandt and Uhlig (2011) overstates total tax revenues to GDP compared to the data: in particular, labor tax revenues to GDP are too high. We introduce monopolistic competition to solve this: capital income now consists out of rental rates to capital as well as pure pro(cid:12)ts, decreasing the share of labor income in the economy. With this change alone, the model now overpredicts the capital income tax revenue. We therefore furthermore assume that only a fraction of pure pro(cid:12)t income is actually reported to the tax authorities and therefore taxed. With these two changes, the (cid:12)t to the data improves compared to the original version, see (cid:12)gure 2. In terms of the La(cid:11)er curves, this moves countries somewhat closer to the peak of the labor tax La(cid:11)er curve and somewhat farther away from the peak of the capital tax La(cid:11)er curve. For the cross-country comparison, we assume that all structural parameters for technologies and preferences are the same across countries. The di(cid:11)erences between the La(cid:11)er curves therefore arise solely due to di(cid:11)erences in (cid:12)scal policy i.e. the mix of distortionary taxes, government spending and government debt. We (cid:12)nd that 2

labor income and consumption taxes are important for accounting for most of the cross-country di(cid:11)erences. We re(cid:12)ne the methodology of Mendoza et al. (1994) to calculate e(cid:11)ective tax rates on labor and capital income. Broadly, we expand the measured labor tax base by including supplements to wages as well as a fraction of entrepreneurial income of households. As a result, the re(cid:12)nements imply a more reasonable labor share in line with the literature. More importantly, the average 1995-2010 labor income taxes turn out to be lower while capital income taxes are somewhat higher as previously calculated in Trabandt and Uhlig (2011). We update our analysis in Trabandt and Uhlig (2011) by including the additional years 2008- 2010. This is particularly interesting, as it allows us to examine the implications of the recent substantial tax and revenue shocks. While recent (cid:12)scal policy changes were intended to be temporary, we examine the pessimistic scenario that they are permanent. To do so, we calibrate the model to the La(cid:11)er curves implied by the strained (cid:12)scal situation of 2010, and compare them to the La(cid:11)er curves of the average extended sample 1995-2010. We (cid:12)nd that the 2010 calibration moves almost all countries closer to the peak of the labor tax La(cid:11)er curve, with the scope for additional labor tax increases cut by a third for most countries and by up to one half for some countries. It is important, however, to keep the general equilibrium repercussions of raising taxes in mind: even though tax revenues may be increased by some limited amount, tax bases and thereby output fall when moving to the peak of the La(cid:11)er curve due to the negative incentive e(cid:11)ects of higher taxes. We then use these results to examine the scope for long-term sustainability of current debt levels, when interest rates are permanently higher due to, say, default fears. This helps to understand the more complex situation of an extended period with substantially increased interest rates due to, say, default fears. More precisely, we answer the following question: what is the maximum steady state interest rate on outstanding government debt that the government could a(cid:11)ord without cutting government spending, based on a calibration to the (cid:12)scal situation in 2010? To do so, we calculate the implied peak of the La(cid:11)er curve and compute the maximum interest rate on outstanding government debt in 2010 that would still balance the government budget constraint in steady state. The results of our baseline model are in table 7: the most interesting 3

column there may be the second one. We (cid:12)nd that the USA can a(cid:11)ord the highest interest rate if labor taxes are moved to the peak of the La(cid:11)er curve: depending on the debt measure used, a real interest rate of of 12% to 15.5% is sustainable. Interestingly, Ireland can also a(cid:11)ord the high rate of 11.2%, when moving labor taxes only. By contrast, Austria, Belgium, Denmark, Finland, France, Greece and Italy can only a(cid:11)ord permanent real rates in the range of 4.4% to 7.1%, when (cid:12)nancing the additional interest payments with higher labor tax rates alone, while, say, Germany, Portugal and Spain can all a(cid:11)ord an interest rate somewhere above 9%. The picture improves somewhat, but not much, when labor taxes and capital taxes can both be adjusted: notably, Belgium, Denmark, Finland, FranceandItalycannotpermanentlya(cid:11)ordrealinterestratesabove 6.5%. Below we also examine the implications of human capital accumulation and show that the maximum interest rates may be even lower than suggested by our baseline model. It is worth emphasizing that we have not included the possibility of cutting government spending and/or transfers and that our analysis has focussed on the most pessimistic scenario of a permanent shift. In the baseline model, physical capital is the production factor that gets accumulated. It may be important, however, to allow for and consider human capital accumulation, when examining the consequences of changing labor taxation. We build on the quantitative endogenous growth models introduced in Trabandt and Uhlig (2011), and provide a more detailed cross-country comparison. We (cid:12)nd that the capital tax La(cid:11)er curve is a(cid:11)ected only rather little across countries when human capital is introduced into the model. By contrast, the introduction of human capital has important e(cid:11)ects for the labor income tax La(cid:11)er curve. Several countries are pushed on the slippery slope sides of their labor tax La(cid:11)er curves once human capital is accounted for. Intuitively, higher labor taxes lead to a faster reduction of the labor tax base since households work less and aquire less human capital which in turn leads to lower labor income. We recalculate the implied maximum interest rates on government debt in 2010 when human capital accumulation is allowed for in the model. Table 9 contains the results: the US may only a(cid:11)ord a real interest rate between 5.8% to 6.6% in this case. Most of the European countries cluster between 4% and 4.9% except for Denmark, Finland and Ireland who can a(cid:11)ord real interest rates between 5.9% and 9.5%. 4

We add a cross-country analysis on consumption taxes. In Trabandt and Uhlig (2011), we have shown that the consumption tax La(cid:11)er curve has no peak. Essentially, the di(cid:11)erence between the labor tax La(cid:11)er curve and the consumption tax La(cid:11)er curve arises due to \accounting" reasons: the additional revenues are provided as transfers, and are used for consumption purchases, to be taxed at the consumption tax rate. In Trabandt and Uhlig (2011), we only provided the analysis for the U.S. and the aggregate EU-14 economy. Here, we extend the consumption tax analysis to individual countries. The range of maximum additional tax revenues (in percent of GDP) in the baseline model is roughly 40-100 percent while it shrinks to roughly 10-30 percent in the model with added human capital. Higher consumption taxes a(cid:11)ect equilibrium labor via the labor wedge, similar to labor taxes. As above, human capital ampli(cid:12)es the reduction of the labor tax base triggered by the change in the labor wedge. Overall, maximum possible tax revenues due to consumption taxes are reduced massively, although at fairly high consumption tax rates. The paper is organized as follows. Section 2 provides the model. The calibration and parameterization of the model can be found in section 3. Section 4 provides and discusses the results. Section 5 discusses the extension of the model with human capital as well as the results for consumption taxation. Finally, section 6 concludes. 2. Model We employ the baseline model in Trabandt and Uhlig (2011) and extend it by allowing for intermediate inputs, supplied by monopolistically competitive (cid:12)rms. Time is discrete, t = 0;1;:::;1. Households maximize ∑1 max E (cid:12)t[u(c ;n )+v(g )] ct;nt;kt;xt;bt 0 t t t t=0 subject to (1+(cid:28)c)c +x +b = (1(cid:0)(cid:28)n)w n +(1(cid:0)(cid:28)k)[(d (cid:0)(cid:14))k +ϕ(cid:5) ] t t t t t t t t t t(cid:0)1 t +(cid:14)k +Rbb +s +(1(cid:0)ϕ)(cid:5) +m t(cid:0)1 t t(cid:0)1 t t t k = (1(cid:0)(cid:14))k +x (1) t t(cid:0)1 t 5

where c , n , k , x , b , m denote consumption, hours worked, capital, investment, government t t t t t t bonds and an exogenous stream of payments. The household takes government consumption g , which provides utility, as given. Further, the household receives wages w , dividends d , t t t pro(cid:12)ts (cid:5) from (cid:12)rms and asset payments m . The payments m are a stand-in for net imports, t t t modelled here as exogenously given income from a \tree", see Trabandt and Uhlig (2011) for further discussion. The household obtains interest earnings Rb and lump-sum transfers s from t t the government. It has to pay consumption taxes (cid:28)c, labor income taxes (cid:28)n and capital income t t taxes (cid:28)k on dividends and on a share ϕ of pro(cid:12)ts.1 t As introduced and extensively discussed in Trabandt and Uhlig (2011), but also used in Hall (2009), Shimer (2009) and King and Rebelo (1999), we work with constant Frisch elasticity preferences (CFE), given by u(c;n) = log(c)(cid:0)(cid:20)n1+ φ 1 (2) if (cid:17) = 1, and by ( ( ) ) 1 (cid:17) u(c;n) = c1(cid:0)(cid:17) 1(cid:0)(cid:20)(1(cid:0)(cid:17))n1+ φ 1 (cid:0)1 (3) 1(cid:0)(cid:17) if (cid:17) > 0;(cid:17) ̸= 1, where (cid:20) > 0. These preferences are consistent with balanced growth and feature a constant Frisch elasticity of labor supply, given by φ, without constraining the intertemporal elasticity of substitution. Competitive (cid:12)nal good (cid:12)rms maximize pro(cid:12)ts max y (cid:0)d k (cid:0)p z (4) kt(cid:0)1;zt t t t(cid:0)1 t t subject to the Cobb-Douglas production technology, y = (cid:24)tk(cid:18) z1(cid:0)(cid:18), where (cid:24)t denotes the trend t t(cid:0)1 t of total factor productivity. p denotes the price of an homogenous input, z , which in turn is t t produced by competitive (cid:12)rms who maximize pro(cid:12)ts ∫ max p z (cid:0) p z di (5) t t t;i t;i zt;i 1We allow for partial pro(cid:12)t taxation due to the various deductions and exemptions that are available for (cid:12)rms andhouseholdsinthisregard. Further,notethatcapitalincometaxesareleviedondividendsnet-of-depreciation as in Prescott (2002, 2004) and in line with Mendoza et al. (1994). 6

( ) ∫ 1 ! subject to z = z! di with ! > 1. Intermediate inputs, z , are produced by monopolistit t;i t;i cally competitive (cid:12)rms which maximize pro(cid:12)ts max p z (cid:0)w n t;i t;i t t;i pt;i subject to their demand functions and production technologies: ( ) ! p !(cid:0)1 t z = z t;i t p t;i z = n t;i t;i In equilibrium, all (cid:12)rms set the same price which is a markup over marginal costs. Formally, p = p = !w . Aggregate equilibrium pro(cid:12)ts are given by (cid:5) = (! (cid:0)1)w n . t;i t t t t t The government faces the budget constraint, g +s +Rbb = b +T (6) t t t t(cid:0)1 t t where government tax revenues are given by T = (cid:28)cc +(cid:28)nw n +(cid:28)k[(d (cid:0)(cid:14))k +ϕ(cid:5) ] (7) t t t t t t t t t(cid:0)1 t It is the goal to analyze how the equilibrium shifts, as tax rates are shifted. More generally, the tax rates may be interpreted as wedges as in Chari et al. (2007), and some of the results in this paper carry over to that more general interpretation. What is special to the tax rate interpretation and crucial to the analysis in this paper, however, is the link between tax receipts and transfers (or government spending) via the government budget constraint. The paper focuses on the comparison of balanced growth paths. We assume that government debt, government spending as well as net imports do not deviate from their balanced growth paths, i.e. we assume that b = t(cid:22) b, g = tg(cid:22) as well as m = tm(cid:22) where is the growth t(cid:0)1 t t factor of aggregate output. We consider exogenously imposed shifts in tax rates or in returns 7

on government debt. We assume that government transfers adjust according to the government budget constraint (6), rewritten as s = t(cid:22) b( (cid:0)Rb)+T (cid:0) tg(cid:22). t t t 2.1 Equilibrium In equilibrium the household chooses plans to maximize its utility, the (cid:12)rm solves its maximization problem and the government sets policies that satisfy its budget constraint. In what follows, key balanced growth relationships of the model that are necessary for computing La(cid:11)er curves are summarized. Except for hours worked, interest rates and taxes all other variables grow at a 1 constant rate = (cid:24)1(cid:0)(cid:18). For CFE preferences, the balanced growth after-tax return on any asset is R (cid:22) = (cid:17)=(cid:12). It is assumed throughout that (cid:24) (cid:21) 1 and that parameters are such that R (cid:22) > 1, but (cid:12) is not necessarily restricted to be less than one. Let k=y denote the balanced growth path value of the capital-output ratio k =y . In the model, it is given by t(cid:0)1 t ( ) R (cid:22) (cid:0)1 (cid:14) (cid:0)1 k=y = + : (8) (cid:18)(1(cid:0)(cid:28)k) (cid:18) Labor productivity and the before-tax wage level are given by, y (cid:18) (1(cid:0)(cid:18))y t = tk=y1(cid:0)(cid:18) and w = t : t n(cid:22) ! n(cid:22) It remains to solve for the level of equilibrium labor. Let c=y denote the balanced growth path ratio c =y . With the CFE preference speci(cid:12)cation and along the balanced growth path, the t t (cid:12)rst-order conditions of the household and the (cid:12)rm imply ( ) (cid:0)1 1 (cid:17)(cid:20)n(cid:22)1+ φ 1 +1(cid:0) = (cid:11)c=y (9) (cid:17) ( ) ( ) where (cid:11) = ! 1+(cid:28)c 1+ φ 1 depends on tax rates, the labor share, the Frisch elasticity of labor 1(cid:0)(cid:28)n 1(cid:0)(cid:18) supply and the markup. 8

In this paper, we shall concentrate on the case when transfers s(cid:22) are varied and government spending g(cid:22) is (cid:12)xed. Then, the feasibility constraint implies 1 c=y = (cid:31)+(cid:13) (10) n(cid:22) (cid:0)(cid:18) where (cid:31) = 1 (cid:0) ( (cid:0) 1 + (cid:14))k=y and (cid:13) = (m(cid:22) (cid:0)g(cid:22))k=y1(cid:0)(cid:18): Substituting equation (10) into (9) therefore yields a one-dimensional nonlinear equation in n(cid:22), which can be solved numerically, (cid:22) given values for preference parameters, production parameters, tax rates and the levels of b, g(cid:22) and m(cid:22). After some straightforward algebra, total tax revenues along a balanced growth path can be calculated as [ ( )] (1(cid:0)(cid:18)) ! (cid:0)1 T = (cid:28)cc=y +(cid:28)n +(cid:28)k (cid:18)(cid:0)(cid:14)k=y +ϕ(1(cid:0)(cid:18)) y (11) ! ! and equilibrium transfers are given by, ( ) s = (cid:0)Rb b(cid:0)g +T: (12) 3 Data, calibration and parameterization The model is calibrated to annual post-war data of the USA, the aggregate EU-14 economy and individual European countries. An overview of the calibration is in tables 1 and 2. We re(cid:12)ne the methodology of Mendoza et al. (1994) to calculate e(cid:11)ective tax rates on labor and capital income. Broadly, we expand the measured labor tax base by including supplements to wages as well as a fraction of entrepreneurial income of households. As a result, the re(cid:12)nements imply a more reasonable labor share in line with the empirical literature. More importantly, the average 1995-2010 labor income taxes turn out to be lower while capital income taxes are higher as previously calculated in Trabandt and Uhlig (2011). Appendix A provides the new tax rates across countries over time and Appendix B contains the details on the calculations with further discussion of the implications for e.g. the La(cid:11)er curves. 9

There are two new key parameters, compared to Trabandt and Uhlig (2011). The (cid:12)rst parameter is !, the gross markup, due to monopolistic competition. We set ! = 1:1, which appears to be a reasonable number, given the literature. The second parameter is ϕ, the share of monopolisticcompetition pro(cid:12)ts which are subject to capital taxes. We set this parameter equal to the capital share, i.e. to 0.36. While we could have explored speci(cid:12)c evidence to help us pin down this parameter, we have chosen this value rather arbitrarily and with an eye towards the (cid:12)t of the model to the data instead. The sample covered in Trabandt and Uhlig (2011) is 1995-2007. Here we extend the sample to 2010 using the same data sources. We update all data up to 2010, except for taxes and tax revenues which we can update only to 2009 due to data availability reasons. For most of the analysis in this paper, we assume that the 2010 observation for taxes and revenues are the same as in 2009. We also pursue an alternative approach for tax rates for the year 2010, see subsection 3.2 below for the details. We also re(cid:12)ne the calculation of transfers in the data compared to Trabandt and Uhlig (2011). In the data, there is a non-neglible di(cid:11)erence between government tax revenues and government revenues. This di(cid:11)erence is mostly due to \other government revenue" and \government sales". Wesubstractthesetwoitemsfromthemeasureoftransfersde(cid:12)nedinTrabandtandUhlig(2011). USandaggregateEU-14taxrates, governmentexpendituresandgovernmentdebtaresetaccording to the upper part of table 1. We also calibrate the model to individual EU-14 country data for tax rates, government spending and government debt as provided in table 2. Although we allow (cid:12)scal policy to be di(cid:11)erent across countries, we restrict the analysis to identical parameters across countries for preferences and technology, see the lower part of table 1 for the details.2 Finally, the empirical measure of government debt for the US as well as the EU-14 area provided bytheAMECOdatabaseisnominalgeneralgovernmentconsolidatedgrossdebt(excessivede(cid:12)cit procedure, based on ESA 1995) which is divided by nominal GDP. For the US the gross debt to GDP ratio is 66.2% in the sample. For checking purposes, we also examine the implications if 2SeeTrabandtandUhlig(2011)forthedi(cid:11)erenceswithrespecttoLa(cid:11)ercurveswhenparametersfortechnology and preferences are assumed to be identical or country speci(cid:12)c. 10

we use an alternative measure of US government debt: debt held by the public. See tables 1 and 2 for the di(cid:11)erences. However, given that to our knowledge data on \debt held by the public" is not available for European countries, we shall proceed by using gross debt as a benchmark if not otherwise noted. Where appropriate, we shall perform a sensitivity analysis with respect to the measure of US government debt. 3.1 Model Fit and Sensitivity The structual parameters are set such that model implied steady states are close to the data. In particular, (cid:12)gure 1 provides a comparison of the data vs. model (cid:12)t for key great ratios, hours as well as transfers and tax revenues.3 Overall, the (cid:12)t is remarkable given the relatively simple model in which country di(cid:11)erences are entirely due to (cid:12)scal policy.4 Most of the structual parameter values in the lower part of table 1 are standard and perhaps uncontroversial, see e.g. Cooley and Prescott (1995), Prescott (2002, 2004, 2006) and Kimball and Shapiro (2008). The new parameters here compared to Trabandt and Uhlig (2011) are the gross markup, ! = 1:1 and the share of monopolistic-competition pro(cid:12)ts subject to capital taxation, ϕ = (cid:18) = 0:36. Figure 2 contains a sensitivity analysis for ! and ϕ. When ! ! 1, the model overstates labor tax revenues and understates capital tax revenues, see the black crosses in (cid:12)gure 2.5 In the adapted model with intermediate inputs, a gross markup ! > 1 reduces the labor tax base. At the same time, pro(cid:12)ts increase the capital tax base, but too much if pro(cid:12)ts are fully subject to capital taxation, i.e. ϕ = 1, see the red triangles in (cid:12)gure 2. Overall, the (cid:12)t improves considerably if we set the share of pro(cid:12)ts subject to capital taxes, ϕ = (cid:18) = 0:36. The (cid:12)t is not sensitive to ϕ: all values in ϕ 2 [0:3;0:4] work practically just as well in terms of the (cid:12)t, for example. 3We assume a mapping of data and model in the literal sense, i.e. the one based on the de(cid:12)nitions of the national income and product accounts and the revenues statistics. For work that takes an alternative perspective and emphasizes the general relativity of (cid:12)scal language, see Green and Kotliko(cid:11) (2009). 4The present paper, and in particular the comparison of data vs. model hours is closely related to Prescott (2002,2004)andsubsequentcontributionsbye.g. Blanchard(2004),Alesinaetal.(2006),LjungqvistandSargent (2007), Rogerson (2007) and Pissarides and Ngai (2009). 5Note that in this case, the value of ϕ becomes immaterial since equilibrium pro(cid:12)ts are zero. 11

3.2. The year 2010 At the end of our sample, government spending and government debt have risen substantially as a fallout of the (cid:12)nancial crisis, see table 2. We are particularly interested in characterizing La(cid:11)er curves for the year 2010. While there is no tax rate data for the year 2010 at the time of writing this paper, we do have data for government spending and debt in 2010. We wish to consider the pessimistic scenario of a steady state, in which these changes are permanent. We therefore use the government budget constraint of the model to infer the labor tax rate, i.e. we calculate the implied labor tax given government debt and government consumption in 2010 as well as average (1995-2010) model implied government transfers. Table 2 contains the resulting labor tax rates across countries. According to the model, in the US and EU-14 labor taxes need to be 5-8 percentage points higher to balance the government budget in 2010 compared to the sample average. There is substantial country speci(cid:12)c variation. While e.g. labor taxes in Germany and Italy remain unchanged, those in the United Kingdom, Ireland, Spain and the Netherlands increase by 10 or more percentage points. 4. Results 4.1. Sources of di(cid:11)erences of La(cid:11)er curves What accounts for the di(cid:11)erences between the USA La(cid:11)er curves and (individual) EU-14 La(cid:11)er curves? To answer this question, we proceed as follows. As before, we calibrate the model to country speci(cid:12)c averages of 1995-2010, see table 2, keeping structural parameters as in table 1. Next, we compute La(cid:11)er curves. Results are in the \Baseline" column of tables 3 and 4. All other columns report results if in the USA calibration, (cid:12)scal instruments are set to European country speci(cid:12)c values, one at a time. It appears that labor income and consumption taxes are most important for accounting for cross-country di(cid:11)erences. Imposing country speci(cid:12)c debt to GDP ratios has no e(cid:11)ect in our calculations, due to Ricardian equivalence: a di(cid:11)erent debt to GDP ratio, holding taxes and government consumption (cid:12)xed, results in di(cid:11)erent transfers along the equilibrium path. 12

Finally, note that compared to Trabandt and Uhlig (2011), intermediate inputs and pro(cid:12)t taxation in the present paper move countries somewhat closer to the peak of the labor tax La(cid:11)er curve and somewhat farther away from the peak of the capital tax La(cid:11)er curve. 4.2. La(cid:11)er curves: average 1995-2010 vs. 2010 To compute La(cid:11)er curves, we trace out tax revenues across balanced growth paths, as we change eitherlabortaxratesorcapitaltaxrates,andcomputingtheresultingchangesintransfers. When changing both tax rates, we obtain a \La(cid:11)er hill". We compute La(cid:11)er curves and the La(cid:11)er hill for a 1995-2010 vs. 2010 calibration, i.e., when the model is calibrated in terms of (cid:12)scal policy either to the average of 1995-2010 or to the year 2010, see table 2. Structural parameters are set as in table 1. Figure 3 shows the resulting La(cid:11)er curves for all countries for the average 1995-2010 calibration. Figure 4 provides a comparison of La(cid:11)er curves for the 1995-2010 vs. 2010 calibration for the USA and aggregate EU-14 economy. Further cross-country results in this respect are available in table 5 and in (cid:12)gure 5. The latter (cid:12)gure shows how far each country is from its peak, given its own tax rate: perhaps not surprisingly, the points line up pretty well. In the (cid:12)gure, we compare it to the benchmark of performing the same calculation for the US, given by the dash-dotted line: there, we change, say, the labor tax rate, and, for each new labor tax rate, recalculate (cid:20) as (cid:22) well as g(cid:22);m(cid:22) and b to obtain the same n(cid:22) and g=y, b=y and m=y as in table 1. We then recalculate s(cid:22)and s=y to balance the government budget and calculate the distance to the peak of the La(cid:11)er curve. One would expect this exercise to result in a line with a slope close to -1, and indeed, this is what the (cid:12)gure shows. The points for the individual countries line up close to this line, though not perfectly: in particular, for the capital tax rate, the distance can be considerable, and is largely explained by the cross-country variation in labor taxes and consumption taxes. According to the results, the vast majority of countries have moved closer to the peaks of their labor and capital income tax La(cid:11)er curves and La(cid:11)er hills respectively. The movements to the peaks are sizeable for some countries such as e.g. the United Kingdom, the Netherlands and Ireland for labor taxes. As above and for the average 1995-2010 sample, it does not matter 13

whether \gross US debt or \US debt held by the public" is used. For the year 2010, however, small di(cid:11)erences arise since transfers are kept at the model average for 1995-2010. Finally, table 6 provides the output losses associated with moving to the peak of the La(cid:11)er curve. According to the model, US and EU-14 output falls by about 27 respectively 14 percent when labor taxes are moved to the peak of the La(cid:11)er curve. The magnitudes for the case of capital taxes are similar. There is considerable country speci(cid:12)c variation among European countries: Denmark looses 4 percent while Ireland looses 24 percent of output at the labor tax La(cid:11)er curve peak. Clearly, if a country is already close to its La(cid:11)er curve peak in terms of tax rates, the output losses associated with increasing taxes a little more to attain the peak are more muted than in a country that has more scope to increase tax revenues. Nevertheless, the table highlights thegeneralequilibriumrepercussionsofraisingtaxes: eventhoughtaxrevenuesmaybeincreased by some limited amount, tax bases and thereby output fall when moving to the peak of the La(cid:11)er curve due to the negative incentive e(cid:11)ects of higher taxes. 4.3. La(cid:11)er curve and interest rates What is the maximum interest rate on outstanding government debt that the government could a(cid:11)ord without cutting government spending? Put di(cid:11)erently, how high can interest rates on government debt be due to, say, default fears (and not due to generally higher discounting by households), so that (cid:12)scal sustainability is still preserved if countries move to the peak of their La(cid:11)er curves? To answer this question we pursue the following experiment. We calibrate the model in terms of (cid:12)scal policy to the year 2010, see table 2. Structual parameters are set as in table 1. We calculate La(cid:11)er curves for labor and capital taxation as well as the La(cid:11)er hill for joint variations of capital and labor taxes. Keeping model implied government transfers and government consumption to GDP ratios at their 2010 levels, we calcuate the interest rate that balances the government budget at maximal tax revenues. For the calcuations, we focus on balanced growth relationships ignoring transition issues for simplicity. Consider the scaled government budget constraint along the balanced growth path: 14

( ) ( ) ( ) ( ) s=y + g=y = b=y ( (cid:0)R (cid:22) )+ T=y (13) Max 2010 2010 2010 Max ( ) where T=y denotesthemaximumadditionaltaxrevenues(expressedin%ofbaselineGDP) Max that results from moving from the 2010 status quo to the peak of the La(cid:11)er curve. We solve for (cid:22) R = 1+r(cid:22) that balances the above government budget constraint. Max Max Table 7 contains the baseline model results. For eachof the three tax experiments (adjusting only labor taxes, adjusting only capital taxes, adjusting both), the table lists the maximal additional obtainable revenue as a share of GDP as well as the maximal sustainable interest rate that can be sustained with these revenues. For comparison, the last two columns of the table also contain real long-term interest rates for 2010 downloaded from the European Commission AMECO database. Thesearenominal10yearsgovernmentbondinterestratesminusin(cid:13)ation-eitherusingtheGDP de(cid:13)ator (ILRV, (cid:12)rst column) or the consumption de(cid:13)ator (ILRC, second column). The value for the aggregate EU-14 is the real GDP weighted average of individual European countries. The most interesting column in table 7 may be the second one. We (cid:12)nd that the USA can a(cid:11)ord thehighestinterestrateiflabortaxesaremovedtothepeakoftheLa(cid:11)ercurve: dependingonthe debtmeasureused, arealinterestrateofof12%to15.5%issustainable. Interestingly, Irelandcan also a(cid:11)ord the high rate of 11.2%, when moving labor taxes only. By contrast, Austria, Belgium, Denmark, Finland, France, Greece and Italy can only a(cid:11)ord permanent real rates in the range of 4.4% to 7.1%, when (cid:12)nancing the additional interest payments with higher labor tax rates alone, while, say, Germany, Portugal and Spain can all a(cid:11)ord an interest rate somewhere above 9%. The picture improves somewhat, but not much, when labor taxes and capital taxes can both be adjusted: notably, Belgium, Denmark, Finland, France and Italy cannot permanently a(cid:11)ord real interest rates above 6.5%. Note that now, the comparison of \US gross government debt" vs. \US debt held by the public" matters for the results since government spending is kept constant. Indeed, the US could a(cid:11)ort higher interest rates if \US debt held by the public" is considered. 15

Interestingly, inthenextsection, wealsoexaminetheimplicationsofhumancapitalaccumulation and show that the maximum interest rates may be even lower than suggested by our baseline model. For the above analysis, some caveats should be kept in mind. The interest rate on outstanding government debt deviates from the one on private capital but does not crowd out private investment. In other words, it is implicitly assumed that the interest rate payments due to the higher interest rate are paid lump-sum to the households and thereby do not a(cid:11)ect household consumption, hours or investment, and that it does not a(cid:11)ect the rate at which (cid:12)rms can borrow privately.6 Note that the steady state safe real interest rate is calibrated to equal 4 percent and represents therefore the lower bound for r(cid:22) : our analysis on sustainable rates may therefore be too Max optimistic, keeping in mind that the interest rates are real interest rates, not nominal interest rates. It is worth emphasizing that we have not included the possibility of cutting government spending and/or transfers and that our analysis has focussed on the most pessimistic scenario of a permanent shift. 5. Extensions: human capital, consumption taxes 5.1. Baseline model vs. human capital accumulation We compare the distance to the peak of La(cid:11)er curves for the above baseline model and the above baseline model with added human capital accumulation. More speci(cid:12)cally, we assume that human capital is accumulated following the second generation case considered in Trabandt and Uhlig (2011).7 6For related work, see e.g. Bi (2010) and Bi et al. (2010). 7Seee.g. Jones(2001), BarroandiMartin(2003)orAcemoglu(2008)fortextbooktreatmentsofmodelswith endogenousgrowthandhumancapitalaccumulation. Belowweconsideraspeci(cid:12)cationincorporatinglearning-bydoing as well as schooling, following Lucas (1988) and Uzawa (1965). While (cid:12)rst-generation endogenous growth models have stressed the endogeneity of the overall long-run growth rate, second-generation growth models have stressed potentially large level e(cid:11)ects, without a(cid:11)ecting the long-run growth rate. We shall focus on the second generation case here since little evidence has been found that taxation impacts on the long-run growth rate, see e.g. Levine and Renelt (1992). 16

In particular, we assume that human capital can be accumulated by both learning-by-doing as well as schooling. The agent splits total non-leisure time n into work-place labor q n and t t t schooling time (1(cid:0)q )n , where 0 (cid:20) q (cid:20) 1. Agents accumulate human capital according to t t t h = (Aq n +B(1(cid:0)q )n )(cid:23) h1(cid:0)(cid:23) +(1(cid:0)(cid:14) )h (14) t t t t t t(cid:0)1 h t(cid:0)1 where A (cid:21) 0 and B > A parameterize the e(cid:11)ectiveness of learning-by-doing and schooling respectively and where 0 < (cid:14) (cid:20) 1 is the depreciation rate of human capital. Wages are paid per h unit of labor and human capital so that the after-tax labor income is given by (1(cid:0)(cid:28)n)w h q n : t t t(cid:0)1 t t Given this, the adaptions of the model on the parts of (cid:12)rms is straightforward so that we shall leave them out here. The model is calibrated to the average of 1995-2010 for (cid:12)scal variables. Standard parameters for technology and preferences are set as in table 1. Parameters for human capital accumulation are set as in Trabandt and Uhlig (2011). More precisely, the same calibration strategy for the initial steady state is applied as before, except assuming now q(cid:22)n(cid:22) = 0:25. Further, (cid:23) = 0:5 and (cid:14) = (cid:14) US h are set for simplicity. A is set such that initial q(cid:22) = 0:8. Moreover, B is set to have h = 1 US US initially. Figure6showsthecomparisonfortheUSandEU-14. Furthercross-countryresultsarecontained in (cid:12)gure 7. Interestingly, the capital tax La(cid:11)er curve is a(cid:11)ected only very little across countries when human capital is introduced. By contrast, the introduction of human capital has important e(cid:11)ects for the labor income tax La(cid:11)er curve. Several countries are pushed on the slippery slope sides of their labor tax La(cid:11)er curves. This result is due to two e(cid:11)ects. First, human capital turns labor into a stock variable rather than a (cid:13)ow variable as in the baseline model. Higher labor taxes induce households to work less and to aquire less human capital which in turn leads to lower labor income. Consequently, the labor tax base shrinks much more quickly when labor taxes are raised. Second, the introduction of intermediate inputs moves countries closer to the peaks of their labor tax La(cid:11)er curves already in the baseline model compared to Trabandt and Uhlig (2011). This e(cid:11)ect is reinforced when human capital is introduced. 17

Finally, we recalculate the implied maximum interest rates on government debt in 2010 when human capital accumulation is allowed for in the model. Table 9 contains the results: the US may only a(cid:11)ord a real interest rate between 5.8% to 6.6% in this case. Most of the European countries cluster between 4% and 4.9% except for Denmark, Finland and Ireland who can a(cid:11)ord real interest rates between 5.9% and 9.5%. 5.2. Consumption taxes We compute maximum additional tax revenues that are possible from increasing consumption taxes. We do this in the above baseline model and in the model with added human capital accumulation as in the previous subsection. The model is calibrated to the average of 1995-2010 for (cid:12)scal variables. Standard parameters for technology and preferences are set as in table 1. Parameters for human capital accumulation are set as in the previous subsection. The upper panel of (cid:12)gure 8 shows the comparison for the US and EU-14. Further cross-country resultsareshowninthelowerpanelofthesame(cid:12)gure. AsdocumentedandexaminedinTrabandt and Uhlig (2011), the consumption tax La(cid:11)er curve has no peak. However, the introduction of human capital has important quantitative e(cid:11)ects across countries. The range of maximum additional tax revenues (in percent of GDP) in the above baseline model is roughly 40-100 percent while it shrinks to roughly 10-30 percent in the model with added human capital. Higher consumption taxes a(cid:11)ect equilibrium labor via the labor wedge, similar to labor taxes. Human capital ampli(cid:12)es the reduction of the labor tax base triggered by the change in the labor wedge by the same argument as in the previous subsection. Overall, maximum possible tax revenues due to consumption taxes are reduced massively, although at fairly high consumption tax rates. 6. Conclusion We have studied how La(cid:11)er curves di(cid:11)er across countries in the US and the EU-14. This provides insight into the limits of taxation. To that end, we extended the analysis in Trabandt and Uhlig (2011) to include monopolistic competition as well as partial taxation of the monopolisticcompetition pro(cid:12)ts: we have shown that this improves the (cid:12)t to the data considerably. We have also provided re(cid:12)ned data for e(cid:11)ective labor and capital income taxes across countries. 18

For the cross-country comparison, we assume that all structural parameters for technologies and preferences are the same across countries. The di(cid:11)erences between the La(cid:11)er curves therefore arise solely due to di(cid:11)erences in (cid:12)scal policy i.e. the mix of distortionary taxes, government spending and government debt. We (cid:12)nd that labor income and consumption taxes are important for accounting for most of the cross-country di(cid:11)erences. To examine recent developments, we calibrate the steady state of the model to the La(cid:11)er curves implied by the strained (cid:12)scal situation of 2010, and compare them to the La(cid:11)er curves of the average extended sample 1995-2010. We (cid:12)nd that the 2010 calibration moves all countries considerably closer to the peak of the labor tax La(cid:11)er curve, with the scope for additional labor tax increases cut by a third for most countries and by up to one half for some countries. In this context, we show that it is important to keep the general equilibrium repercussions of raising taxes in mind: even though tax revenues may be increased by some limited amount, tax bases and thereby output fall when moving to the peak of the La(cid:11)er curve due to the negative incentive e(cid:11)ects of higher taxes. We calculate the implications for the long-term sustainability of current debt levels, by calculating the maximal permanently sustainable interest rate. We calculated that the USA can a(cid:11)ord the highest interest rate if only labor taxes are adjusted to service the additional debt burden: depending on the debt measure used, a real interest rate of of 12% to 15.5% is sustainable. Interestingly, Ireland can also a(cid:11)ord the high rate of 11.2%, when moving labor taxes only. By contrast, Austria, Belgium, Denmark, Finland, France, Greece and Italy can only a(cid:11)ord permanent real rates in the range of 4.4% to 7.1%, when (cid:12)nancing the additional interest payments with higher labor tax rates alone, while, say, Germany, Portugal and Spain can all a(cid:11)ord an interest rate somewhere above 9%. The picture improves somewhat, but not much, when labor taxes and capital taxes can both be adjusted: notably, Belgium, Denmark, Finland, France and Italy cannot permanently a(cid:11)ord real interest rates above 6.5%. We have shown that the introduction of human capital has important e(cid:11)ects for the labor income tax La(cid:11)er curve across countries. Several countries are pushed on the slippery slope sides of their labor tax La(cid:11)er curves once human capital is accounted for. We recalculated the implied maximum interest rates on government debt in 2010 when human capital accumulation is allowed 19

for in the model. In this case, the US may only a(cid:11)ord a real interest rate between 5.8% to 6.6%. Most of the European countries cluster between 4% and 4.9% except for Denmark, Finland and Ireland who can a(cid:11)ord real interest rates between 5.9% and 9.5%. We have performed a cross-country analysis on consumption taxes. We document that the range of maximum additional tax revenues (in percent of GDP) in the baseline model is roughly 40- 100 percent while it shrinks to roughly 10-30 percent in the model with added human capital, although the underlying consumption taxes are fairly high in both cases. References Acemoglu,D.,2008.IntroductiontoModernEconomicGrowth,1stEdition.PrincetonUniversity Press, Princeton. Alesina, A., Glaeser, E., Sacerdote, B., 2006. Work and leisure in the US and Europe: Why so di(cid:11)erent? NBER Macroeconomic Annual 2005, Vol. 20, MIT Press, Cambridge, pp. 1{100. Barro, R. J., i Martin, X. S., 2003. Economic Growth, 2nd Edition. MIT Press, Cambridge. Bi, H., 2010. Sovereign default risk premia, (cid:12)scal limits, and (cid:12)scal policy. Unpublished Manuscript. Bi, H., Leeper, E. M., Leith, C., 2010. Stabilization versus sustainability: Macroeconomic policy tradeo(cid:11)s. Unpublished Manuscript. Blanchard, O., 2004. The economic future of europe. Journal Of Economic Perspectives 18(4), 3{26. Chari, V. V., Kehoe, P. J., Mcgrattan, E. R., 2007. Business cycle accounting. Econometrica 75 (3), 781{836. Cooley, T. F., Prescott, E., 1995. Economic growth and business cycles. In: T. F. Cooley (Ed.), Frontiers Of Business Cycle Research, Princeton University Press, Princeton, pp. 1{38. 20

Green, J., Kotliko(cid:11), L. J., 2009. On the general relativity of (cid:12)scal language. Key Issues in Public Finance - A Conference in Memory of David Bradford, Eds. Alan J. Auerbach And Daniel Shaviro, Harvard University Press. Hall, R. E., 2009. Reconciling cyclical movements in the marginal value of time and the marginal product of labor. Journal of Political Economy 117 (2), 281{323. Jones, C. I., 2001. Introduction to Economic Growth, 2nd Edition. Norton, New York. Kimball, M. S., Shapiro, M. D., 2008. Labor supply: Are the income and substitution e(cid:11)ects both large or both small? NBER Working Paper 14208, NBER. King, R. S., Rebelo, S. T., 1999. Resuscitating real business cycles. In: J. B. Taylor And M. Woodford (Eds.), Handbook Of Macroeconomics, Amsterdam: Elsevier 1B, pp. 927{1007. Levine, R., Renelt, D., 1992. A sensitivity analysis of cross-country growth regressions. American Economic Review 82(4), 942{63. Ljungqvist, L., Sargent, T. J., 2007. Do taxes explain european employment? Indivisible labor, human capital, lotteries, and savings. NBER Macroeconomics Annual 2006, Vol. 21, MIT Press, Cambridge, pp. 181{246. Lucas, R. E., 1988. On the mechanics of economic development. Journal of Monetary Economics 22, 3{42. Mendoza, E. G., Razin, A., Tesar, L. L., 1994. E(cid:11)ective tax rates in macroeconomics: Crosscountry estimates of tax rates on factor incomes and consumption. Journal Of Monetary Economics 34, 297{323. Pissarides, C., Ngai, L. R., 2009. Welfare policy and the sectoral distribution of employment. Center for Structual Econometrics Discussion Paper No. 09/04, London School of Economics. Prescott, E. C., 2002. Prosperity and depression. American Economic Review 92, 1{15. Prescott, E. C., 2004. Why do americans work so much more than europeans? Quarterly Review, Federal Reserve Bank Of Minneapolis 28, 2{13. 21

Prescott, E. C., 2006. Nobel lecture: The transformation of macroeconomic policy and research. Journal Of Political Economy 114(2), 203{235. Rogerson, R., 2007. Taxation and market work: is Scandinavia an outlier? Economic Theory 32 (1), 59{85. Shimer, R., 2009. Convergence in macroeconomics: The labor wedge. American Economic Journal: Macroeconomics 1(1), 280{297. Trabandt, M., Uhlig, H., May 2011. The La(cid:11)er curve revisited. Journal of Monetary Economics 58 (4), 305{327. Uzawa, H., 1965. Optimum technical change in an aggregative model of economic growth. International Economic Review 6, 18{31. 7. Tables and Figures 22

Baseline calibration and parameterization Variable US EU-14 Description Restriction Fiscal Policy (cid:28)n 22.1 34.2 Labor tax rate Data (cid:28)k 41.1 36.8 Capital tax rate Data (cid:28)c 4.6 16.7 Consumption tax rate Data g=y 18.0 23.1 Gov. consumption+invest. to GDP Data Gross Government Debt b=y 66.2 67.3 Government gross debt to GDP Data s=y 4.3 11.1 Government transfers to GDP Implied Sensitivity: Government Debt Held By The Public b=y 42.4 - Government debt held by public to GDP Data s=y 4.9 - Government transfers to GDP Implied Trade m=y 3.6 -1.2 Net imports to GDP Data Technology 1.5 1.5 Annual balanced growth rate Data (cid:18) 0.36 0.36 Capital share in production Data (cid:14) 0.07 0.07 Annual depreciation rate of capital Data R (cid:22) (cid:0)1 4 4 Annual real interest rate Data ! 1.1 1.1 Gross markup Data ϕ 0.36 0.36 Share of pro(cid:12)ts subject to capital taxes Data CFE Preferences (cid:17) 2 2 Inverse of IES Data φ 1 1 Frisch labor supply elasticity Data (cid:20) 3.30 3.30 Weight of labor n(cid:22) = 0:25 us Table 1: Baseline calibration and parameterization for the US and EU-14 benchmark model. Numbers expressed inpercentwhereapplicable. Sample: 1995-2010. IESdenotesintertemporalelasticityofsubstitution. CFErefers to constant Frisch elasticity preferences. n(cid:22) denotes balanced growth labor in the US which is set to 25 percent us of total time. 23

Calibration of the model to individual countries (cid:28)(cid:22)n (cid:28)(cid:22)c (cid:28)(cid:22)k b=y m=y g=y s=y ∅ 2010a 2010b ∅ 2010 ∅ 2010 ∅ 2010 ∅ 2010 ∅ 2010 ∅ 2010 USA 22 20 28 5 4 41 38 66 92 4 4 18 20 4 4 USA(cid:3) 22 20 28 5 4 41 38 42 64 4 4 18 20 5 5 EU-14 34 35 40 17 15 37 36 67 83 -1 -1 23 25 11 11 GER 34 35 35 16 17 25 27 64 83 -3 -5 21 21 10 10 FRA 39 39 43 18 16 43 43 63 82 -0 2 27 28 12 12 ITA 36 39 39 14 13 41 45 111 119 -1 2 22 23 13 13 GBR 24 25 36 15 13 52 50 48 80 2 3 22 26 11 11 AUT 43 43 45 20 20 26 24 66 72 -3 -5 21 21 18 18 BEL 39 38 43 17 17 51 50 104 97 -4 -3 24 26 16 16 DNK 43 44 50 34 31 49 56 49 44 -5 -6 28 32 22 22 FIN 44 41 51 26 23 31 30 45 48 -6 -3 25 27 17 17 GRE 29 28 35 15 13 19 17 105 143 10 8 21 21 6 6 IRL 25 24 40 24 19 17 16 48 96 -13 -19 19 23 7 7 NET 36 38 50 19 19 32 23 58 63 -7 -8 27 32 6 6 PRT 22 24 30 19 16 32 34 61 93 9 7 23 24 7 7 ESP 30 30 42 14 10 31 24 54 60 3 2 22 24 8 8 SWE 50 46 43 26 26 40 52 54 40 -7 -6 30 31 16 16 Table 2: Individual country calibration of the benchmark model for the average (∅) sample 1995-2010 and for the year 2010. Country codes: Germany (GER), France (FRA), Italy (ITA), United Kingdom (GBR), Austria (AUT), Belgium (BEL), Denmark (DNK), Finland (FIN), Greece (GRE), Ireland (IRL), Netherlands (NET), Portugal (PRT), Spain (ESP) and Sweden (SWE). See table 1 for abbreviations of variables. All numbers are expressed in percent. a - due to data availability reasons, the year 2009 value for tax rates has been assumed to remainin2010formostoftheanalysisinthispaper. b-wedeviatefromainsubsection3.2bylettinglabortaxes in 2010 adjust to balance the 2010 government budget. More precisely, we calculate the 2010 labor tax given government debt and consumption in 2010 as well as average (1995-2010) model implied transfers. (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. 24

Max. add. tax revenues (in % of baseline GDP) Start with US and impose country calibration for... Baseline (cid:28)(cid:22)n (cid:28)(cid:22)k (cid:28)(cid:22)c b=y g=y m=y USA 9.0 9.0 9.0 9.0 9.0 9.0 9.0 USA(cid:3) 9.0 9.0 9.0 9.0 9.0 9.0 9.0 EU-14 4.3 4.9 9.3 6.6 9.0 9.6 9.6 GER 5.0 4.8 10.2 6.7 9.0 9.3 9.9 FRA 2.9 3.6 8.8 6.3 9.0 10.2 9.5 ITA 3.6 4.3 9.0 7.0 9.0 9.4 9.6 GBR 6.0 8.4 8.0 6.8 9.0 9.5 9.2 AUT 2.1 2.5 10.1 5.9 9.0 9.3 9.8 BEL 2.4 3.4 8.2 6.4 9.0 9.8 10.0 DNK 0.7 2.4 8.3 3.7 9.0 10.4 10.1 FIN 1.8 2.2 9.7 4.9 9.0 9.9 10.4 GRE 5.6 6.5 10.6 6.9 9.0 9.3 8.3 IRL 9.0 7.9 10.7 5.3 9.0 9.2 11.8 NET 5.2 4.3 9.7 6.1 9.0 10.3 10.4 PRT 6.7 8.9 9.7 6.1 9.0 9.6 8.4 ESP 5.7 6.2 9.7 7.1 9.0 9.5 9.1 SWE 0.9 1.0 9.1 5.0 9.0 10.7 10.5 Table 3: Labor tax La(cid:11)er curve: sources of di(cid:11)erences across countries. The table provides maximal additional taxrevenues(inpercentofbaselineGDP)iflabortaxesarevaried. \Baseline"referstotheresultswhenthemodel iscalibratedtocountryspeci(cid:12)caveragesof1995-2010, seetable2. Parametersfortechnologyandpreferencesare set as in table 1. All other columns report results if in the US calibration, (cid:12)scal instruments are set to country speci(cid:12)c values (each at a time). (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. 25

Max. add. tax revenues (in % of baseline GDP) Start with US and impose country calibration for... Baseline (cid:28)(cid:22)n (cid:28)(cid:22)k (cid:28)(cid:22)c b=y g=y m=y USA 2.6 2.6 2.6 2.6 2.6 2.6 2.6 USA(cid:3) 2.6 2.6 2.6 2.6 2.6 2.6 2.6 EU-14 1.2 1.2 3.1 1.4 2.6 2.8 2.8 GER 2.2 1.2 4.5 1.5 2.6 2.7 3.0 FRA 0.4 0.9 2.3 1.3 2.6 3.1 2.8 ITA 0.8 1.1 2.5 1.6 2.6 2.8 2.8 GBR 0.6 2.4 1.3 1.5 2.6 2.8 2.7 AUT 1.1 0.6 4.4 1.1 2.6 2.7 2.9 BEL 0.1 0.8 1.5 1.4 2.6 2.9 3.0 DNK 0.0 0.6 1.6 0.4 2.6 3.2 3.0 FIN 0.7 0.5 3.7 0.8 2.6 3.0 3.2 GRE 2.7 1.7 5.1 1.5 2.6 2.7 2.3 IRL 4.1 2.2 5.3 0.9 2.6 2.6 3.7 NET 1.9 1.1 3.7 1.2 2.6 3.1 3.2 PRT 2.0 2.6 3.7 1.2 2.6 2.8 2.4 ESP 2.0 1.7 3.7 1.6 2.6 2.8 2.6 SWE 0.2 0.2 2.7 0.8 2.6 3.3 3.2 Table 4: Capital tax La(cid:11)er curve: sources of di(cid:11)erences across countries. The table provides maximal additional tax revenues (in percent of baseline GDP) if capital taxes are varied. \Baseline refers" to the results when the model is calibrated to country speci(cid:12)c averages of 1995-2010, see table 2. Parameters for technology and preferences are set as in table 1. All other columns report results if in the US calibration, (cid:12)scal instruments are set to country speci(cid:12)c values (each at a time). (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. 26

Max. additonal tax revenues (in %): average 1995-2010 vs. year 2010 Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k Vary (cid:28)(cid:22)n and (cid:28)(cid:22)k jointly ∆T ∆T ∆T Max Max Max ∅ 2010 ∅ 2010 ∅ 2010 USA 37.6 27.9 10.7 8.8 37.6 28.1 USA(cid:3) 37.6 28.2 10.7 8.9 37.6 28.4 EU-14 11.9 7.9 3.2 2.5 12.1 8.2 GER 15.4 14.9 6.8 6.1 16.4 15.7 FRA 7.1 4.6 1.1 0.7 7.1 4.6 ITA 9.8 7.3 2.1 1.1 9.9 7.3 GBR 17.5 8.6 1.7 0.7 17.9 8.8 AUT 5.2 4.7 2.6 2.8 5.8 5.5 BEL 5.7 4.0 0.3 0.1 5.9 4.1 DNK 1.3 0.3 0.0 0.4 1.6 1.0 FIN 4.1 1.6 1.6 1.0 4.4 1.9 GRE 18.9 14.2 8.9 7.8 19.9 15.6 IRL 32.7 21.5 14.9 12.2 35.4 25.9 NET 14.7 6.6 5.3 4.6 15.6 8.6 PRT 21.6 15.4 6.6 4.6 21.8 15.6 ESP 18.5 10.3 6.5 5.4 19.0 11.4 SWE 2.0 3.3 0.5 0.0 2.1 3.5 Table 5: La(cid:11)er curves and La(cid:11)er hill for 1995-2010 vs. 2010 calibration. The model is either calibrated to the average of 1995-2010 or to the 2010, see table 2. Parameters are set as in table 1. ∆T denotes the maximum Max additionaltaxrevenues(in%)thatresultsfrommovingfromtothepeakoftheLa(cid:11)ercurve. (cid:3)-resultswhen\debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. 27

Output losses (in %) from moving to the La(cid:11)er curve peak Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k Vary (cid:28)(cid:22)n and (cid:28)(cid:22)k jointly ∆y at ∆T ∆y at ∆T ∆y at ∆T Max Max Max USA -27.2 -21.1 -29.6 USA(cid:3) -27.3 -21.1 -29.7 EU-14 -17.5 -12.8 -20.1 GER -22.0 -17.7 -26.5 FRA -14.2 -7.5 -14.3 ITA -17.6 -8.8 -16.7 GBR -18.5 -7.3 -15.8 AUT -14.6 -13.0 -18.9 BEL -13.6 -3.8 -11.2 DNK -3.9 6.0 2.2 FIN -9.0 -8.3 -12.5 GRE -22.3 -20.3 -27.5 IRL -23.6 -23.6 -34.6 NET -15.9 -16.1 -23.7 PRT -22.6 -16.5 -24.5 ESP -19.3 -17.7 -24.8 SWE -12.3 -1.0 -8.5 Table 6: Output losses in perent from moving to the peak of La(cid:11)er curves. The model is calibrated to the year 2010, see table 2. Parameters are set as in table 1. ∆y is the reduction of balanced growth output in the model from moving from the status quo equilibrium to the peak of the La(cid:11)er curve. ∆T denotes the Max maximumadditionaltaxrevenues(in%)thatresultsfrommovingfromtothepeakoftheLa(cid:11)ercurve. (cid:3) -results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. 28

Baseline Model: Maximum real interest rates on government debt (in %) Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k Vary (cid:28)(cid:22)n and (cid:28)(cid:22)k jointly Data: long-term ∆T=y r(cid:22) ∆T=y r(cid:22) ∆T=y r(cid:22) interest ratesy Max Max Max Max Max Max USA 7.3 12.0 2.3 6.5 7.4 12.0 2.0 1.4 USA(cid:3) 7.4 15.5 2.3 7.7 7.4 15.6 2.0 1.4 EU-14 3.0 7.6 0.9 5.1 3.1 7.7 2.4 1.5 GER 5.0 10.0 2.0 6.4 5.2 10.3 2.1 0.8 FRA 1.9 6.4 0.3 4.4 1.9 6.4 2.3 1.9 ITA 2.8 6.4 0.4 4.3 2.8 6.4 3.7 2.5 GBR 3.4 8.2 0.3 4.3 3.4 8.3 0.5 -0.4 AUT 1.9 6.6 1.1 5.6 2.2 7.1 1.4 1.1 BEL 1.8 5.8 0.1 4.1 1.8 5.9 1.6 1.6 DNK 0.2 4.4 0.2 4.5 0.6 5.3 -0.5 0.4 FIN 0.7 5.5 0.5 5.0 0.9 5.8 2.6 1.1 GRE 4.4 7.1 2.4 5.7 4.8 7.4 7.3 4.4 IRL 6.9 11.2 3.9 8.1 8.3 12.7 8.4 8.0 NET 2.6 8.2 1.8 6.9 3.4 9.4 1.7 1.5 PRT 5.1 9.5 1.5 5.6 5.2 9.5 4.3 3.7 ESP 3.5 9.8 1.8 7.0 3.9 10.5 3.8 1.8 SWE 1.6 8.0 0.0 4.0 1.7 8.2 1.6 1.6 Table7: MaximumadditionaltaxrevenueandinterestratesforthelaborandcapitaltaxLa(cid:11)ercurverespectively La(cid:11)er hill. The model is calibrated to the year 2010, see table 2. Parameters are set as in table 1. ∆T=y Max denotesthemaximumadditionaltaxrevenues(expressedin%ofbaselineGDP)thatresultsfrommovingfromthe 2010 status quo to the peak of the La(cid:11)er curve. r(cid:22) is the maximum net real interest rate that the government Max could a(cid:11)ord on outstanding debt in the year 2010 if all additonal tax revenue is spent on interest rate payments. y - real long-term interest rates for 2010 downloaded from the European Commission AMECO database. These are nominal 10 years government bond interest rates minus in(cid:13)ation - either using the GDP de(cid:13)ator (ILRV, (cid:12)rst column) or the consumption de(cid:13)ator (ILRC, second column). EU-14 value is the real GDP weighted average of European countries. (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. All numbers in the table in percent. 29

Distance to Peak in Terms of Tax Rates (in %) Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k Baseline Human Capital Baseline Human Capital USA 39.9 20.9 29.9 27.9 USA(cid:3) 39.9 20.9 29.9 27.9 EU-14 26.8 7.8 23.2 22.2 GER 28.5 11.5 36.1 36.1 FRA 21.4 1.4 13.6 12.6 ITA 23.8 3.8 17.7 15.7 GBR 33.2 11.2 12.9 9.9 AUT 17.2 -3.8 26.3 22.3 BEL 19.7 -1.3 6.5 4.5 DNK 10.7 -15.3 -2.4 -5.4 FIN 17.0 -4.0 20.5 20.5 GRE 29.9 7.9 41.0 34.0 IRL 42.8 34.8 50.7 56.7 NET 30.9 17.9 32.3 36.3 PRT 34.8 12.8 30.3 26.3 ESP 31.0 12.0 31.9 28.9 SWE 12.2 -8.8 12.2 13.2 Table 8: Distance to the peak of La(cid:11)er curves for baseline model and baseline model with added human capital accumulation (second generation, see the main text and Trabandt and Uhlig (2011) for details). Distance is measured in terms of tax rates. All numbers are expressed in percent. The model is calibrated to the average of 1995-2010for(cid:12)scalvariables. Standardparametersfortechnologyandpreferencesaresetasintable1. Parameters forhumancapitalaccumulationaresetasinthemaintextandTrabandtandUhlig(2011). (cid:3) -resultswhen\debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. All numbers in the table in percent. 30

Model with human capital: Max. real interest rates on government debt (in %) Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k Data: long-term ∆T=y r(cid:22) ∆T=y r(cid:22) interest ratesy Max Max Max Max USA 1.7 5.8 1.7 5.8 2.0 1.4 USA(cid:3) 1.7 6.6 1.7 6.6 2.0 1.4 EU-14 0.0 4.0 0.6 4.8 2.4 1.5 GER 0.8 4.9 1.7 6.0 2.1 0.8 FRA 0.1 4.1 0.1 4.2 2.3 1.9 ITA 0.0 4.0 0.2 4.1 3.7 2.5 GBR 0.0 4.0 0.1 4.1 0.5 -0.4 AUT 0.1 4.1 0.7 5.0 1.4 1.1 BEL 0.1 4.1 0.0 4.0 1.6 1.6 DNK 2.4 9.5 0.2 4.5 -0.5 0.4 FIN 0.9 5.9 0.3 4.6 2.6 1.1 GRE 0.2 4.1 1.3 4.9 7.3 4.4 IRL 4.0 8.1 4.8 9.0 8.4 8.0 NET 0.3 4.5 2.2 7.5 1.7 1.5 PRT 0.4 4.4 0.9 4.9 4.3 3.7 ESP 0.1 4.2 1.3 6.1 3.8 1.8 SWE 0.1 4.3 0.0 4.0 1.6 1.6 Table9: Modelwithhumancapital: maximumadditionaltaxrevenueandinterestratesforthelaborandcapital tax La(cid:11)er curves. Second generation model with human capital accumulation, see the main text and Trabandt andUhlig(2011)fordetails. Themodeliscalibratedtotheyear2010,seetable2. Parametersaresetasintable1. ForhumancapitalaccumulationparametersseethemaintextandTrabandtandUhlig(2011). ∆T=y denotes Max the maximum additional tax revenues (expressed in % of baseline GDP) that results from moving from the 2010 statusquotothepeakoftheLa(cid:11)ercurve. r(cid:22) isthemaximumnetrealinterestratethatthegovernmentcould Max a(cid:11)ord on outstanding debt in the year 2010 if all additonal tax revenue is spent on interest rate payments. y - real long-term interest rates for 2010 downloaded from the European Commission AMECO database. These are nominal 10 years government bond interest rates minus in(cid:13)ation - either using the GDP de(cid:13)ator (ILRV, (cid:12)rst column) or the consumption de(cid:13)ator (ILRC, second column). EU-14 value is the real GDP weighted average of European countries. (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. All numbers in the table in percent. 31

Vary Consumption Taxes: Distance to Peak in Terms of Tax Revenues (in % of GDP) Baseline Human Capital USA 90.7 27.2 USA(cid:3) 90.7 27.2 EU-14 63.9 19.9 GER 61.7 20.2 FRA 58.7 17.9 ITA 67.8 20.0 GBR 79.7 23.5 AUT 62.6 18.5 BEL 58.2 17.3 DNK 48.9 14.4 FIN 47.0 15.2 GRE 97.8 27.3 IRL 44.2 18.1 NET 42.3 15.8 PRT 91.2 26.8 ESP 76.0 23.2 SWE 37.8 12.5 Table 10: Maximum additional tax revenues due to consumption taxes. Baseline model versus baseline model with added human capital accumulation (second generation human capital accumulation growth model, see the maintextandTrabandtandUhlig(2011)fordetails). Additionaltaxrevenuesaremeasuredinpercentofbaseline GDP.Themodeliscalibratedtotheaverageof1995-2010for(cid:12)scalvariables. Standardparametersfortechnology and preferences are set as in table 1. Parameters for human capital accumulation are set as in the main text and Trabandt and Uhlig (2011). (cid:3) - results when \debt held by the public" is used for the USA rather than the harmonized cross-country measure of gross government debt provided by the AMECO database. All numbers in the table in percent. 32

PDG ot latipaC ERG 5.3 TUA EWS REG PSE ARF 3 ATI 41−UE TEN TRP LRI LEB NIF RBG 5.2 ASU KND 5.3 3 5.2 TRP PSE LRI TUA 62.0 REG 42.0 ATI 41−UE K NLEDB ERG T N E I N F ASU RBG 22.0 ARF 2.0 EWS 62.0 42.0 22.0 2.0 )ataD( lautcA sruoH PDG ot noitpmusnoC PDG ot tnemtsevnI ERG 82.0 56.0 TRP ASU 62.0 6.0 LRI ASU ERG TR R P BG EW S T KUNAD 42.0 PSE A4T1I−UE 55.0 RBG NIF ARREFG ATI 22.0 TLEUBA 5.0 41−UE TEN NIF R E P G S E ARF 2.0 KND T EENWS 54.0 LEB LRI 82.0 62.0 42.0 22.0 2.0 56.0 6.0 55.0 5.0 54.0 EWS 52.0 K TNUDA NIF LEB ARF T E R N EG 2.0 4A1T−IUE PSE 51.0 R B AGSU ERG TRP LRI 52.0 2.0 51.0 )ataD( lautcA PDG ot srefsnart teN 5.0 2.0 TUA EWS KND 54.0 REG NIF KND LEB ARF 51.0 LE B A TRUFA 4.0 ATI N EIFWS 4 1R−BUGE A T TIEN 41−UE REG 53.0 1.0 RBG ETRRGP PSE PS E LRI T REPRG 3.0 TEN LRI 50.0 ASU 52.0 ASU 2.0 51.0 1.0 50.0 5.0 4.0 3.0 PDG ot seunever xat noitpmusnoC PDG ot seunever xat latipaC PDG ot seunever xat robaL 51.0 KND 1.0 ATI RBG NI F EWS LEB TRP TU LARI ASU 80.0 E 4R AR 1 B L − RG E GU FT RB E E E N G 1.0 KND ARF EW 41 S −UE PNSIFE LRI P A S T E I TEN ERG 60.0 TRP TUA REG 50.0 40.0 ASU 51.0 1.0 50.0 1.0 80.0 60.0 40.0 detciderP detciderP detciderP )ataD( lautcA PDG ot seunever xat latoT ledom ot srefer "detciderP\ .0102-5991 rof segareva elpmas atad ot srefer "lautcA\ .selbairav "detciderp\ .sv "lautca\ fo nosirapmoC :1 erugiF dna ygolonhcet rof sretemaraP .)tbed SU ssorg( 2 elbat ni sa detarbilac si ledom eht nehw selbairav )htap htworg decnalab( etats ydaets deilpmi .)tbed ssorg( 1 elbat ni sa tes era secnereferp 33

5.0 54.0 4.0 53.0 3.0 52.0 5.0 54.0 4.0 53.0 3.0 52.0 )ataD( lautcA PDG ot srefsnart teN PDG ot seunever xat latoT 2.0 51.0 1.0 50.0 2.0 51.0 1.0 50.0 1=φ 1→ ω )63.0=φ,1.1=ω( kramhcneB 3.0 82.0 62.0 42.0 22.0 2.0 81.0 61.0 41.0 21.0 3.0 52.0 2.0 51.0 )ataD( lautcA PDG ot seunever xat latipaC PDG ot seunever xat robaL 21.0 1.0 80.0 60.0 40.0 21.0 1.0 80.0 60.0 40.0 detciderP detciderP .0102-5991 rof segareva elpmas atad ot srefer "lautcA\ .srefsnart tnemnrevog dna seunever xat "detciderp\ .sv "lautca\ fo ytivitisneS :2 erugiF eht ni desu ledom eht si esac kramhcneb ehT .denimaxe era sesac eerhT .)htap htworg decnalab( etats ydaets deilpmi ledom ot srefer "detciderP\ ledom desu ylsuoiverp ruo si siht :srecudorp sdoog etaidemretni yb rewop tekram on si ereht nehw ,sniatbo 1! ! esac ehT .1 erug(cid:12) ni sa dna ,repap latipac ot tcejbus ylluf era st(cid:12)orp erehw tub ,noititepmoc citsiloponom htiw esac etaidemretni eht si ereht ,yllaniF .)1102( gilhU dna tdnabarT ni no tcapmi eht ,revewoH .sruoh rof tpecxe ,sisylana ytivitisnes eht yb detce(cid:11)anu era 1 erug(cid:12) ni dettolp selbairav rehto lla taht etoN .1=ϕ ,noitaxat .)tbed SU ssorg( 2 dna 1 selbat ni sa era setats ydaets dna sretemarap rehto llA .ereh dettimo erofereht dna llams si sruoh 34

140 135 130 125 120 115 110 105 100 95 90 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Steady State Labor Tax )001=egarevA( seuneveR xaT etatS ydaetS Labor Tax Laffer Curves Across Countries Country Pos. Avg. 95−2010 USA IRL PRT GREES P GBR GERN ET EU−14 ITA FRA BAEULT FIN DNK SWE 115 110 105 100 95 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Steady State Capital Tax )001=egarevA( seuneveR xaT etatS ydaetS Capital Tax Laffer Curves Across Countries Country Position Avg. 95−2010 IRL USA GRE GPEERRST P NET EU−14 AUT ITA FIN GBR FRA DNK SWE B EL Figure 3: Labor and capital tax La(cid:11)er curves across all countries. The model is calibrated to the average of 1995-2010, see table 2 (gross US debt). Parameters for technology and preferences are set as in table 1 (gross US debt). Shown are steady state (balanced growth path) total tax revenues when labor taxes (upper panel) or capital taxes (lower panel) are varied between 0 and 100 percent. All other taxes and parameters are held constant. Total tax revenues at the average 1995-2010 tax rates are normalized to 100. Stars indicate positions of respective countries on their La(cid:11)er curves. Note that the (cid:12)rst letter of each country name indicates the peak of the respective La(cid:11)er curve. 35

140 130 120 110 100 90 80 70 60 50 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Steady State Labor Tax )001=egarevA( seuneveR xaT etatS ydaetS Labor Tax Laffer Curves for USA and EU−14 USA, 1995−2010 USA, 2010 EU−14, 1995−2010 EU−14, 2010 Country Position 115 110 105 100 95 90 85 80 75 70 65 60 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Steady State Capital Tax )001=egarevA( seuneveR xaT etatS ydaetS Capital Tax Laffer Curves for USA and EU−14 USA, 1995−2010 USA, 2010 EU−14, 1995−2010 EU−14, 2010 Country Position Figure 4: Comparing the US and the EU-14 labor and capital tax La(cid:11)er curve. The model is either calibrated to the average of 1995-2010 or to the 2010, see table 2 (gross US debt). Parameters for technology and preferences are set as in table 1 (gross US debt). Shown are steady state (balanced growth path) total tax revenues when labor taxes (upper panel) or capital taxes (lower panel) are varied between 0 and 100 percent. All other taxes and parameters are held constant. Total tax revenues at the average 1995-2010 or at the year 2010 tax rates are normalized to 100. Stars indicate positions of respective countries on their La(cid:11)er curves. 36

Changes of Distance to the Peak of the Labor Tax Laffer Curve 0.45 IRL 0.4 USA 0.35 PRT GBR ESP NET 0.3 GRE GER EU−14 0.25 ITA FRA 0.2 BEL AUFTI N 0.15 SWE 0.1 DNK 0.05 0 0.2 0.25 0.3 0.35 0.4 0.45 0.5 Steady State Labor Tax τ n τ xaT robaL etatS ydaetS eht fo smreT ni ecnatsiD n Country Position avg. 1995−2010 Country Position 2010 (arrow head) Varying US Steady State Labor Tax Changes of Distance to the Peak of the Capital Tax Laffer Curve 0.6 0.5 IRL 0.4 GRE GER ENSEPT 0.3 PRT USA AUT EU−14 0.2 FIN ITA SWE FRA GBR 0.1 BEL 0 DNK −0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 Steady State Capital Tax τ k τ xaT latipaC etatS ydaetS eht fo smreT ni ecnatsiD k Country Position avg. 1995−2010 Country Position 2010 (arrow head) Varying US Steady State Capital Tax Figure 5: Distance to the peak of La(cid:11)er curves for average 1995-2010 vs. 2010 calibration. The model is either calibrated to the averageof 1995-2010 or to the 2010, see table 2 (gross US debt). Parametersfor technology and preferences are set as in table 1 (gross US debt). Horizontal axis shows calibrated tax rates. Vertial axis shows distance to the peak in terms of tax rates. The dashed-dotted line shows the distance to the peak for the US when the initial steady state tax is varied and the model is re-calibrated for each assumed tax rate. 37

140 130 120 110 100 90 80 70 60 50 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Steady State Labor Tax )001=egarevA( seuneveR xaT etatS ydaetS Labor Tax Laffer Curves for USA and EU−14 USA, Baseline USA, Human Capital EU−14, Baseline EU−14, Human Capital Country Position 120 110 100 90 80 70 60 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Steady State Capital Tax )001=egarevA( seuneveR xaT etatS ydaetS Capital Tax Laffer Curves for USA and EU−14 USA, Baseline USA, Human Capital EU−14, Baseline EU−14, Human Capital Country Position Figure6: LaborandcapitaltaxLa(cid:11)ercurves: theimpactofendogenoushumancapitalaccumulation. Shownare steady state (balanced growth path) total tax revenues when labor taxes are varied between 0 and 100 percent in the USA and EU-14. All other taxes and parameters are held constant. Total tax revenues at the average tax rates are normalized to 100. Two cases are examined. First, the benchmark model with exogenous growth. Second, the benchmark model with a second generation version of endogenous human capital accumulation (see the main text and Trabandt and Uhlig (2011) for details). The model is calibrated to the average of 1995-2010 for (cid:12)scal variables. Standard parameters for technology and preferences are set as in table 1 (gross US debt). Parameters for human capital accumulation are set as in the main text Trabandt and Uhlig (2011). 38

Changes of Distance to the Peak of the Labor Tax Laffer Curve IRL 0.4 USA PRT GBR 0.3 GR E E S P NET GER EU−14 ITA FRA 0.2 BEL AUFTI N SWE 0.1 DNK 0 −0.1 −0.2 0.2 0.25 0.3 0.35 0.4 0.45 0.5 Steady State Labor Tax τ n τ xaT robaL etatS ydaetS eht fo smreT ni ecnatsiD n Country Position Baseline Model Country Position Human Capital (arrow head) Changes of Distance to the Peak of the Capital Tax Laffer Curve 0.5 IRL 0.4 GRE GER ENSEPT 0.3 PRT USA AUT EU−14 0.2 FIN ITA SWE FRA GBR 0.1 BEL 0 DNK −0.1 0.1 0.2 0.3 0.4 0.5 0.6 Steady State Capital Tax τ k τ xaT latipaC etatS ydaetS eht fo smreT ni ecnatsiD k Country Position Baseline Model Country Position Human Capital (arrow head) Figure 7: Distance to the peak of La(cid:11)er curves for baseline model and baseline model with added human capital accumulation (second generation, see the main text and Trabandt and Uhlig (2011) for details). The model is calibrated to the average of 1995-2010 for (cid:12)scal variables. Standard parameters for technology and preferences are set as in table 1 (gross US debt). Parameters for human capital accumulation are set as in the main text and Trabandt and Uhlig (2011). Horizontal axis shows calibrated tax rates. Vertial axis shows distance to the peak in terms of tax rates. 39

500 450 400 350 300 250 200 150 100 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 Steady State Consumption Tax )001=egarevA( seuneveR xaT etatS ydaetS Consumption Tax Laffer Curves for USA and EU−14 USA, Baseline USA, Human Capital EU−14, Baseline EU−14, Human Capital Country Position Changes of Distance to the Peak of the Consumption Tax Laffer Curve 100 GRE 90 USA PRT 80 GBR ESP 70 ITA 60 GE E R B U FE − RL 1 4 A A UT 50 DNK FIN IRL NET 40 SWE 30 20 10 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 Steady State Consumption Tax )PDG fo %( seuneveR xaT etatS ydaetS fo smreT ni ecnatsiD Country Position Baseline Model Country Position Human Capital (arrow head) Figure 8: Upper panel: Consumption tax La(cid:11)er curve in the USA and EU-14: the impact of endogenous human capitalaccumulation. Shownaresteadystate(balancedgrowthpath)totaltaxrevenueswhenconsumptiontaxes are varied between 0 and 500 percent. All other taxes and parameters are held constant. Total tax revenues at the average consumption tax rate are normalized to 100. Two cases are examined. First, the benchmark model with exogenous growth. Second, the benchmark model with a second generation version of endogenous human capital accumulation (see the main text and Trabandt and Uhlig (2011) for details). The model is calibrated to the average of 1995-2010 for (cid:12)scal variables. Standard parameters for technology and preferences are set as in table 1 (gross US debt). Parameters for human capital accumulation are set as in the main text and Trabandt and Uhlig (2011). Lower panel: Distance to the peak of La(cid:11)er curves for baseline model and baseline model with added human capitalaccumulation. Horizontalaxisshowscalibratedtaxrates. Vertialaxisshowsdistancetothepeakinterms of tax revenues (in percent of GDP). 40

selbat etar xaT .A xidneppA (cid:3)0102 9002 8002 7002 6002 5002 4002 3002 2002 1002 0002 9991 8991 7991 6991 5991 0.02 0.02 4.12 3.22 9.12 6.12 6.02 7.02 7.12 8.32 1.42 8.32 5.32 3.32 8.22 2.22 ASU 8.43 8.43 8.43 3.43 1.43 7.33 4.33 5.33 2.33 6.33 8.33 7.43 3.43 9.43 0.53 9.43 41-UE 2.53 2.53 3.43 1.43 7.33 2.33 5.33 0.43 4.43 2.53 9.43 1.53 0.53 6.43 4.43 2.53 REG 6.83 6.83 7.83 7.83 1.93 1.93 0.83 3.83 7.73 9.73 5.83 9.83 3.83 2.93 2.93 7.83 ARF 0.93 0.93 4.83 4.73 0.63 8.53 7.53 5.53 0.53 8.43 9.43 4.53 8.43 6.73 3.63 7.33 ATI 8.42 8.42 8.52 7.52 2.52 6.42 2.42 3.32 1.32 6.32 6.32 2.32 6.22 6.12 9.12 7.22 RBG 4.34 4.34 0.34 3.24 4.24 6.24 4.34 7.34 8.34 8.34 4.24 9.24 0.34 8.24 8.14 8.04 TUA 5.83 5.83 8.83 6.83 8.83 7.93 6.04 3.04 0.04 1.93 2.93 5.93 7.93 6.93 0.93 0.93 LEB 4.44 4.44 3.34 4.34 1.24 4.24 4.24 3.34 3.34 2.44 9.44 7.44 2.24 0.34 3.24 0.24 KND 4.14 4.14 3.24 8.24 2.34 7.24 8.14 7.24 0.44 4.44 9.44 7.44 7.54 0.64 2.84 4.74 NIF 5.82 5.82 3.03 3.92 2.92 5.92 7.92 5.03 7.92 3.82 8.62 NaN NaN NaN NaN NaN ERG 4.42 4.42 3.42 7.62 0.72 9.52 8.52 4.42 8.32 NaN NaN NaN NaN NaN NaN NaN LRI 1.83 1.83 4.83 6.63 9.63 2.43 5.33 2.33 1.33 9.23 6.53 5.53 2.43 3.83 0.83 7.04 TEN 6.32 6.32 4.32 4.32 7.22 1.22 0.22 7.22 4.22 4.22 7.12 2.12 2.12 3.12 1.12 9.02 TRP 0.03 0.03 6.03 3.13 7.03 2.03 8.92 8.92 7.92 5.92 9.82 NaN NaN NaN NaN NaN PSE 9.54 9.54 6.74 2.84 2.05 2.05 2.05 8.94 4.84 8.94 5.15 3.55 6.35 0.25 0.05 5.84 EWS modgniK detinU ,)ATI( ylatI ,)ARF( ecnarF ,)REG( ynamreG :sedoc yrtnuoC .emit dna seirtnuoc ssorca tnecrep ni sexat emocni robaL :11.A elbaT niapS ,)TRP( lagutroP ,)TEN( sdnalrehteN ,)LRI( dnalerI ,)ERG( eceerG ,)NIF( dnalniF ,)KND( kramneD ,)LEB( muigleB ,)TUA( airtsuA ,)RBG( ees ,evitanretla na roF .9002 ni sa emas eht eb ot demussa era setar xat 0102 ,snosaer ytilibaliava atad ot eud - (cid:3) .)EWS( nedewS dna )PSE( .txet niam eht ni 2.3 noitcesbus 41

(cid:3)0102 9002 8002 7002 6002 5002 4002 3002 2002 1002 0002 9991 8991 7991 6991 5991 6.73 6.73 6.24 6.54 1.24 9.04 7.83 7.83 4.73 9.93 2.34 9.14 6.24 7.14 6.24 0.44 ASU 5.53 5.53 1.73 3.83 0.93 7.63 6.43 1.43 3.53 9.73 8.93 3.04 2.83 7.73 6.53 4.33 41-UE 1.72 1.72 3.62 7.52 9.52 2.42 9.22 5.32 7.12 9.02 4.92 8.72 1.52 8.32 6.32 9.22 REG 8.24 8.24 4.84 5.64 6.84 4.44 5.44 9.14 1.44 9.54 0.44 8.44 0.24 7.04 5.83 6.43 ARF 8.44 8.44 1.64 1.64 1.44 6.73 0.63 8.53 0.83 0.93 0.73 9.14 1.93 8.54 0.34 1.14 ATI 2.05 2.05 7.94 1.05 9.45 1.25 0.84 0.84 4.25 7.26 6.16 6.55 7.45 3.05 2.64 3.74 RBG 1.42 1.42 4.62 6.42 5.32 5.42 3.52 4.52 3.52 1.23 9.52 2.62 6.72 9.72 0.62 0.22 TUA 4.05 4.05 4.25 6.84 5.05 0.94 1.54 9.74 4.25 6.65 2.35 6.45 2.45 0.05 5.84 8.44 LEB 5.55 5.55 0.65 1.75 7.85 1.55 4.94 5.84 4.74 7.64 8.24 0.44 9.05 7.14 4.14 0.04 KND 1.03 1.03 7.03 4.03 1.03 8.03 4.03 1.03 7.13 0.23 6.04 1.43 8.33 0.23 8.03 1.62 NIF 8.61 8.61 3.71 6.81 2.71 0.91 5.71 9.71 3.02 6.02 3.72 NaN NaN NaN NaN NaN ERG 7.51 7.51 6.71 8.81 4.02 1.81 7.71 4.61 2.51 NaN NaN NaN NaN NaN NaN NaN LRI 3.32 3.32 4.72 8.82 1.92 1.33 5.03 8.92 4.33 5.63 4.53 3.73 9.63 9.53 7.53 6.13 TEN 8.33 8.33 3.04 0.73 8.43 7.33 2.03 3.13 1.23 1.03 7.33 7.03 9.62 5.72 1.72 0.52 TRP 4.42 4.42 1.82 3.14 1.04 3.73 5.23 7.92 0.92 1.72 7.82 NaN NaN NaN NaN NaN PSE 5.25 5.25 2.04 9.93 0.83 1.04 8.53 8.43 6.73 4.44 3.84 0.83 6.63 4.63 2.43 3.72 EWS modgniKdetinU,)ATI(ylatI,)ARF(ecnarF,)REG(ynamreG :sedocyrtnuoC .emitdnaseirtnuocssorcatnecrepnisexatemocnilatipaC :21.AelbaT niapS ,)TRP( lagutroP ,)TEN( sdnalrehteN ,)LRI( dnalerI ,)ERG( eceerG ,)NIF( dnalniF ,)KND( kramneD ,)LEB( muigleB ,)TUA( airtsuA ,)RBG( .9002 ni sa emas eht eb ot demussa era setar xat 0102 ,snosaer ytilibaliava atad ot eud - (cid:3) .)EWS( nedewS dna )PSE( 42

(cid:3)0102 9002 8002 7002 6002 5002 4002 3002 2002 1002 0002 9991 8991 7991 6991 5991 0.4 0.4 1.4 3.4 5.4 5.4 4.4 4.4 5.4 6.4 7.4 9.4 0.5 0.5 1.5 1.5 ASU 2.51 2.51 1.61 7.61 6.61 5.61 6.61 7.61 8.61 9.61 4.71 6.71 3.71 1.71 1.71 0.71 41-UE 7.61 7.61 6.61 7.61 3.51 1.51 3.51 7.51 5.51 6.51 0.61 0.61 2.51 0.51 3.51 4.51 REG 6.51 6.51 5.61 1.71 4.71 5.71 6.71 5.71 0.81 1.81 8.81 8.91 6.91 6.91 4.91 6.81 ARF 5.21 5.21 1.31 0.41 2.41 7.31 7.31 1.41 6.41 9.41 6.51 7.41 1.51 2.41 4.41 4.51 ATI 0.31 0.31 1.41 7.41 8.41 0.51 6.51 6.51 5.51 7.51 3.61 7.61 7.61 7.61 9.61 7.61 RBG 5.91 5.91 6.91 6.91 2.91 0.02 2.02 2.02 7.02 2.02 5.02 6.12 0.12 0.12 0.02 3.91 TUA 5.61 5.61 8.61 8.71 3.81 2.81 8.71 0.71 2.71 8.61 9.71 0.81 0.71 1.71 8.61 5.61 LEB 0.13 0.13 1.33 3.53 0.63 6.53 8.43 0.53 7.53 8.53 7.53 4.63 4.53 2.43 9.33 4.23 KND 9.22 9.22 9.32 8.42 8.52 1.62 2.62 2.72 7.62 8.62 1.82 9.82 5.82 9.82 4.62 5.62 NIF 8.21 8.21 1.41 8.41 4.41 2.41 5.41 9.41 6.51 7.51 1.51 8.51 6.51 3.61 8.51 7.51 ERG 3.91 3.91 1.12 5.42 9.52 0.62 0.52 3.32 5.32 3.22 4.52 5.62 0.62 8.42 4.42 1.42 LRI 7.81 7.81 2.02 5.02 5.02 7.02 8.91 2.91 1.91 9.91 3.91 5.91 7.81 5.81 4.81 9.71 TEN 9.51 9.51 4.81 6.91 7.02 5.02 7.91 0.02 2.02 5.91 4.91 6.02 6.02 5.91 8.91 2.91 TRP 2.01 2.01 4.21 3.41 9.41 9.41 7.41 7.41 3.41 2.41 7.41 0.51 3.41 5.31 1.31 8.21 PSE 8.52 8.52 3.62 1.62 8.52 7.52 3.52 1.52 1.52 1.52 7.42 0.52 5.52 2.52 4.52 8.62 EWS modgniK detinU ,)ATI( ylatI ,)ARF( ecnarF ,)REG( ynamreG :sedoc yrtnuoC .emit dna seirtnuoc ssorca tnecrep ni sexat noitpmusnoC :31.A elbaT niapS ,)TRP( lagutroP ,)TEN( sdnalrehteN ,)LRI( dnalerI ,)ERG( eceerG ,)NIF( dnalniF ,)KND( kramneD ,)LEB( muigleB ,)TUA( airtsuA ,)RBG( .9002 ni sa emas eht eb ot demussa era setar xat 0102 ,snosaer ytilibaliava atad ot eud - (cid:3) .)EWS( nedewS dna )PSE( 43

Appendix B. Calculation of tax rates We use the same data sources as in Trabandt and Uhlig (2011), i.e. the AMECO database of the European Commission, the OECD revenue statistics database and the NIPA database of the BEA. In this paper, we re(cid:12)ne the methodology of Mendoza et al. (1994) to calculate e(cid:11)ective tax rates on labor and capital income. Broadly, we expand the measured labor tax base by including supplements to wages as well as a fraction of entrepreneurial income of households. Supplements to wages beyond employers social security contributions account for about 7 percent of e.g. U.S. GDP. Also, entrepreneurial income of households is sizable as a fraction of GDP but entirely accounted as capital income in Mendoza et al. (1994). We argue that at least a fraction, say (cid:11), of this income ought to be attributed to labor income. As a result, the re(cid:12)nements imply in a more reasonable labor share in line with the empirical literature. More importantly, the average 1995-2010 labor income taxes turn out to be lower while capital income taxes are higher as previously calculated in Trabandt and Uhlig (2011). Table B.14 provides an overview of the re(cid:12)nements.8 Income Tax Mendoza et al. (1994) This paper Personal: (cid:28)h = 1100 (cid:28)h = 1100 OSPUE+PEI+W (1(cid:0)(cid:11)+(cid:11))(OSPUE+PEI)+W+Wsuppl Labor: (cid:28)n = (cid:28)hW+2000+3000 (cid:28)n = (cid:28)h[W+Wsuppl+(cid:11)(OSPUE+PEI)]+2000+3000 W+2200 W+Wsuppl+(cid:11)(OSPUE+PEI)+2200 Capital: (cid:28)k = (cid:28)h(OSPUE+PEI)+1200+4100+4400 (cid:28)k = (cid:28)h(1(cid:0)(cid:11))(OSPUE+PEI)+1200+4100+4400 OS OS(cid:0)(cid:11)(OSPUE+PEI) Table B.14: Calculations of e(cid:11)ective tax rates: Mendoza et al. (1994) as used in Trabandt and Uhlig (2011) vs. this paper. where 8Note that we retain the assumption in Mendoza et al. (1994) that, implicitly, income from capital and labor is taxed at the same rate. In future research, it would be interesting to take di(cid:11)erences in the taxation of labor and capital income explicitly into account when calculating tax rates. 44

1100: Income, pro(cid:12)t and capital gains taxes of individuals, revenue statistics (OECD). 1200: Income, pro(cid:12)t and capital gains taxes of corporations, revenue statistics (OECD). 2000: Social security contributions, revenue statistics (OECD). 2200: Social security contributions of employers, revenue statistics (OECD). 3000: Payroll taxes, revenue statistics (OECD). 4000: Property taxes, revenue statistics (OECD). 4100: Recurrent taxes on immovable property, revenue statistics (OECD). 4400: Taxes on (cid:12)nancial and capital transactions, revenue statistics (OECD). OS: Net operating surplus: total economy (AMECO, NIPA). W: Gross wages and salaries: households and NPISH (AMECO, NIPA). OSPUE+PEI: Gross operating surplus minus consumption of (cid:12)xed capital plus mixed income plus net property income: households and NPISH (AMECO). Wsuppl: Supplements to wages: households and NPISH. Calculated as the residual of compensation of employees minus wages and salaries minus social security contributions of employers. Weselectavaluefor(cid:11)suchthattheaverage1995-2010laborshare,i.e. W+Wsuppl+(cid:11)(OSPUE+ PEI)+2200)=GDP equals 64 percent in the U.S. It turns out that we need to set (cid:11) = 0:35. We keep the same value for (cid:11) for all other countries. Table B.15 shows the resulting e(cid:11)ective tax rates across countries and compares them to those when the standard Mendoza et al. (1994) methodology is applied as used e.g. in Trabandt and Uhlig (2011). It turns out, that due to the broader labor tax base, e(cid:11)ective labor taxes are somewhat smaller while e(cid:11)ective capital taxes are higher. Finally, table B.16 provides maximum additional tax revenues that result from moving from the peak of the La(cid:11)er curve when either the standard Mendoza et al. (1994) tax rates or the re(cid:12)ned version proposed in this paper are used. Further, the table also shows the implications 45

of imperfect vs. perfect competition. The introduction of imperfect competition reduces the e(cid:11)ective labor tax base and thus less additional tax revenues are attainable when varying labor taxes. By contrast, pro(cid:12)ts arising from market power increase maximum additional tax revenues when capital taxes are varied. The fourth column shows the results when the standard Mendoza tax rates are used in the analysis and are essentially those obtained by Trabandt and Uhlig (2011). In this case, higher e(cid:11)ective labor taxes at the status quo equlibrium reduce the scope for more tax revenues when labor and capital taxes are varied. 46

Labor Taxes, (cid:28)(cid:22)n Capital Taxes, (cid:28)(cid:22)k Labor Share TU (2011) This paper TU (2011) This paper TU (2011) This paper USA 0.27 0.22 0.35 0.41 0.50 0.64 EU-14 0.41 0.34 0.32 0.37 0.48 0.58 GER 0.41 0.34 0.22 0.25 0.49 0.60 FRA 0.45 0.39 0.35 0.43 0.50 0.59 ITA 0.47 0.36 0.34 0.41 0.38 0.52 GBR 0.28 0.24 0.44 0.52 0.50 0.60 AUT 0.50 0.43 0.24 0.26 0.48 0.57 BEL 0.48 0.39 0.43 0.51 0.48 0.60 DNK 0.48 0.43 0.50 0.49 0.50 0.56 FIN 0.48 0.44 0.32 0.31 0.48 0.53 GRE 0.41 0.29 0.17 0.19 0.32 0.46 IRL 0.27 0.25 0.17 0.17 0.42 0.45 NET 0.44 0.36 0.28 0.32 0.45 0.55 PRT 0.28 0.22 0.27 0.32 0.44 0.56 ESP 0.35 0.30 0.27 0.31 0.46 0.55 SWE 0.56 0.50 0.39 0.40 0.51 0.57 Table B.15: Comparison of e(cid:11)ective tax rates. TU (2011) abbreviates Trabandt and Uhlig (2011) who use the methodology proposed by Mendoza et al. (1994). The table shows the implications of the re(cid:12)ned calculations of e(cid:11)ective tax rates as well as the implied labor share. See Appendix B for details. 47

Vary Labor Taxes, (cid:28)(cid:22)n Vary Capital Taxes, (cid:28)(cid:22)k ∆T ∆T Max Max This paper TU (2011) This paper TU (2011) ! = 1:1 ! ! 1 ! ! 1 ! = 1:1 ! ! 1 ! ! 1 USA 37.6 42.5 33.3 10.7 8.2 7.3 EU-14 11.9 13.9 8.4 3.2 1.6 1.0 GER 15.4 17.3 10.1 6.8 3.9 2.3 FRA 7.1 8.6 4.9 1.1 0.3 0.3 ITA 9.8 11.6 4.2 2.1 0.9 0.3 GBR 17.5 21.0 18.7 1.7 0.9 1.6 AUT 5.2 6.1 2.0 2.6 1.0 0.3 BEL 5.7 7.2 3.0 0.3 0.0 0.0 DNK 1.3 2.1 0.6 0.0 0.4 0.9 FIN 4.1 5.1 2.9 1.6 0.4 0.2 GRE 18.9 21.0 8.2 8.9 5.6 2.1 IRL 32.7 36.3 32.3 14.9 10.7 9.4 NET 14.7 16.9 8.7 5.3 3.0 1.6 PRT 21.6 25.1 18.6 6.6 4.5 3.6 ESP 18.5 21.0 15.0 6.5 4.0 3.1 SWE 2.0 2.7 0.7 0.5 0.0 0.0 TableB.16: La(cid:11)ercurvesforthe1995-2010calibration. ∆T denotesthemaximumadditionaltaxrevenues(in Max %) that results from moving from to the peak of the La(cid:11)er curve. Results are shown for the standard Mendoza et al. (1994) taxes used in Trabandt and Uhlig (2011), \TU", as well as for the re(cid:12)ned tax rate calculations discussed in Appendix B. Further, the case of imperfect competition with a gross markup ! = 1:1 is compared to the case of perfect competition, i.e. ! !1. 48