# **V.  Tax structure and competitiveness**

We have mentioned earlier that the Dutch disease effects are exacerbated by the domestic supply response. Inflationary pressure for domestic non-tradables (and thus real exchange rate appreciation) is directly linked to what happens to factors supply and in particular to labor supply. Econometric evidence shows that labor supply tends to shrink in response to rising remittances. Within the margins of narrow fiscal spaces, can governments implement policies that counteract this negative labor supply and thus mitigate wage and real exchange rate increases?<sup>13</sup> A policy response considered here consists of a contemporary reduction of payroll taxes and an increase in sales taxes, i.e. a partial switch from direct taxes to indirect taxes. Taxing remittances directly is not a viable policy option for, at least, two reasons: the income generating the remittances has already been taxed at the origin and the double taxation would increase the agents’ incentives to transfer money through the black market; secondly, remittances are an important source of household income and taxing them could increase the vulnerability of households to income shocks. A reduction in payroll taxes is a better alternative policy tool to limit the negative labor supply response following a remittance shock. From the workers’ point of view, lower payroll taxes directly provide greater incentives to work through higher wages. This policy also reduces the wages paid by the employers and thereby increases their labor demand. Payroll tax (or other direct tax) cuts should be considered as illustrative for any set of policies aiming at stimulating labor supply.<sup>14</sup> With the help of a Computable General Equilibrium (CGE) model, we have tested this policy for Jamaica, a country that during the 1990s witnessed, on the one hand, a combination of lagging participation rates (especially for women) and rising real wages and, on the other hand, a remarkable increase in international remittance inflows, reaching almost 20 percent of GDP in 2003.

Using data for Jamaica, we test whether a 25 percent cut in payroll tax is a viable policy to sterilize the reduction in labor supply induced by a 10 percent increase in remittances<sup>15</sup> . The main results are shown in table 4. Consider initially the effect of higher remittances in the first column. Total labor income change is comprised of two components: on the one hand, labor income falls because more non-labor income encourages households to consume more leisure, but on the other hand, reduced labor supply is accompanied by increased labor demand (given the increased demand for goods) and wages rise. The change in wages adds a set of second-order effects to the mentioned change in labor supply, since an increase in the wage rate raises the

> 13 The following discussion draws heavily on Bussolo and Medvedev (2007)

> 14 Here we assume that the government through a cut of the payroll tax is directly able to stimulate supply by reducing the wedge between wages paid by the employers and those received by the workers; however the actual fiscal instruments at the government disposal may be less direct, and revenues from payroll taxes may not be easily substituted by revenues from other taxes. Less direct ways of affecting labor market outcomes may consist of a set of microeconomic interventions aiming at increasing markets flexibility and labor productivity (see below).

> 15 This increase in remittance inflows is not very large considering the rapid pace of remittance growth over the last decade. Since remittances represent approximately one-fifth of Jamaican total household income, a 10 percent remittance shock raises total household income by 2 percent.

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