transformed its personal income tax system into a consumption-based tax by allowing deduction of interest income.

33. The effects of labor and consumption taxes on formal sector employment depend on wage flexibility. In countries where the wage bargaining power of workers is strong enough to resist a tax-induced fall in the net real wage by claiming a higher nominal wage, both the labor tax and the consumption tax are shifted back to firms, thus wage costs increase, and as a result employment falls (depending on the elasticity of demand). By contrast, if real wages are allowed to fall as a result of a higher labor tax or a higher consumption tax, labor demand is not affected. However, workers tend to supply less labor to the formal sector (depending on the elasticity of supply) and may instead shift their employment to the informal sector in order to preserve real earnings. Similarly, buyers of goods and services may respond to a higher consumption tax by shifting purchases to the informal sector to prevent a decline of their real disposable income.

34. In the NM-EU countries both labor supply and labor demand effects may play a role in carrying out undeclared work. As the wage bargaining power of workers tends to be relatively weak, part of the labor tax burden may be borne by workers through lower real wages. Additionally, workers tend to respond by underdeclaring wages in the regular sector and also by working in secondary jobs in the informal sector. This hypothesis is supported by the above-mentioned polls, which show that low salaries in the regular sector are seen as an important cause for carrying out undeclared work. At the same time, in some of the NM-EU countries, the combination of a relatively high minimum wage and high employer contributions to social security tends to reduce labor demand for low-skilled workers who then try to find a job in the informal sector or work as self-employed where it is easier to underdeclare income.

35. Given the similarities between labor taxation and consumption taxation it has been argued that lowering labor taxation and increasing consumption taxation accordingly has no major effect on employment, as the real wage remains broadly constant (e.g. Layard et al. 1996). However, this neglects the fact that a general consumption tax (such as the VAT) has a broader base than a labor tax, as consumption is not only financed by labor income but also by capital income, wealth, and government transfers. The effects on prices are also different as labor taxation affects producer prices while consumption taxation affects consumer prices. Reducing employer contributions to social security and increasing VAT accordingly therefore leads to a fall in export prices and an increase in import prices, which increases international competitiveness of firms in the same way as a depreciation of the currency. There may also be some nominal wage rigidity so that lowering labor taxes and increasing consumption taxes may – at least for some time – reduce wage costs for employers. It is therefore not surprising that a number of studies have found that shifting the tax burden from labor onto consumption increases employment and growth, in particular if transfer recipients are not fully compensated for the tax-induced increase in prices (e.g. Daveri and Tabellini, 2000; EC, 2006).

36. From these latter studies one could conclude that shifting from labor tax to consumption tax helps to reduce the informal sector. However, more country-specific analysis is needed before drawing a strong conclusion on how such a tax shift affects the informal economy. While the labor tax reduction makes the use of labor in the formal sector less expensive, which tends to increase formal sector output, the increase in the consumption tax reduces demand for formal sector output. The net effect on formal sector output (and the 15