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1 Notes on the Lisbon process: An analysis of the impacts of reaching the Lisbon targets for skills, R&D and the administrative burden in the European Union Industrial Policy and Economic Reforms Papers No. 7 Ray Barrell and Simon Kirby Enterprise and Industry Directorate-General European Commission

2 Notes on the Lisbon process: An analysis of the impacts of reaching the Lisbon targets for skills, R&D and the administrative burden in the European Union Ray Barrell and Simon Kirby (NIESR)* November 2007 * National Institute of Economic and Social Research, London. Contact: ;

3 Industrial Policy and Economic Reforms Papers are written by the staff of the Directorate General for Enterprise and Industry or by experts working in association with them. This publication series aims to raise the awareness and stimulate the debate on issues in the areas of industrial policy and economic reforms. Views expressed in these papers represent the positions of the authors and do not necessarily reflect those of the European Commission. Contac information European Commission Enterprise and Industry Directorate-General Unit B4 "Economic Analysis and Evaluation" Rue de la Loi / Wetstraat 200 B-1049 Brussels Tel: (32-2) Fax: (32-2) Web page: A great deal of additional information on the European Union is available on the internet. It can be accessed through the Europa server ISBN: ISSN: DOI: /47768 Luxembourg: Office for Official Publications of the European Communities European Communities, 2008 Reproduction is authorised provided the source is acknowledged.

4 Abstract This paper describes the National Institute of Economic and Social Research s (NIESR) approach to the analysis of the implementation of the Lisbon Agenda. It forms the background to the European Commission Competitiveness Report chapter on spillovers and the Lisbon Process. The paper describes the assumptions that have been made and discusses in more depth the outline results presented in that chapter. The paper discusses both synergies and spillovers, and looks first at the impacts from policies taken unilaterally in each country one at a time and then all simultaneously in all the European Union countries. Simulations show there are a number of spillovers from the various policies and targets within the Lisbon Agenda. Our analysis suggests that if the administrative burden were to be reduced by 25 per cent then the aggregate EU unemployment rate would be ¾ percentage point lower than baseline. The results suggest synergies are strongest between the policies to increase skills and to raise R&D expenditure. Overall the effective implementation of the Lisbon Agenda would be to increase the level of output by 0.6 per cent. JEL Classification: E17, E61, O52 Keywords: Macroeconomic modelling, Lisbon Agenda, policy spillovers.

5 Introduction This paper describes the National Institute approach to the analysis of the implementation of the Lisbon Agenda. In combination with Barrell, Holland, Kirby, and Riley (2007) it forms the background to the 2007 European Commission Competitiveness Report chapter on spillovers and the Lisbon strategy. The paper describes the assumptions that have been made and discusses in more depth the outline results presented in that chapter. The first policy initiative discussed involves an increase in skills produced by increased spending on education, and especially primary and secondary educations. The analysis allows both for the impacts of the increase in spending and taxation this requires and also for the impacts of increased skills on output. The second policy initiative involves using government subsidies to raise the level of Research and Development (R&D) spending to the Commission target of 2.7 percent of GDP. As a result the level of technical progress increases and output rises significantly. This initiative requires a significant increase in the level of taxation, and hence impacts on the level of saving in the European economies. Given their size this puts upward pressure on (world) real interest rates, and this has a noticeable offsetting effect even in these economies with high levels of capital mobility. The third policy initiative results in a reduction in the margin between costs and prices, as the administrative burden on the economy declines by 25 per cent. The inputs are derived from the CPB modelling analysis based on their Computable General Equilibrium (CGE) model Worldscan and on background research on education and R&D. The policies have impacts on output and real wages as well as on the level of employment. Only the policy on margins changes the equilibrium level of employment and unemployment in the main cases analysed, as it is assumed in these analyses that labour market participation is not affected by real wage developments. The analyses of each of the policy initiatives when introduced unilaterally and in a fashion have been repeated with endogenous participation based on plausible synthetic elasticities. This gives some guidance on the potential impact of the policies on the level of employment, and hence allows us to assess how far the European Union falls short of the Commission target of 70 per cent of the population of working age in employment. The paper concludes with an analysis of the impacts of an exogenous, and hence unexplained, increase in participation in all countries that would be sufficient to achieve this Union wide target. The paper discusses both synergies and spillovers, and looks first at the impacts from policies taken unilaterally in each country one at a time and then all simultaneously in all the European Union countries. The analysis is then extended to look at the policies taken in combination, building them up to a complete package. The impact on the immediately relevant Commission target is reported along with the impacts other targets in order to determine the synergies between policies. All the analysis is undertaken on the National

6 Institute Global Econometric Model (NiGEM) which is a dynamic stochastic general equilibrium model 1. The path to equilibrium also matters to policies makers, and it is useful to discuss changes that can ensure that equilibrium is reached more quickly or at lower cost. Different policies will have different effects on their way to equilibrium, and they are discussed in the analysis below. In particular the speed of adjustment depends upon what one assumes about expectations formation and about market structure. If expectations are rational, then adjustment is generally faster. If financial markets are liberalised this would allow consumers to be more forward looking, and hence adjustment will also be more rapid. Skills Increasing the skills base in the European Union requires an initial reduction in the level of employment since average years of schooling can only be increased through the members of the working age population extending their participation in the educational system. Hence the impacts on output are initially small. However, the initial impact on output is positive because of the fiscal expansion associated with the extra educational spending. This expenditure, set out in Lejour and Rojas-Romagosa (2007), initially increases the public sector deficit initially. In the NiGEM simulation the requirement that governments are fiscally solvent leads to income taxes being raised gradually over a five-year period and hence to a return to the initial trajectory for government borrowing. The impacts of a higher skilled workforce begin to feed through after 4 years, but they cumulate slowly as the increase in education moves upward through the age structure over time. The impact of the policy is not complete until 45 years after its inception, and hence these results represent less than half of its positive impact. The short run impacts of the policy depend upon expectations, and firms and financial markets are assumed to be forward looking. Consumers who are unconstrained and form rational expectations may shift their consumption forward as their disposable income will be higher in the future given that skills will be increased. There are two caveats to this suggestion. The consumers whose incomes will be higher in future will initially be in education not work and they are likely to be partially liquidity constrained. In addition, the initial impact of the increase in public spending will be less as they also likely to correctly anticipate higher taxes to pay for increased schooling. If financial markets are not liberalised and consumers cannot spend in relation to their future incomes, then the benefits of the skilling of the workforce are delayed, and hence the net present value is lower. There is an obvious synergy between the liberalisation process and the Lisbon Agenda, and this is strengthened if the benefits of the agenda are made clear to the public. Figure 1 plots the impacts of the skilling policy on the EU 15 economies under the standard assumption of 1 But not necessarily a Dynamic Stochastic General Equilibrium model as DSGE models have specific features that are options in NiGEM

7 forward looking firms and financial markets, and also under the assumption that consumers can also react to future events because they do not face liquidity constraints. Figure 1 The impacts on GDP of increasing the skills base in the EU15 (per cent difference from baseline) Standard Unconstrained The impacts of the skills policy vary significantly between countries, especially in regard to the effects on employment. These impacts depend on the increase in years in education, as set out in Jacobs (2005), and the extent to which the increase in the school-aged population reduces the labour force available for employment. Unemployment reaches its independently determined equilibrium rate before 2025 in all countries with this policy initiative. It is assumed that the skills policy does not involve either an increase in the average retirement age, nor does it involve participation in education starting at a younger age, and hence the increase is fully absorbed from the existing labour force. It is assumed that young workers withdrawn from the workforce have half the average level of productivity of the employed population as a whole and hence their withdrawal can be modelled partly as a shock to the level of technical progress. In order to undertake the shock it is necessary to estimate the reduction in the workforce that it implies. International Labour Office data on years of schooling and retirement ages have been used and it is assumed school starts at age 5 and hence ends at 5 years plus years of schooling. A constant activity rate in between leaving schooling and retirement and a constant cohort size have been assumed. Table 1 applies Lejour and Rojas-Romagosa (2007) numbers for the percentage rise in schooling (column 3) to years of schooling to give the reduction in person years, and the resulting reduction in the workforce is given in column 4. The increase

8 in public spending as a percent of GDP is that reported in Jacobs (2005) and it is financed by an increase in taxation. Table 1 Assumptions for the simulations on increasing the skills base Average years of schooling Average retirement age Percentage rise in schooling Percentage change in labour force Increase in government spending ( of GDP) Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovak Slovenia Sweden Estonia Latvia Lithuania In NiGEM the unemployment rate is endogenous, and hence a shock might change the equilibrium rate of unemployment, but the skills shock would not be expected to do this. Any policy that changes the size of the labour force will, however, change equilibrium employment. Figure 2 plots our trajectory for unemployment on our baseline and the impacts of the skills policy on that unemployment rate. The skills policy reduces unemployment in the first few years, but after that it is around its baseline trajectory. This baseline takes account of a slow return to equilibrium output and employment from the current situation where there may be some spare capacity. Unemployment also trends downwards on the baseline because of the impacts of policies, such as the Hartz reforms in Germany that are currently being implemented. Figure 2 EU 15 unemployment rate, pre and post skills policies

9 Per cent EUSU15(skills) EUSU15(base) The impacts on output vary across countries in line with the impacts on the labour force and the level of technical progress which captures the change in the skill structure. Table 2 gives the impacts on output, consumption and real average wages in each of the countries in 2025 when acting alone and when acting together, and appendix A gives more detail. The population of working age declines in UK, Ireland, Netherlands, France, Finland, Greece and Belgium, as schooling needs to increase most in these countries according to CPB estimates. The output effects are largest in Portugal, Poland, Greece and the UK, and the weighted average across the Union is around ¾ of a percent. Changes in consumption and real wage effects are driven by a number of forces. The increase in the workforce requires a matching increase in capital, and much of this will be financed by borrowing from abroad. Hence some of the increase in output finances the increase in borrowing and national income rises by 0.1percentage points less than national output by As a result consumption also rises rather less as well. If the skills programme has produced a reduction in employment then this will drive wages up, with the supply of labour moving up the demand curve and as the elasticity of substitution is around a half a decrease in the supply of labour should therefore raise the wage share in the medium term. If expenditure on education has risen significantly, as it has in some countries this will require an equivalent rise in taxation if fiscal solvency is to be maintained, and hence consumption will be constrained. Technical change on its own has a complex effect, with gains in productivity being offset by potential effects on the terms of trade. An increase in the output of one country can lead to a fall in the relative price of its goods and hence export revenues will not rise as much as export volumes. Import prices will rise relative to domestic output prices and hence consumption cannot rise as much as output. This effect is noticeable in a number of countries when they act alone, and consumption falls marginally. However, it is absent when

10 acting together, as we can see from Table 2. It is possible that the increase in skills leads to a rise in the variety and quality of goods, then the terms of trade effect may be absent. Such changes are not included in the analysis. Results might be marginally different if we were to allow for the differences between traded and non-traded goods, but this effect would not outweigh the overall impacts of changes in terms of trade without changes in the variety of goods. Table 2 Implementing the Skills Target (per cent difference from base) GDP Consumption Real producer wage Coordinat ed Unilateral Coordinat ed Unilateral Coordinat ed Unilateral EU Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations. Participation is exogenous. The effects of the skills shock alone and together vary noticeably across countries. The more open a country is to trade, the greater the difference in the increase in consumption (in percentage terms) when acting unilaterally and in a fashion. The correlation of this difference with openness is Real producer wages rise in almost all countries when acting alone, and in all countries when acting together. The increase in taxation required to finance increased spending on education holds back consumption in a number of countries when they act alone, but not when they act together. Output rises by 0.74 percentage points after 18 years, and consumption would be 0.44 per cent higher in the EU as a whole. As noted above it would take up to 45 years for the full effects of the policy to work through the skill structure of the workforce as each cohort gets older and long run gains would be noticeably higher.

11 Real consumption wages rise by 0.66 per cent in the EU as a whole when all countries act simultaneously. If participation were to react to these changes in real wages, then activity levels would rise further. This dependency is not a feature of NiGEM, as the evidence for it is weak, but it is possible that participation could rise. The CPB meta-study of the participation elasticity with respect to real wages by Evers et al. (2005) suggests that we would see a 0.25 percentage point increase in participation. We report on the results with endogenous participation in a later section. An Increase in R&D The Lisbon Programme requires a large increase in Research and Development (R&D) in all Euro Area countries. The Worldscan analysis implements a set of increases in R&D that are designed to meet the target, and these have been replicated on NiGEM. There are three sources of spillover in this scenario, with the normal trade and interest rates routes being dwarfed by information spillovers between countries. Lejour and Rojas-Romagosa (2007) suggest that the impacts on technical progress of a rise in R&D depend on R&D elsewhere, with spillovers ranging from under a quarter of the domestic effect in Belgium, for instance, to over a half of the domestic effect in the larger, and more industrial, German economy. When all countries act simultaneously, output effects in the Lejour and Rojas-Romagosa (2007) study are around twice as large as the average of those when they act unilaterally. This study allows for the impacts of the increase in R&D spending by increasing the level of technical progress in line with the Lejour and Rojas-Romagosa (2007) results. The effects on output, consumption and the real producer wage are presented in Table 3 below, and further details are given in appendix B. The overall impact of a increase in R&D spending is to raise output in the EU by 4.2 percentage points, which is marginally higher than the 3.3 percentage points in the Worldscan results. As there has to be an increase in borrowing from abroad to finance higher investment national income in the European Union rises by 0.4 percentage points less than national income, and this will affect the resulting increase in consumption. The NiGEM model is based on a CES production function, and hence the policy is implemented by an increase labour augmenting technical progress. The increase in R&D is generated by government spending, and this is allocated to the government capital stock. The increase in the capital stock accounts for the larger increase in output in these simulations, and hence gives an upper bound to the impact of the policies. The large increase in government spending on R&D has to be financed by higher taxation, with the budget balance remaining at its target level in the medium term after an initial increase in the deficit. The scale of the increase in public spending and taxation has an impact on real interest rates, raising them by around 0.2 percentage points at the peak of the R&D spend, and by around 0.1 percentage points in the long run.. As the private sector capital stock

12 depends on the user cost of capital, which moves with the real interest rate, the level of private sector capital and investment is lower than it would otherwise have been given the level of output. The impacts of the increase in R&D come through slowly. Forward looking financial markets speed up the impacts, with the effects being 25 percent larger after 5 years than if the world were backward looking. However, forward looking consumers would react to higher taxes in the early part of the simulation and would marginally slow the improvement in output in the first four years as compared to the standard simulation with only forward looking firms and financial markets. The long run effects are independent of assumptions on expectations. The ratio of unilateral to policy effects on output varies, as we can see from table 3 and appendix B, with the smallest ratios (and hence the largest gains from coordination) being observed for countries such as Finland, Austria and Denmark. They benefit from the spillover of knowledge sectors without having to increase their spending and taxation much as they have relatively high levels of spending. Countries such as Germany are sources of R&D rather than users of R&D and hence most of the effects of the increase in R&D spending come from their own increase in spending, and not from spillovers from elsewhere. The scale of spillover effects are larger than for fiscal policy actions in NiGEM, where spillovers rarely reach 20 per cent of the home country impact of a shock even in the short run, and they are absent in the long run. The crowding our effects that reduce the spillovers from fiscal policy, detailed in Barrell, Holland Liadze and Pomerantz (2007), are the combination of the decline in net trade that comes from higher domestic demand and prices and the negative impact of increases in interest rates on investment, and both will be present here. The unweighted average ratio of unilateral to joint effects is 0. 6 in Worldscan as compared to 0.8 in NiGEM, indicating that spillovers are smaller because the crowding out from net trade and from higher interest rates are larger 2. Table 3 The impact by 2025 of R&D, as a per cent if GDP, reaching 2.7 per cent GDP Consumption Real producer wage Coordinat ed Unilateral Coordinat ed Unilateral Coordinat ed Unilateral EU Austria Belgium Czech Republic Germany Denmark Spain Direct technical spillovers from R&D across countries are the same in the two pieces of analysis.

13 Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations diff from base participation exogenous The impacts on consumption and real wages also vary significantly between unilateral and concerted action. Even in the case when a country increases its spending on R&D unilaterally all the effects of the increase in public spending must be reflected in higher taxes. Therefore the consumption benefits are small for countries that raise their R&D expenditure in isolation, but they are much larger, on average about 2 percentage points larger, with a concerted increase in spending on R&D. This is partly because output effects are on average 2/3 of a percentage point larger, but mainly because the negative terms of trade effects are much smaller when countries act simultaneously. This is reflected in real producer wages which rise (almost) everywhere when countries act unilaterally and increase noticeably more when they act simultaneously. Labour markets react in a similar way everywhere except in the small Baltic countries and the Slovak Republic, where a reservation wage in the model wage bargain means that increases in real wages on the scale we see here lead to noticeable reductions in unemployment. Such increases would inevitably lead to increased labour market participation in these countries. The increase in R&D, which is accompanied by a large, but tax financed, increase in government spending raises employment for a sustained period of years, but the effects on unemployment will ultimately be transitory in most countries. The effect on real consumer and producer wages varies across countries, and details are given in appendix B. In aggregate real consumer wages rise by 2.5 per cent, and this could induce a rise in participation of between 0.4 and 0.6 percentage points, as is discussed below. Some of this impact would be offset if the increase in spending were to be financed by a rise in direct taxes, as is assumed here. The overall impact on employment is limited, with an average increase of less than 0.2 per cent, with unemployment falling by the same amount, although effects vary from country to country.

14 Reducing the Administrative Burden The reduction in the administrative burden is one of the policy instruments highlighted with in the Lisbon Agenda. The approach to modelling the impact of a reduction in the administrative burden is fraught with difficulty, as Gelauff and Lejour (2006) acknowledge. Their estimates of a 25 per cent reduction in the administrative burden rely on data from Kok (2005), where the administrative burden is measured as a per cent of GDP. Lejour et al (2007) have introduced a reduction in the administrative burden in the form of a labour efficiency shock. Our approach to simulating the effect of a reduction in the administrative burden differs from Lejour et al. (2007). We simulate this administrative burden reduction through a shock to the mark-up of prices over unit costs. The administrative burden forms part of the regulation firms face within an economy. Crafts (2007) provides a summary of the literature that finds a positive relationship between product market regulation and the mark-up over unit costs. Barrell, Holland, Kirby and Riley (2007) show that the mark-up appears in the long-run price and wage equations imbedded in NiGEM We need to explicitly identify the mark-up in these equations to allow us to simulate the impact of a reduction in the administrative burden. We use an estimate derived from Oliveria-Martins et al. (1996) that has been adjusted for the country-specific industry mix of the economy using 2003 data from the OECD STAN database. Oliveria-Martins et al. (1996) do not provide an estimate of the mark-up for all the EU countries. In order to provide an estimate for each country in our analysis we impose the variation in the administrative burden between countries in Kok (2005) to our estimates of country-specific mark-ups 3. Figure 3 shows the variation in mark-ups across the European Union. The mark-up in an economy is not just the administrative burden, but is also due to the competitive environment faced by firms. Reducing the mark-up by 25 per cent in the economy would provide positively biased estimates of the likely impact of a reduction in the administrative burden. As such we have scaled the reduction in the mark-up using the information provided by Kok (2005). Since a significant proportion of the variation in markups is based on Kok, the variation in a 25 per cent shock to the administrative burden is similar in its variation to Lejour et al (2007). Figure 3 Estimates of European mark-ups 3 As in Kok (2005) we use the Netherlands as the benchmark country. The mark-up estimates are adjusted for the mean difference between country estimates using this approach and the estimate for which Oliveria-Martins (1996) provides data. Where Kok (2005) does not provide an estimate for a country we use his source of the variation, Djankov et al. (2002), to extend our sample.

15 Sweden Finland UK Germany Ireland France Netherlands Denmark Lithunania Czech Republic Slovenia Belgium Spain Austria Portugal Slovak Republic Italy Poland Latvia Greece Hungary

16 Table 4 The impact of a 25 per cent reduction in the administrative burden GDP Consumption Unemployment rate Coordinat ed Unilateral Coordinat ed Unilateral Coordinat ed Unilateral EU Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations with exogenous particiaption. All per cent difference from baseline except unemployment rate which is percentage difference from baseline. The 25 per cent reduction in the administrative burden is introduced as a permanent shift down in the mark-up. As we can see from table 4 there is a decline in unemployment everywhere, and output rises everywhere, both when acting alone and when acting together 4. The effects on output are particularly large in Hungary and Spain, and the impacts on unemployment are largest in Belgium and in Spain. These are the countries where the burden is reduced the most. Consumption rises by more than output in the European Unions as a whole when all countries act together as the policies reduce consumer prices relative to producer prices. The unweighted average of the effects of the policies on consumption when acting alone is two thirds that of acting together, suggesting significant export price based spillovers across countries. There are clear synergies between the policies for reducing the administrative burden and for raising employment. Variation in the impact of the reduction in the administrative burden is due, in part, to the openness of the country with the size of the impact rising with openness, with a correlation of In smaller countries the reduction in the administrative burden also has a larger impact, although this may be subsumed in 4 More detailed results are reported in appendix C.

17 openness, and the impact increases with the initial level of unemployment, with a correlation of The impact on unemployment larger the higher is the initial level of unemployment, with a correlation of -0.2, and hence unemployment rates converge somewhat across the Union as a result of the policy on the administrative burden. There appear to be no employment spillovers from policies, with the unweighted average of changes in unemployment rates when acting alone being marginally below (with a ration of 0.97) the unweighted average of the effects when acting together. Output rises by 1.1 per cent (and income by 1.0 per cent) in the European Union as a whole when countries act together to reduce the administrative burden, and the unweighted average of acting alone to acting together is This suggests that spillovers are present in the long run, but not on the scale that we see with R&D spending increases. This is a significantly higher level of spillovers than we would observe from fiscal policy, as Barrell, Holland, Liadze and Pomerantz (2007) demonstrate. Spillovers, as indicated by the ratio of unilateral to output effects, are negatively related to openness with a coefficient of Putting it all together: estimated synergies The Lisbon Agenda is about a combined package of policies to raise output and employment. The combination of skills packages, R&D increases and reductions in the administrative burden will have the desired effects of raising output and consumption as well as employment. Output in the European Union would rise by more than 6 per cent, with the largest impacts coming in the countries with lower levels of incomes, as we can see from Table 5. This details the output effects from each part of the package together, whilst figure 4 plots the effects of the cumulated policies on unemployment in the Euro Area. The impacts of the R&D package are large, and they involve significant increases in public spending and taxation. Only the administrative burden reduction has a significant impact on unemployment rates.

18 Table 5 Comparison of the effect on GDP of the policies combined with the summation of the effects of separate policies Combined policies Individual policies summed Combined minus individual Combined Margins and R&D less sum Margins and R&DI Combined R&D and Skills less sum R&D and skills EU Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations with exogenous participation. Per cent difference from baseline in columns 1 and 2, percentage point difference between results in columns 3 to 5. The most important synergy is that between the administrative burden and the employment objective, as we can see from the figure 4 and table 6. The reduction in the administrative burden reduces unemployment by almost two thirds of a percentage point in the European Union, and raises output by more than one per cent. Hence it impacts on both employment and administrative burden targets. The R&D strategy impacts mainly on output, raising it by more than 4 per cent, but also has some synergies. If it were implemented it would raise employment and reduce unemployment by around 0.2 percentage points, mainly because of the impacts on the labour markets in the new member states. However, it is implausible that R&D spending could be raised by such an amount so quickly especially in the new member states. Hence the synergies that are achieved with R&D may be noticeably smaller. Figure 4 The cumulated effects of policies on the European Union unemployment rate (percentage points difference from baseline)

19 Skills R&D with skills All policies When policies are combined together the result is to generally raise output by marginally more than the sum of the parts. The exception is in the smaller new members where we assume the reservation wage does not change with technical progress and hence there is a small offset to the R&D shock. Table 5 shows that the level of output in the European Union as a whole increases by around 6.3 per cent as a result of all the policies when implemented all together. This is 0.6 percentage points more than the sum of the effects of the individual policies. Hence there are clear output synergies between policies. In addition Crafts (2007) does suggest that lower margins encourage R&D. In our simulation the increase in the R&D spend is taken in by assumption, but it could be higher if margins were lower. It is obviously useful to identify which policies induce synergies, and we have also implemented them two at a time. There are no apparent synergies when we compare the joint implementation of the R&D policy and the reduction in the administrative burden policy. The sum of the effects of the two policies when undertaken separately is similar to the impact of the policies when undertaken together, as we can see from column four of table 5. The skills improvement policy and the R&D policy when undertaken together have more impact than the policies do when they are implemented individually. Indeed, column five of table 5 demonstrates that most of the synergies that we observe come from the combination of these two policies, and in combination they raise output by almost 0.6 percentage points more than the sum of the impacts on output when undertaken individually. The synergies that are observed come from the complementarities of skills and knowledge and increases in the supply of capital that the R&D policy induces.

20 Table 6 The impacts of policies on employment and unemployment in 2025 (percentage points difference from baseline) Unemployment rate - all policies Unemployment rate - skills base increased Unemployment rate - admin. burden reduced Total employment (per cent) EU Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations with exogenous participation. Overall real consumer wages have risen by 3.6 per cent, with most of this coming from the R&D shock and this could raise participation by three quarters of a percentage point or more, whilst the unemployment rate has fallen by approximately one percentage point. Figure 5 plots the average increase in the real consumer wage for the whole of the European Union. This overall conclusion belies the wide variation in the effect on individual countries, with a small increase of 1.5 per cent in Germany reflecting the small scale of R&D spillovers to that country, to around 7 per cent in the small Baltic countries. Given the differences between countries it would be expected that there should be differences in the impact on the participation rate.

21 Figure 5 EU25 real consumer wage (per cent difference from base) The Employment Rate and Endogenous Participation The Lisbon Agenda includes a European Union wide target of a 70 per cent employment rate for the population of working age. On our baseline in 2006 the employment rate in the European Union averaged 65.6 percent, marginally above the figure reported for the same group for 2005 in the OECD Employment Outlook (2006). Column 1 of Table 7 provides the country details. The background to the differences between countries is discussed in Algan and Cahuc (2006) and we follow their argument. The employment rate was already above 70 per cent in the largely Protestant countries, Sweden, Denmark, the UK and Estonia as well as in the Netherlands which has about an equal share of Catholics and Protestants. Participation was relatively low at around 62 per cent in Catholic France and Belgium, and Orthodox Greece, and was below 60 per cent in Catholic Italy and Poland as well as in Hungary and Slovakia.

22 Table 7 The impacts of policies on the employment rate Baseline employment rate 2006 (per cent) Steady state employment rate (per cent) Impact of endogenous participation (percentage points) Impact of policies on employment rate (percentage points) Post policy employment rate (per cent) Per cent increase in employment rate needed to reach 70 EU Austria Belgium Czech Repubic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations with exogenous participation in column 4 and the impact of endogenous participation in columns 3 and 5.

23 There are already policies and trends in place that should raise the participation rate over the next two decades, and these are built into the NiGEM baseline. The resulting employment rates are reported in column 2 of Table 7. They include reforms to unemployment assistance in countries such as Germany as well as a trend to later retirement in countries such as Spain. Even after we take account of these trends and changes we expect the steady state employment rate in the European Union to reach 67.3 per cent, still short of the Union wide goal of 70 per cent. If participation were exogenous then the policy package considered here would raise employment in the European Union by 1.75 per cent, as can be see from column 4 of Table 7. The largest impacts would be in Spain, Portugal, Belgium, Slovakia, Slovenia and the Baltic States, but the gains would be widespread. The evidence on the impact of real consumption wages on participation is relatively weak, and even in the heavily investigated UK and US it is not clear what the impact of an increase in the real wage is on participation. It is possible to conclude that an increase in the relative pay of married women as compared to their partners does increase their participation, but it is not clear that the policies we consider here induce that change in relativities. It is however, plausible to assume that increases in real wages will impact on participation and the meta study by the Evers, de Mooij and van Vuuren (2005) of empirical work on participation suggests that all else equal a one per cent rise in the real wage increases participation by 0.25 percentage points. We have repeated our set of policies, both separately and combined, with endogenous participation, and Table 7 details the impact on participation whilst Table 8 reports on the additional impacts on output and employment. The additional output is directly proportional to the increase in real wages, and is hence largest for the R&D initiative, and Table 8 reports on that policy as well as on the combination of all three together. The overall impact of assuming that participation is endogenous is to raise the level of output by around an additional half of a per cent in the European Union and to increase employment by around an additional three quarters of a per cent. After the full package has been implemented on our baseline only a few countries would need to take further measures to meet the employment guideline of 70 per cent in the Lisbon Agenda. Overall the European Union would need to raise employment by 2.2 per cent to achieve the target in The largest shortfalls would be in Hungary, Italy and Poland, where employment would need to increase by 14 per cent, 15 ½ per cent and 19 per cent respectively. Belgium and France would still need to raise employment by 8 per cent and Greece by 5 per cent. The Czech Republic,

24 Slovenia and Slovakia would also need to make small increases in participation in order to achieve a 70 per cent employment rate. Table 8 The incremental impacts by 2025 of endogenising participation R&D policies All policies GDP Employment GDP Employment EU Austria Belgium Czech Republic Germany Denmark Spain Finland France UK Greece Hungary Ireland Italy Netherlands Poland Portugal Slovakia Slovenia Sweden Estonia Latvia Lithuania Notes: NiGEM simulations. Percentage points differences between the impact of polices with endogenous participation less the impact of policies with exogenous participation Increasing the Employment Rate In this section participation is raised in order to achieve the employment objective, although we do not specify the tools that would be used to increase participation. There are a number of policies that could be used to directly increase employment in the European Union, and they have different impacts on output and unemployment. The evidence in Barrell Kirby, Riley and van Welsum (2002) suggests that a reduction in unemployment benefits or an effective increase in the stringency of unemployment assistance regulations would reduce equilibrium unemployment and raise employment. Reductions in the level of the minimum wage would clearly have similar impacts. A reduction in the generosity of invalidity and single parent benefits would reduce inactivity and raise employment and to a lesser extent unemployment. All of them raise employment but have different impacts on unemployment and the real wage. These policies would also have significantly different impacts on the public finances and hence on tax rates.

25 The policies discussed in previous sections all use specific levers to raise output and employment, and it made sense to implement them both singly and together. As no specific policies are analysed in this section results are presented for an increase in participation that is driven exogenously as if it were a uniform change in preferences for work over leisure or inactivity 5. Of course the observed pattern of employment rates could reflect either preferences, or the differential working of legal and other constraints. Policies could be designed to remove these differentials, but none are envisaged within the set of policies analysed here. Table 9 reports on the results of the simulations where participation is raised exogenously by 2 ½ per cent everywhere in the European Union. This reflects the Commission goal of raising overall employment and also recognises that there may be differences in preferences between countries that would require positive action to change. The burden of adjustment is equally shared, whatever the baseline preferences and constraints people face. Output in general rises by around two and a half per cent, although there are differences between countries. These largely reflect the differential speed of adjustment of the capital stock, as this has not increased by 2 ½ per cent, which would be required for equilibrium, after just 18 years. The required rate of return on capital is determined in the world market, and an increase in the supply of labour would raise the marginal product of capital in Europe and induce a capital inflow. The public sector capital stock adjusts more slowly on NiGEM (and in the world) than does the business sector capital stock because it is less affected by differences from world rates of return, and its equilibrium would only be reached after another decade. The increase in the capital stock has to be largely financed from abroad as the investment has to come in advance of the increase in output. As a result the net asset position would deteriorate marginally, and national income would rise by a quarter of a percentage point less than national output on average across the European Union. As a result consumption would not rise as much as output, as we can see from table 9. 5 One obvious cause of such a change in preferences might be a significant increase in the influence of the Augsburg Confession. Although possibly desirable, its advocates have had difficulty seeing how to implement this change in Europe in the past.

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