In this paper the method of laboratory experiments is used to investigate the economic effects of financing social insurance via a wage tax. This is done for a closed economy and an open economy with a small `home' country and large `foreign' country. The main findings are the following. First, there is clear evidence for a vicious circle in the dynamic interaction between the wage tax and unemployment. Second, in the short run employment is boosted by budget deficits - in line with Keynesian thinking. However, subsequent tax rate adjustments lead to employment levels that substantially fall short of the predictions of general equilibrium theory. Third, and related to the previous point, there appears to be a downward pressure on the employment of production factors caused by an (out of equilibrium) sales risk for producers, which is not accounted for in existing general equilibrium models. For labor this downward pressure is exacerbated by the wage tax. In view of these findings, the study suggests that shifting taxation from inputs (labor) to outputs might be worthwhile investigating.

Co-author Arno Riedl