1 The Impact of Tax and Market Distortions on the Phillips Curve and the Natural Rate of Unemployment*

Most people accept that structural and labour market reforms are needed in Europe. However few have been undertaken. The usual conjecture is that reforms are costly in economic performance and costly to finance. Blanchard and Giavazzi (2003) and Spector (2004) develop a general equilibrium model with imperfect competition to show the impact of labour or product market deregulation. We extend that model to combine these two types of reform, and then to include the effects of lowering tax distortions, the costs of financing these reforms and the conflict between long run gains and short run costs. Specifically, we use the model to explain the natural rate of unemployment and non-wage employment costs in order to show the impact of these reforms on the short and long run Phillips curve parameters. We find that structural reforms imply short run costs but long run gains; that the long run gains outweigh the short run costs; and that the financing of such reforms will be the main stumbling block. Likewise, we find an ambiguous effect on flattening the Phillips curve in the short run, but favourable effects on the natural rate in the long run. However the implications for welfare improvements and employment generation are quite distinct. Tax reforms are more effective for welfare gains, but market liberalisation is more valuable for generating employment