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Macroeconomic shocks such as the recent global economic crisis can have far-reaching effects on the levels and the distribution of resources at the individual and the household levels. A recession associated with a labor market downturn and turbulent property and financial markets gives rise to significant and widespread losses for workers and households. Identifying the likely pattern of losses is, however, not straightforward. This is especially the case at the outset of a severe recession, when up-to-date information about current household circumstances is patchy, and economic conditions are subject to rapid change.

By reducing the real value of nominally fixed tax band limits, deductions and tax credits, inflation can lead to higher real tax burdens (“fiscal drag”). The traditional view is that this reduces aggregate demand and thus acts as an automatic stabiliser. Yet, this familiar reasoning ignores the supply side and, in particular, possible effects of higher tax burdens on labour costs. Recent work on imperfect labour markets has shown that such effects can indeed arise as employees are able to bargain for higher wages that partly compensate for tax increases. In this case, the resulting upwards pressure on real labour costs can be inflationary. To illustrate this mechanism, this article analyses labour tax burdens in four European countries and how they are altered if tax systems are not adjusted for inflation. This is then combined with available results on the effects of tax changes on wages in imperfect labour markets. The results suggest that, in an unadjusted tax system, inflation can produce a moderate upward pressure on wages. It is argued, however, that more detailed empirical work on the role of taxes in the wage-setting process is needed as existing work ignores the substantial heterogeneity of workers and the tax rates they face.

As unemployment rises across the European Union (EU), it is important to understand the extent to which the incomes of the new unemployed are protected by tax–benefit systems and to assess the cost pressures on the social protection systems of this increase in unemployment. This chapter uses the EU tax–benefit model EUROMOD to explore these issues, comparing effects in five EU countries. It provides evidence on the differing degrees of resilience of the household incomes of the newly unemployed due to the variations in the protection offered by the tax–benefit systems, according to whether unemployment benefit is payable, the household situation of the unemployed person and across countries.