Analysing Structural Reforms in the EU using QUEST III Model

1. Comments on:“Modelling the Lisbon Strategy: Analysing Structural Reforms in the EU using the QUEST III model”byRoeger, Varga and Veld Vedran Šošić, CNB

2. Motivation • Estimate the possible impact of policies that have the potential of closing the productivity gap with respect to the US (via knowledge generation and innovation) • Testing the impact of policy proposals framed at EU level • No “deep” insight into the causes of the productivity gap • Using simple “benchmarking” exercise to identify differences between the US and EU in the R&D sector

3. Estimates Rely on the QUEST III Model • Heavily used in different incarnations over the previous decade for simulations of different shocks/policy options: • Macroeconomic shocks (monetary and fiscal policy shocks, permanent supply shocks, productivity shock, shock to the reservation wage) • Income tax reforms in member states • EU structural policy • Other (avian flu) • Strain of “general practice models” – able to address a broad range of policy issues, but not specifically designed to deal with all of them – therefore not so easy to introduce each specific policy • The model should come with a user’s manual!

4. Discussed Policy Options • One set of policies mentioned in the introduction, another actually discussed?! (Maybe due to missing chapter 4.3?) • Actually discussed policies: • Subsidizing R&D investments (via tax credit) • Increasing competition in services (reduction of mark-ups) • Reducing entry barriers for new firms • Reducing high financing costs for start ups • Reducing administrative entry barriers • Increasing the share of highly skilled workers (by boosting immigration of the highly skilled)

5. Implementation of the Policies Into the Model • Mapping of the policies to specific variables into the model is not unique • The way variables are modified to aacount for policies allow for a wide range of possible alternatives • The model does not show any preference between specific measures (e.g. How to reduce mark-up in services) • The criterion for selection of policy options not entirely clear • Testing a battery of different policy options would probably give a better idea of the optimal policies, some policies could be superior to others • e.g. What is the optimal ratio of research to production employment and what are the best policy options to get there

6. Tax Credits • R&D subsidies increase GDP but • Differences in R&D subsidies do not explain much of the gap • Model well placed for such simulation because of great detail in modelling the R&D sector

7. Reducing Mark-ups in the Services Sector • Reduction of mark-ups in the services (final goods) sector by 1 pp increases GDP by about 1% • Identified with the completion of the internal market in services • Possible effects of completing the internal market in services probably still open to debate – what about other policy options (e.g. reform of the product market regulation, zoning regulations, etc.)?

8. Entry Barriers for New Firms • High financing costs for start ups • Authors admit having the most problems with fitting financing constraint into the model (policy equivalent of supporting venture capital) • Performed through reduction of risk premium • This reduces financing costs, but whether it simulates more developed financial system? • EU financial system highly developed • Venture capital surely important, but it is not clear why such a large reduction of risk premium can be expected from a fairly small increase in the size of the venture capital

9. Entry Barriers II • Administrative barriers - modelled as “fixed entry costs” (or sunk costs) • Fairly stragihforward and common way • Fixed entry costs are not real entry barriers in the sense of Stigler (1968) if newcomers bear the same costs as the incumbents

10. Skills and Immigration • Impact of more generous (but selective) immigration policy found to be positive • Process of human capital formation could potentially be important for explaining the dynamics of the productivity gap vs. the US, but skill composition of the workforce is exogenously fixed • With 100 years forecasting horizon, human capital formation will probably depend on some of the endogenous variables, such as wage skill premium or skill specific unemployment rates, which also change (migrations probably also affected by similar variables) • Also, Europe does not perform badly in education - what is behind the skill gap?

11. Ratio of Science and Engineering PhDs From Non-us Universities to Those From US Universities Source: Freeman (2005)

12. Source: ECFIN/EPC (2006)

13. What Else? • Some discussion on sensitivity analysis would be useful • E.g. What would happen to the results if the proportion of financially constrained households is modified? • What are the implications of more radical change in assumptions - it would be useful to compare the results with alternative models • Bradley and Untiedt (2007) perform such an exercise for the analysis of the impacts of cohesion policy and find dramatic differences in implications of different models

14. To Conclude • Policy areas found to be most promising also have most problems with implementation into the model (mark-ups and barriers) • “Build a basement before you build an attic” ...or “think before you jump” • For the future QUEST version 4, it could be useful to compile a list of important policy issues before building a model