I INTRODUCTION The relationship between an income tax and labour supply is described in most economics textbooks. A rise in the rate of proportional income tax is said to reduce labour supply due to a substitution effect, and to raise it due to a wealth effect. In an attempt to resolve this ambiguity, Tibor Scitovsky wrote in 1951 that: the imposition or raising of an income tax, accompanied by free public services, always tends to diminish people’s willingness to work. 1 He predicted that the expansion of the public sector would unambiguously reduce the labour supply because the wealth effect of public spending would offset the wealth effect of wage taxation leaving the substitution effect of taxes to reduce the number of hours spent working. 2 A development not anticipated at the time is the recent persistent increase in involuntary leisure, unemployment, in most OECD countries. An often mentioned explanation of the European unemployment problem is again the © Scottish Economic Society 1997 269 *Birkbeck College, London Scottish Journal of Political Economy, Vol. 44, No. 3, August 1997 © Scottish Economic Society 1997. Published by Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA PUBLIC CONSUMPTION AND UNEMPLOYMENT Gylfi Zoega ABSTRACT This paper introduces public consumption — hence the size of the public sector—into an efficiency wage model of the labour market. The effect of a simultaneous rise in taxes and public consumption on unemployment is derived. There arises an unambiguous positive relationship between the size of the public sector and equilibrium unemployment if public and private consumption are substitutes and wages are taxed. The impact of taxes on consumption on unemployment, although in general not equal to zero, is ambiguous. 1 Scitovsky (1951), pp. 90–2. 2 Gordon Winston (1965) pointed out that the argument depended crucially on the assumption that public consumption and private income were substitutes.