Firms play an important role in the impact of payroll taxes: Insights from Hungary

Payroll taxes and employer social security contributions account for just under 40 percent of the tax wedge—the difference between before-tax and after-tax wages—in developed countries. Their importance is also increasing in developing countries but there is still untapped potential for revenue-raising efforts. There is a longstanding interest in understanding the impact of payroll tax policies on employment and wages. The standard approach in public finance suggests that the market-level responsiveness of labor supply and demand determine the employment and wage impacts and the incidence of payroll taxes. This approach typically assumes that firms passively accept market-level wages and so the incidence of the payroll tax will be homogeneous across firms and workers. Nevertheless, a growing number of studies highlight the role of firms in wage determination. This suggests that the incidence of tax policies can also vary between different firm types, which influences their welfare implications. 

Age-specific payroll tax cut in Hungary increased employment at low-productivity firms

Our recent study provides evidence that firms play an important role in the impact of payroll taxes on their workers and that different firms respond differently to payroll tax cuts. In 2013, the Hungarian government significantly decreased social security contributions for over-55 employees to improve the employment prospects of older workers. On average, labor costs decreased by 5.3 percent for workers over the age of 55 relative to their younger peers (figure 1).

Figure 1: Employer’s Social Security Contribution Rate by Workers’ Age

Comparing affected and unaffected workers, we find a large increase in employment in response to the policy. Employment of the affected workers increased by 1.6 percent. This increase in employment mainly came from nonemployment and inactivity, while the change in self-employment and public sector employment was limited, reflecting that these workers were ineligible for the payroll tax cut. We also find substantial heterogeneity across firm types. The employment-increasing effects of the policy come from less-productive firms, while more-productive firms did not increase employment (figure 2).

Figure 2: Evolution of Employment at Low- and High-Productivity Firms

We also find that employment increased mainly at the bottom of the wage distribution at low-productivity firms, while we find no indication for substantial change in employment in the upper part of the wage distribution, where the relative change in labor cost was limited. The results are driven by firm heterogeneity, rather than worker heterogeneity: even among low-paid workers in low-paying occupations and among less-educated workers, we find different responses to the policy by firm type. We also highlight that firms that hired more affected workers after the introduction of the payroll tax cut did not cut their hiring of unaffected workers. Accordingly, the policy is likely to have improved overall employment and not just led to substitution of affected workers for unaffected ones.

Payroll tax cut increased wages at high-productivity firms

We also study the impact of the policy on wages. We estimate that the overall passthrough of the policy is small: out of $1 only 22 cents benefit workers, while 78 cents go to firms. The impact of the policy on wages is also heterogeneous: we find that there is a significant increase in wages at high-productivity firms, but we find no change in wages at low-productivity firms (figure 3). At high-productivity firms the pass-through rate is 60 cents on the dollar, while at low-productivity firms the pass-through rate is close to zero. We also show that the pass-through rate difference is present for workers with low and high levels of education, though it is more prominent for the latter group.

Figure 3: Evolution of Wage Changes in Private Sector Companies

Among younger workers, tax cuts increased employment but not wages

Because a tax cut for older workers was introduced at the same time that a tax cut for workers under 25 was introduced, we can compare our estimated responses for older workers to impacts among younger workers. We find that the payroll tax cut increased employment of younger workers with little impact on wages. We also find heterogeneity patterns like those documented for older workers though the differences between high- and low-productivity firms are smaller.

Governments may need to take heterogeneous impacts into account when designing policy

The result that more-productive firms increase wages but don’t increase employment, while less-productive firms increase employment but don’t increase wages, suggests that firms play an important role  in determining the incidence of payroll taxes. It appears that workers employed by more-productive firms can extract more of the surplus from the tax cut and so the incidence of the tax cut (partly) falls on them. At the same time, older workers who are employed by less productive firms are benefiting from the tax cut through increased hiring, while firms capture a larger share of the surplus for these workers. This is consistent with a model of the labor market where less-productive firms often hire unemployed workers, while more-productive firms move workers over from other firms by offering them higher wages and sharing the benefits of the payroll tax cut with them.

Our findings suggests that governments need to consider the differential impact of payroll tax policies on different firms and workers, as well as on the composition of jobs in the labor market.  Depending on their policy priorities, governments may want to target different types of firms and workers when implementing payroll tax cuts aimed at improving the labor market outcomes of vulnerable groups.