Linking maternity benefits to social security contributions: Lessons on tax evasion from Hungary

The views expressed in the Let’s Talk Development blog are solely those of the author(s).
 

In most countries, social security benefits depend on an individual's earnings history. This contribution-benefit link creates a trade-off between the incentive to report higher earnings to increase the amount of future benefits and the incentive to report lower earnings to decrease the amount of taxes owed. This trade-off is important for both the design of social security systems and approaches to combating tax evasion and encouraging formalization. In this blog, based on our recent working paper we highlight that the design of maternity benefits in Hungary creates incentives for women to report higher earnings and formalize their employment during pregnancy.

Prior to pregnancy, many women in Hungary—especially those working in small, domestic, and less-productive firms—underreport earnings. However, during pregnancy, reported earnings increase, particularly in response to a policy change that incentivized reporting higher earnings during pregnancy by moving the earnings reference period to coincide with pregnancy and shortening it.
 

Reported earnings respond to incentives embedded in the design of maternity benefits

In Hungary, maternity benefits received for two years after giving birth depends on earnings over a narrow time window before childbirth. Benefits are 70% of average earnings calculated over a reference period and are uncapped for six months and capped at 140% of the monthly minimum wage thereafter. In 2015, the incentive to report higher earnings became much stronger as the contribution period used to determine benefits changed from 12 months in the most recent calendar year to the first six months of pregnancy.
 

Figure 1: Reported earnings appear to increase during pregnancy in smaller but not larger firms, particularly when reporting incentives become stronger

We find that before 2015, the earnings of expectant mothers working in firms with fewer than 50 employees increased by 1.8% between the second and sixth months of pregnancy. This increase was much larger, 5.3%, after reporting incentives became stronger in 2015. In firms with fewer than 10 employees, the increase was even more pronounced, 3.0% before and 7.6% after 2015, while pre-birth earnings declined during pregnancy both before and after 2015 in firms with over 50 employees. Decreasing earnings in larger firms suggest that pregnancy negatively affects earnings, possibly due to health concerns, discrimination, or other factors. At the same time, increasing earnings in smaller firms suggest that another mechanism dominates in those firms: formalization of some previously informal earnings to obtain higher maternity benefits.

That we detect this in smaller firms is in line with tax evasion being more likely and employer-employee coordination easier than in larger firms. Big increases in reported earnings are also more common in less-productive and domestic firms, also known to be more prone to tax evasion than more productive and foreign-owned firms. Before large pre-birth earnings increases, earnings are concentrated at the monthly minimum wage. After large increases, they are concentrated at the benefit-maximizing threshold given the benefit cap, consistent with pre-pregnancy under-reporting and an adjustment just large enough to qualify for higher maternity benefits.
 

Informal jobs also become formalized in response to the benefit incentives

We also document an “extensive-margin” formalization response to maternity benefit incentives. While, consistent with discrimination, health concerns, or decreased labor supply, the probability of transitioning into formal employment in a firm with over 50 employees decreases by 1.7 percentage points during pregnancy, women are about 0.2 percentage points more likely to appear to join small firms during the first trimester than before pregnancy. In the second and third trimesters, the decline in the probability of transitioning into formal employment in smaller firms is much slower than in larger firms. Conditional on transitioning into formal employment, the share of transitions into smaller, domestic, and less-productive firms increases relative to larger, foreign, and more-productive firms. For example, conditional on a formal employment transition, the probability of finding a new job in a smaller firm is up to 41% higher during pregnancy, with an analogous decrease for larger firms. This suggests that smaller, domestic, and less-productive firms formalize some of their informal employees during pregnancy to give them access to maternity benefits.

Figure 2: Formal employment in smaller firms increases at the beginning of pregnancies and then declines much more slowly than in larger firms

Examining post-birth earnings, we find that large pre-birth increases are associated with higher reported earnings in the longer term. Women who receive large, reported wage increases during pregnancy also continue to report higher wages when returning from maternity leave. Higher post-birth wages result from “sticky”' wages: nominal (reported) wage decreases are rare, and about half of women who reported a wage increase to the benefit-maximizing threshold before birth have the same wage after returning from maternity leave even as the benefit-maximizing threshold itself adjusts with increases in the minimum wage.

Our results highlight that tax evasion is responsive to the incentives created by the contribution-benefit link: individuals report higher earnings to receive higher benefits. Thus, governments could use the social security benefit system to lower tax evasion. However, if benefits were more responsive to contributions to encourage tax compliance, they would redistribute less from high- to low-earners, an important objective of most social security systems.