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Can Tax Reforms Help Create Jobs?

Sebastian Eckardt's picture

Europe faces a significant job challenge. At an average of 11 percent, unemployment remains stubbornly high while labor force participation, at 58 percent of the working age population, lags behind most other regions of the world. This means, that only every second person in working age currently has a paying job across the region. Addressing the job challenge requires multifaceted labor market policies. We argue however that reducing the tax burden on labor, which remains high across the region, holds the promise of improving labor market outcomes. Such tax cuts could especially target low-wage workers, which often face the highest marginal tax rates and very elastic labor demand and are therefore most likely to be priced out of the formal labor market.

Labor taxes in the EU (including new EU member states) absorb on average about 40 percent of total gross labor costs, surpassing the already high 34 percent average in the OECD zone. Labor taxes drive a wedge between the wages a firm pays and the wages that workers receive. High labor taxes discourage employers from creating formal jobs while workers face weak incentives to increase labor supply. To gain a better understanding of how labor taxes affect employment we looked at evidence from a panel of 40 OECD and EU countries, including new EU member states, over the period 1995-2012. Specifically, we tried to find out how differences in total labor taxes affect employment in proportion to working-age population. We controlled for other factors that may affect employment, such as economic growth, but also differences in economic structure and the quality of labor market policies and institutions through “fixed country effects”. The empirical results are highly significant and clearly show two points (Table): First, economic growth very strongly and positively affects employment. Second, higher labor taxes (understood as the difference between the total labor cost to the employer and the worker’s net take-home pay) are associated with lower employment. This effect is particularly strong in new EU member states - more than three times higher than for the rest of the sample. For these countries we found that, on average, a 1 percent reduction in labor taxes in proportion to total labor cost is associated with a 0.23 percent increase in the employment rate.

But this does not mean that taxes should necessarily be cut across the board. A closer look at labor tax structures shows that, within countries, the tax burden on labor (the so-called “tax wedge”) varies with taxpayers’ income (Figure). This is because the base for social security contributions is subject to minimum and maximum income thresholds while taxable personal income is often subject to deductions and progressive taxation. The figure also takes into account income from social assistance cash transfers that may be received based on income level and withdrawn if wage income surpasses a certain threshold. As a result low wage tax payers, face steeply increasing marginal tax rates when they participate in the formal labor market. For example, in Romania, the marginal “tax wedge” at very low income levels (below 10 percent of the average wage) can be as high as 100 percent, which means any additional wage income earned is taxed away in the form taxes or withdrawal of social assistance benefits. Under these circumstances workers face weak financial incentives to enter employment.

Perhaps not surprisingly, Ireland which has a lower overall tax wedge with a particularly low burden for low income workers, experienced stronger labor market outcomes-at least prior to the global economic crisis with higher employment growth (1.1% compared to 0.7% EU average, 2000-2007) and lower unemployment (4.3% compared to 9% EU Average, 2000-2007).

The tax wedge increases sharply for low-wage workers1
Labor tax Wedge in % of total labor cost by income level (average gross wage = 100)2

So what can be done? Many countries are considering or implementing reforms to strengthen the work incentives associated with their labor tax and social benefit systems, especially for low wage earners. Different policy options are available. The average PIT and social security contribution rate for low-income taxpayers could be lowered by setting the basic tax allowance at a higher gross income level.  To achieve a larger reduction in the tax burden on labor cost, reduced employer social security contribution rates for low-income workers, below a certain threshold could be considered.  Alternatively, a temporary reduction in the rate of the employer social security contribution could be targeted to particular groups of workers (young workers and unemployed) to incentivize employers to hire from these groups. To minimize the risk that reduced employer social security contributions for specific worker groups could displace existing workers, such tax cuts should be granted on condition of increasing total hiring of the firm for the duration of the tax concession. One of the policy innovations among OECD countries are so called in-work benefits extended as income tax credits for low income workers and families. Since the benefit level under these programs increase with the income earned they provide income support while offering financial incentives to work. Such tax reforms could be, to some extent, self-financed through their positive impact on employment, income, and tax revenue. But these benefits could materialize only over the medium term, while the short-term cost of tax cuts can be high. Thus, any tax reform, including those options proposed here, will have to be assessed carefully in terms of the likely fiscal impact, and –depending on the particular fiscal environment in each country- be accompanied by increases of other taxes (VAT, property, capital taxes) or expenditure cuts.

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