The Economics of Imperfect Labor Markets. Chapter 4. Payroll taxes
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1 1 / 36 The Economics of Imperfect Labor Markets Tito Boeri October 2010 Tito Boeri and Jan van Ours (2008) The Economics of Imperfect Labor Markets Princeton University Press Chapter 4. Payroll taxes
2 Payroll Taxes What Are We Talking About? 2 / 36 Payroll taxes: What are we talking about? Payroll taxes = income taxes & social security contributions Payroll taxes drive a wedge between labor costs and net wage Social security deferred consumption (public pensions) Incidence of taxation who pays? Employers workers Balance of powers: slopes of supply and demand curves
3 Payroll Taxes What Are We Talking About? 3 / 36 Overlaps with other institutions Family policies: individual family Unemployment benefits: incentives Unions: bargaining power Active labor market policies: incentives
4 Payroll Taxes Measures and Cross-Country Comparisons 4 / 36 Measures Average tax rate Marginal tax rate Marginal effective tax rate Progressive tax system Social security: employer - employees Tax systems are complex, impossible to summarize by one particular number Include VAT?
5 5 / 36 Payroll Taxes Measures and Cross-Country Comparisons Payroll taxes and VAT rates, 2005 (% ) Single persons without dependents who earn 100% of the APW wage Average tax wedge Marginal Income SSC Total Tax wedge VAT Denmark France Germany Italy Netherlands Spain UK US APW = Average production worker APW wage= annual gross wage earnings of adult, full-time manual workers in manufacturing sector
6 Payroll Taxes Measures and Cross-Country Comparisons 6 / 36 Cross-country comparison Average payroll tax rate: 29.0 (US), 51.9 (Germany) Marginal tax rate: 34.0 (US), 65.1 (Germany) All countries: marginal tax rates substantially higher than average tax rates progressive tax systems
7 7 / 36 Payroll Taxes Measures and Cross-Country Comparisons Total net income and marginal effective tax rates of first and second earners (% ) Total net income (100% APW) Marginal effective Employees Unemployed tax rates T1 T2 T3 T1 T2 T3 H1 H2 H3 Denmark France Germany Italy Netherlands Spain UK US T1 = single person T2 = lone parent with two children T3 = one-earner couple with two children Included in income are earnings, social assistance, family benefits et cetera
8 Payroll Taxes Measures and Cross-Country Comparisons 8 / 36 Cross-country comparison family situation Effects of tax-benefit system on net income of various types of workers: Household net incomes of working lone parents higher than net incomes of working singles Sometimes for one-earner couple with two children net income higher than gross income Single worker net income during initial phase of unemployment: 33% (Denmark), 57% (Spain)
9 Payroll Taxes Measures and Cross-Country Comparisons 9 / 36 Cross-country comparison changes in labor market position H1 = Single earner from inactivity to 67% of APW: Italy -8%, Denmark 94% H2 = One spouse 67% APW other moves from inactivity to 33% APW; marginal effective tax rate: 16% (Spain) to 89% (Denmark) H3 = One earner moving from 67% to 100% of APW: Spain 19%, UK 77% Polarization work-rich and work-poor families (H2 < H1): Neither is working - big disincentives One is working - substantially smaller incentives
10 Payroll Taxes Theory 10 / 36 Theory effect on functioning labor market 1 Presence of taxes - not necessarily 2 Structure of taxes - yes Labor supply - extensive & intensive margin Labor demand - increase in costs Wedge Competitive markets: tax paid by worker/employer slopes demand and supply curves Non-competitive markets: Bargaining: labor supply curve wage-setting equation: slope increases Workers use their market power to take most of a decrease in taxes
11 11 / 36 Payroll Taxes Theory Competitive market who pays? w Ls wd w0 Tax B A ws C Ld L0 L1 Ld
12 12 / 36 Payroll Taxes Theory Effects tax reduction competitive market w w1 Tax Reduction B Ls w0 A L2 L1 L0 L1
13 Payroll Taxes Theory 13 / 36 Effects tax reduction competitive market Response depends on elasticity of demand and supply The elasticity of supply is affected by the composition of taxation (labor vs non-labor income) In particular: If non-labour income is not taxed, then more effect on employment, less on wages If non-labour income is taxed just like labour, more effect on wages, less on employment Structure of taxation (progressive vs. regressive) does not matter
14 Payroll Taxes Theory Why is indexation of non-labour income important? (I) Case 1: m constant Consumption w m w(1-τ) wr Hours of leisure l0 14 / 36
15 Payroll Taxes Theory Why is indexation of non-labour income important? (II) Case 2: m taxed like w Consumption w m w(1-τ) m(1-τ) wr l0 Hours of leisure 15 / 36
16 16 / 36 Payroll Taxes Theory Effects tax reduction non-competitive market w Ls w1 Tax Reduction B w0 A L2 L1 L0 L1
17 Payroll Taxes Theory 17 / 36 Effects tax reduction non-competitive market Effects depends on imperfections If unions, then effects depend on indexation of non-labour income and structure of taxation (if more progressive, less unemployment). Important also the level of bargaining (do they internalize macro consequences of their actions?) If search frictions again indexation of non-labour income and structure of taxation important if efficiency wages, indexation of non-labour income relevant, but structure of taxation is not, just like in the competitive model. Intuition: action is on labour demand
18 Payroll Taxes Empirical evidence 18 / 36 Empirical evidence Labor supply of men not much affected by changes in tax rates Labor supply of women increases if net wage increases 4 groups of workers where high taxes may affect behavior: 1 In work with high incomes 2 In work with low incomes & eligible for benefits 3 Nearing retirement 4 Considering entrance into the labor force
19 Payroll Taxes Empirical evidence 19 / 36 Box 4.1 The incidence of payroll taxation Gruber (1997) Change of financing social insurance in Chile in 1981: manufacturing firms: reduced employer contributions, increased employee contributions. More financing of taxes from general revenues Analysis using plant level information, available for two groups of workers over several years: Effects of a 1% decrease in wage costs: % Effect Wages Employment Blue collar White collar Wage effect close to -1, employment effect close to 0 Reduced payroll taxes fully passed on to wages
20 Payroll Taxes Policy issues 20 / 36 Policy issue 1: Negative income taxes or in-work benefits? Means-tested welfare system: welfare is reduced one for one when individual starts making money; alternatives 1 NIT: initial level benefits lower, withdrawn with a percentage 2 IWB: individuals only receive benefits if they work - phase-in & phase-out range
21 Payroll Taxes Policy issues 21 / 36 Welfare programs and work incentives Cash grants reduce wage incentives Welfare programs create work disincentives Welfare benefits reduces supply of labor by granting nonlabor income, which raises reservation wage
22 22 / 36 Payroll Taxes Policy issues Welfare benefit example A take-it-or-leave-it cash grant of $ 500 per week to non-working individuals: encourages the worker to leave the labor force.
23 Payroll Taxes Policy issues 23 / 36 Policy application: NIT Negative income tax: workfare program Cash grant of $ 250 per week + 50% marginal tax rate on earnings Mainly affects intensive margin of labor supply
24 Payroll Taxes Policy issues 24 / 36
25 Payroll Taxes Policy issues 25 / 36 Negative Income Tax A C B Gross Income
26 Payroll Taxes Policy issues 26 / 36 The Earned-Income Tax Credit EITC should increase labor force participation of nonworkers of targeted groups EITC produces an income effect Hours worked should change Mainly affects extensive margin of labor supply
27 27 / 36 Payroll Taxes Policy issues The EITC and the Budget Line Consumption ($) F 33,178 G Net wage is 21.06% below the actual wage 17,660 H Net wage equals the actual wage 14,490 13,520 J Net wage is 40% above the actual wage 10,350 E 110 Hours of Leisure
28 Payroll Taxes Policy issues 28 / 36 In-work benefit D E F O A B C Phase-in Flat Phase-out Gross Income
29 Payroll Taxes Policy issues 29 / 36 Policy issue 1: NIT or IWB? Optimal system depends on the behavioral response of individuals: NIT: Mostly along intensive margin: hours of work IWB: Mostly along extensive margin: participation Reduced incentives to work longer hours or earn higher wages Trade-off: NIT provides largest transfers to low-income earners: most in need of support NIT has adverse effects on labor supply along the extensive margin
30 30 / 36 Payroll Taxes Policy issues Example of EITC research: Eissa and Liebman (QJE 1996) EITC introduced 1986 Single mothers were eligible Participation rates of unmarried women: Before With EITC EITC Difference Dif-in-dif Children No Children
31 Payroll Taxes Policy issues 31 / 36 Box 4.2 In-work benefits in action Card and Hyslop (2005) Canadian Self Sufficiency Project New system of time-limited earnings subsidies for long-term welfare recipients Applied to individuals who accepted full-time jobs (more than 30 hours per week), could last up to 3 years Once workers were offered the scheme they had to begin to work within a year Random assignment: 50% offered the SSP benefits, 50% got regular benefits
32 Payroll Taxes Policy issues 32 / 36 SSP in action paid half of difference between actual earnings and target amount Example 1992: 35 hours/week - $ 7/hour: $ 12,730 per year (earnings) Target amount: $ 37,000 Subsidy = (37,000-12,740)*0.5 = $ 12,130 Total income: $ 24,860 Non SSP recipient totally on welfare: $ 17,111 Non SSP recipient 35 hours/week - $ 7/hour + traditional benefit: $ 19,511 Most participants: $ more per year with SSP
33 33 / 36 Payroll Taxes Policy issues Long run effects welfare dependence Years Control Program Effect Program ended after 69 months = 5.75 years So: no long-run effects
34 Payroll Taxes Policy issues 34 / 36 Policy issue 2: Tax credits or wage subsidies? Influence hiring decisions of firms Wage subsidy = direct transfer Both: hire specific categories of workers Tax credits need no separate administration Dead-weight losses Subsidizing marginal employment = difficult to use in practice
35 Payroll Taxes Why Do Payroll Taxes Exist? 35 / 36 Why do payroll taxes exist? Funding government expenditures Social security contribution parts directly related to the functioning of labor markets Contribution to public pension programs: tax or savings?
36 36 / 36 Review questions Payroll Taxes Review questions 1 How do in-work benefits affect incentives of unemployed workers? 2 What happens during the phase-in and phase-out regions of in-work benefits? 3 Why does the impact of taxes depend on the nature of the labor market? 4 What are the main purposes of negative income taxes and in-work benefits, and what are the essential differences between the two systems? 5 What is the trade-off between wage subsidies and tax credits?
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