Labor tax reform, unemployment, and search

Ben J. Heijdra 0 1 2 Jenny E. Ligthart 0 1 2 JEL Classification J 0 1 2 J 0 1 2 0 B.J. Heijdra Netspar, Tilburg, The Netherlands 1 J.E. Ligthart CentER and Department of Economics, Tilburg University , P.O. Box 90153, 5000 LE Tilburg, The Netherlands 2 B.J. Heijdra Institute for Advanced Studies (IHS) , Vienna, Austria A key obstacle to reducing payroll taxes in many industrialized and transition countries is the direct revenue loss to the government that it implies. This paper studies a simple and practical labor tax reform of reducing a payroll tax and increasing a progressive wage tax that keeps the marginal tax wedge unchanged. Such a strategy increases employment, reduces the equilibrium unemployment rate, and increases public revenue as long as workers do not have all the bargaining power in wage negotiations. Moreover, welfare rises if workers' bargaining power is sufficiently large to exceed a critical value determined by the second-best Hosios condition. 1 Introduction Labor tax reform continues to be a key item on the policy agenda of many European countries. High labor tax wedgesgenerally defined as the difference between the gross wage firms are paying and the after-tax wage income of workersare often seen as one of the culprits of the high equilibrium unemployment rates of these countries. A piecemeal reduction in the marginal tax wedge is, therefore, a common measure found in European tax reform programs aimed at stimulating employment. In particular, policy makers have recommended cuts in payroll taxes to reduce unemployment (e.g., OECD 1994).1 Some observers (e.g., Symons and Robertson 1990) argue that the composition of the tax wedge matters for employment and real wages. They argue that shifting the composition of the tax wedge from payroll taxes (i.e., the employers part of labor taxes) to wage taxes (i.e., the employees part of labor taxes) could increase employment.2 Indeed, in view of governments revenue needs, several OECD countries have taken this approach in reforming their direct tax system. For example, Hungary cut its employers social insurance contribution rates by 11 percentage points during 19941999, while increasing its effective labor income tax rates from 24% to 28%. Several other central and eastern European countriesfeaturing high rates of unemployment and overstretched public financesstill have to decide on their structural reform strategies. A pivotal policy question is whether a shift in the composition of the tax wedge would be of help in alleviating the unemployment and budgetary problems of these countries. As a matter of general principle, it is well known that in perfectly competitive labor markets the invariance of tax incidence proposition holds.3 This proposition says that it does not matter to gross wages, net wages, and employment whether (statutory) labor taxes are levied on workers or firms.4 It is not immediately evident, however, whether wage taxes and payroll taxes are equivalent in an imperfectly competitive labor market. For example, unions are unlikely to accept a wage reduction to offset an increase in payroll taxes, but may agree to refrain from wage increases if wage taxes are increased. Empirical evidence is mixed and sensitive to the time dimension. Studies employing wage-bargaining models (e.g., Lockwood and Manning 1993; Holm et al. 1994) suggest that payroll and wage taxes have quite differing effects 1Empirical studies on the employment effects of payroll taxes generally find small negative effects (see Hamermesh 1993). Summers (1989) argues that the effect may even be negligible if workers value the associated benefits (i.e., health care services, unemployment protection, and pension allowances) enough so that they are willing to accept a lower wage in combination with these benefits. In the present paper, payroll taxes are considered to be akin to a tax. 2Throughout the paper, we define wage taxes to include all labor taxes levied on employees wages (including employees social security contributions), whereas payroll taxes are defined to refer to social security contributions levied on employers. 3The invariance of tax incidence proposition is also sometimes called Daltons law (Dalton 1954) or tax liability side equivalence. See Riedl and Tyran (2005). 4This raises the question why, in practice, social security contributions are divided between employers and employees. Musgrave and Musgrave (1987) argue that the legislative intent may have been to share the tax burden equally, although this does not say anything about the economic incidence. Other factors may play a role as well such as liability to tax evasion and tax administration concerns. on wage formation. Some studies find that a shift from payroll taxes to wage taxes decreases firms wage costs, but others cannot find a significant effect (see Symons and Robertson 1990). The composition of the tax wedge seems to play more of a role in the short run than in the long run (cf. Leibfritz et al. 1997), reflecting the greater flexibility of production factors in the long run. The analytical literature offers surprisingly little guidance on what kind of labor tax reform policy makers should employ to reduce equilibrium unemployment without putting the governments revenue position at risk. Only a few formal studies have studied the invariance of tax incidence proposition in a setting of imperfectly competitive labor markets (cf. Koskela and Schb 1999; Picard and Toulemonde, 2001, 2003). In such a framework, households and firms may have different degrees of bargaining power over wages, and, therefore, differ in their ability to shift labor taxes. Koskela and Schb (1999) and Picard and Toulemonde (2001) employ right-tomanage trade union models5 and find that a revenue-neutral substitution of proportional wage taxes for payroll taxes has no effect on employment. However, Koskela and Schb (1999)building on the partial equilibrium frameworks of Koskela and Vilmunen (1996) and Pissarides (1998)show that positive employment effects are obtained if wage taxes are progressive. So far, little attention has been paid to labor tax reform in search-theoretic models of the labor market.6 A notable exception is Picard and Toulemonde (2003), who analyze the employment effects of a revenue-neutral labor tax reform when labor taxes are nonlinear. These authors, however, neither focus on the welfare effects of labor tax reform (reflecting the partial equilibrium nature of their analysis) nor endogenize the labor force participation decision. The aim of the paper is to analyze the allocation and welfare effects of a coordinated reform that reduces payroll taxes and increases progressive wage taxes. Rather than focusing on revenue-neutral tax reforms, as is common in the public economics literature, we consider a strategy of keeping the marginal tax wedge constant. Our approach allows us to focus on the composition of the tax wedge, and thus abstracts from the ef (...truncated)