Taxes affect incentives on both sides of the labour market. They can discourage employers from hiring, would-be employees from taking up work, and current employees from working longer and harder. Unsurprisingly then, cutting taxes can increase employment, but how can this be afforded? And if other taxes have to be increased to finance these tax cuts, won’t this reduce employment?
Not necessarily; for as experience shows, different tax reforms affect some employee and employer decisions more than others.
By targeting reforms at the employees and employers that are most responsive to changes in taxation, then the gains in employment can be significant. Moreover, any revenue lost from those changes can be kept to a minimum.
So what reforms can help? One option is to reduce employer taxes–employer social security contributions and payroll taxes–thereby lowering the cost of hiring workers. This may be particularly beneficial for countries with both high employer taxes and generous minimum wage levels which risk pricing some low-skilled workers out of the job market. Here, tax cuts can potentially generate sustained reductions in unemployment, even after countries fully recover from the crisis. Such cuts may also work on a temporary basis to boost labour demand–at least until the crisis ebbs.
Policy makers can get extra impact from these reductions if they target them at businesses that hire new workers, particularly those that have been most affected by the crisis such as youth and the long-term unemployed. This way they can help maintain skill levels and prevent joblessness from becoming structural and harder to tackle later on. Indeed, several countries have implemented targeted concessions in response to the crisis, including Finland, France, Hungary, Ireland, Portugal and Turkey. Meanwhile, 14 OECD countries had already targeted employer tax reductions at low-skilled workers. The evidence from such efforts shows that targeted employer tax reductions do increase employment.
The trouble with these changes is that they can be administratively complex and can create opportunities for taxpayers to “game” the system–by sacking workers and hiring new ones for instance. Care needs to be taken in correctly designing such initiatives, such as by linking temporary reductions to increases in the total number of employees, as has been done in Korea, or to the total payroll. But the rule of thumb is to keep it simple: the more complex the concession, the less likely businesses are to respond to it.
Targeted tax reforms can also provide incentives for the out-of-work to hunt for jobs, and for those already with jobs to work longer and harder to earn more money. The people who are most responsive to such tax changes include low-income workers, older people, and second earners, which generally means women.
Start with low-income earners. Work incentives for this group can be increased in various ways. For example, a tax-free allowance can be introduced or increased, or personal income tax and social security contribution rates and/or thresholds can be altered. However, these reforms can be expensive to implement as they tend to also benefit higher-income earners. Work contingent tax credits, often paid out in cash, have become an increasingly popular tool to both increase work incentives and alleviate in-work poverty. They can be targeted to restrict revenue losses too. Studies show that these tax credits can be very effective at increasing participation of lowincome workers, particularly single parents. Small wonder that some 17 OECD countries have introduced such measures. However, again careful design is needed, as studies also show that the withdrawal of these tax credits up the income scale can reduce the number of hours worked by some middle and higher income earners.
As for older workers, many tax systems currently tax earned income more heavily than pension income, discouraging older people from continuing to work once they are eligible for pension payments.
To address this problem, policy makers should consider providing age-based rather than pension-specific tax concessions. Social security charges on older workers could also be reduced to match those due on pension income. Countries could go even further and actively encourage older people to keep working by providing workcontingent tax credits targeted at older workers. Some countries, such as Australia and the Netherlands, do this already.
For second earners the basic structure of many tax systems creates greater disincentives to work than for single earners. For example, family-based taxation and dependent spouse tax credits and allowances tend to cause second earners to pay higher average and marginal tax rates than are faced by single individuals (see chart). Under family-based taxation the second earner’s income is effectively added on to the main earner’s income, which pushes the second earner higher up the progressive income tax schedule; so even if they are earning low wages, they could be paying the top rate in income tax.
Moving from family to individual based taxation, and the removal of dependent spouse allowances can provide an easy win for governments as these reforms will improve second earner work incentives at minimal if any revenue cost. Unsurprisingly then, there has been a strong trend towards individual-based taxation in the OECD area over the last 30 years. Nevertheless 11 OECD countries still allow some form of family-based taxation.
Where politics rules out abandoning family-based taxation, an independent allowance or a work contingent tax credit for second earners could supplement existing arrangements instead. Indeed, these options have merit even in countries with individualbased taxation, especially those that target benefits on the basis of family income as this can create disincentives for second earners just like family-based taxation.
In the end governments need tax revenue, and even these targeted tax reforms can exact a cost in terms of foregone revenue. The task for governments is to weigh their immediate revenue needs against the potential (and beneficial) employment gains that such tax reforms can bring.
OECD (2011), Taxation and Employment, OECD Tax Policy Studies, No. 21, Paris.
OECD (2011), Employment Outlook, Paris.
©OECD Observer No 287 Q4 2011