Payroll taxes

Questions

Which are the effects of a payroll tax on the equilibrium in the labour market,
that is on wage, labour cost and employment?

Who actually bears the burden of the tax? The worker or the employer? Does
the tax increase the labour cost for the firm or decrease the take-home pay of
the worker?

How do taxes and social policies interact?

This lesson deals with the effects of payroll taxes on the labour market equilibrium,
but these effects are different according to the shape of labour demand and supply
and to the interaction with other policies

Labour Policies - G. Croce 2

 Some definitions

Payroll taxes (or labour taxes, broadly speaking) may be levied either on the employer
or on the employee as
Personal income taxes (income from any source, not only from employment)
Social security contributions (SSC) which are, by definition, earmarked for social
protection

The sum of personal income tax, employee and employer social security contributions
and any other payroll tax minus benefits, as a percentage of labour cost gives the tax
wedge (OECD 2011), which corresponds to
labour cost - take home pay
tax wedge =
labour cost

where labour cost is given by the (gross) wage plus all contributions paid by the
employer, and take-home-pay is the net wage resulting after deducting income tax
and contributions paid by the worker.

Labour Policies - G. Croce 3

 Annual labour costs and net income, 2011
a family with two children and only one earner at the average wage (in US dollars using PPP)

Cash benefits received by these

families exceeds the sum of
taxes and contributions !
Source: OECD 2011, table I.11

Labour Policies - G. Croce 4

 Payroll taxes as a way to finance benefits
The purpose of the payroll taxes is to finance benefits accruing to workers or firms
such as health benefits, pensions, workplace training, childcare services, maternity
leaves, unemployment insurance or, more generally, social spending

The rationale for them may be some market failures like public goods, merit goods,
externalities (e.g. training), informational asymmetries (e.g. unemployment
benefits) or redistributive purposes

Social spending may be public as well as private

Public social spending is funded by government through

Payroll taxes
General taxation system (not strictly related to the labour market)

Private social spending can be funded through

mandatory or voluntary social contributions
Collective agreements between unions and employers associations can establish
contributions to finance jointly managed agencies charged to provide benefits
Labour Policies - G. Croce 5
 A dilemma: benefits and costs of payroll taxes

The governments devote a large share of their budget to social spending including
policies and benefits targeted at workers (and firms), such as unemployment benefits,
training programmes, parental leaves etc.

Most of the financial resources required to finance social spending are collected
through taxes on labour incomes: these taxes represent the other side of the coin of
social spending, and affect the labour market outcomes with possible negative effects
on efficiency, labour costs, wages and employment.

Then a dilemma arises as payroll taxes, on one hand, allow to implement more
policies and programmes but, on the other hand, may distort the functioning of the
labour market and cause a lower employment.

In an open economy, if taxes rise the labour costs, the competitiveness will decrease
and employment suffers.

Labour Policies - G. Croce 6

 The relevance of payroll taxes: some data
Total (public plus private) social expenditure varies between 17% of GDP in Ireland to
34% in Sweden in 2003 (OECD 2007); social spending constitutes over half of total
public spending in almost all countries

It has risen sharply from 1980 to1993 and has tended to stabilise between 1993 and
2003

In most European contries the share of public spending in total social spending is
around 95% (85% in the Netherlands and the UK)

On average SSC account for almost half of public spending on social protection (OECD
2007)

Over last decades there has been some convergence across countries: the share of SSC
has declined in countries where SSC are the main source of funding and it has
increased somewhat in other countries

Labour Policies - G. Croce 7

 Public social spending in selected OECD countries, in percentage of GDP, 1960-2012

%
Australia France Japan United States EU-21 OECD-34

35

30

25

20

15

10

0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2012
Source: http://www.oecd.org/els/familiesandchildren/socialexpendituredatabasesocx.htm
Labour Policies - G. Croce 8
 Public and private social expenditure in percentage of GDP in 2009

35 Public Private / Priv

30

25

20

15

10

Source: http://www.oecd.org/els/familiesandchildren/socialexpendituredatabasesocx.htm
Labour Policies - G. Croce 9
 The financing of social spending:
level and composition of tax wedge (2011)
100,0 CH
Euro-continental
Social security contributions (% of total tax wedge)

90,0
model
POL
80,0 KO SLR FR
JA CZ
SLO AU
70,0
ME TUPOR HU
SP GE
LU EST SWE IT
OECD
60,0 IS BE
UK NE FI
SWI CA
50,0 IR
US NO
40,0

30,0
DK
IC
20,0 AU.LIA

10,0
Anglo-scandinavian
model
NZ
0,0
0,0 10,0 20,0 30,0 40,0 50,0 60,0
Source: elaborations on OECD 2011, table 0.2 Total tax wedge (% of labour costs)

Labour Policies - G. Croce 10

 Two broad models of welfare state
and two different ways of financing them
Two models of welfare state have arisen since the XX century among the industrialised
countries; despite their continuous evolutions, these two models have proved to be
highly persistent in time

Occupational welfare state: European-Continental countries

high incidence of SSC, with high tax wedge and large social spending

social expenditure is mostly financed through SSC; as a consequence eligibility criteria

and generosity of benefits tend to be diversified and segmentated on a
sectoral/occupational basis

Universalistic welfare state: Anglosaxon and Scandinavian countries

Low incidence of SSC, with high tax wedge and high social spending in Scandinavian
countries, with low tax wedge and lower social spending in Anglosaxon countries

social expenditure is mostly financed through general taxation; policies tend to be

comprehensive and homogeneous, involving citizens regardless of their labour market
status

Labour Policies - G. Croce 11

 Social
Public social Tax wedge security
expenditure (% of labour contributions
(% of GDP) costs)* (% of tax
wedge)*
Anglosaxon
Low Low Low
countries
Scandinavian
High High Low
countries
Eur. continental
High High High
countries

* With reference to the OECD averages in 2011: tax wedge 35.2%, SSC (as % of tax wedge) 62.2

Labour Policies - G. Croce 12

 More definitions: proportional and progressive payroll taxes
Let us consider the general structure of a payroll tax

T = a + tw
where w is the wage received by the worker, t0 is the marginal tax rate on wages, a is a lump-sum tax
if a>0, or an employment subsidy if a<0.
T a
= +t average tax rate
w w
T
=t marginal tax rate
w
Proportional tax: each individual pays the same tax rate regardless of the wage level
avg tax rate= mg tax rate
a + t = t
a=0
w

Progressive tax: the average tax rate increases with income

a
avg tax rate< mg tax rate
+ t < t
w

a<0

Regressive tax: the average tax rate decreases with income

avg tax rate> mg tax rate
a + t > t
a>0
w

The main purpose of progressive tax is redistribution from higher income earners to lower income
earners.
Labour Policies - G. Croce 13
Example. A progressive payroll tax: the average tax rate increases with income

T=a+tw with a =-100 and t =0.10

monthly total tax average marginal

wage (w) (T) tax rate tax rate
500 -50 -0,10 0,10
1000 0 0,00 0,10
2000 100 0,05 0,10
5000 400 0,08 0,10
10000 900 0,09 0,10

0,15

0,10

0,05

0,00 w
500 1000 2000 5000 10000
-0,05

-0,10

-0,15
average tax rate marginal tax rate

Labour Policies - G. Croce 14

Example. A regressive payroll tax: the average tax rate decreases with income

T=a+tw with a =100 and t =0.10

monthly total tax average marginal

wage (w) (T) tax rate tax rate
500 150 0,30 0,10
1000 200 0,20 0,10
2000 300 0,15 0,10
5000 600 0,12 0,10
10000 1.100 0,11 0,10

0,35

0,30

0,25

0,20

0,15

0,10

0,05

0,00
500 1000 tax rate
average 2000 marginal tax 5000
rate 10000

Labour Policies - G. Croce 15

 The effects of payroll taxes on labour market equilibrium:
a graphical analysis

A payroll tax introduces a wedge between labour costs and take-home-pay:

It affects the supply side as it reduces the take-home-pay (net wage), then
decreases the participation rate;
it distorts also the working hours: they decrease (increase) if the
substitution (income) effect prevails.

At the same time it affects the demand side as it increases the labour costs
for the firm, thereby reducing the labour demand.

Labour Policies - G. Croce 16

 the demand side: if the employer has to pay a payroll tax

Hyp.: competitive labour market (in the short run, when capital is fixed)

= y(L)-(w+T)L = y(L)-[w(1+t)+a]L profits

where w+T=w(1+t)+a are labour costs

The condition of max profits /L=0
y(L)=w(1+t)+a

where y(L) is the labour marginal product.(the value of the marginal job).
This result implies that, for a given wage w (the firm is wage-taker), if the employer has to pay a tax T the
labour cost increases (w+T>w ): so the firm is forced to achieve a higher y(L) by reducing employment L. After
this adjustment the firm is no longer at A but at B, where the wage is still w but L1< L0 (an inward shift of the
demand curve occurred).

The condition of max profits without tax

would be y(L)=w, which corresponds to
w the point A

w+T
B A
w
Ld
Ld(T)
L
L 1 L 0
Labour Policies - G. Croce 17
 the equilibrium:
The effects of payroll taxes do not depend on who has to pay
w

B Ls
Labour costs wd
A
w0
Take home pay ws C
Ld

L
L1 L0
The equilibrium with no taxes is (w0, L0) in A.
If the tax is levied on the workers , the curve Ls shifts upwards
equilibrium B
if the tax is paid by the firm, the curve Ld shifts downwards
equilibrium C.
In both cases the labour cost goes up to wd , take-home-pay goes down to ws and employment
decreases from L0 to L1.
From an economic point of view the final outcome does not depend on who must pay the tax
according to the law.

The area of the triangle ABC measures the deadweight loss.

Note: this is a partial equilibrium analysis that does not take into account the effects of benefits
financed through payroll taxes! Labour Policies - G. Croce 18
 but on the elasticities
w w
Ls
Ls
wd C
A
w0 w0 A
ws B
ws B
Ld Ld

L L
L0 L1 L0
With a vertical supply curve (left-hand panel) an increase of the tax on the firms is fully shifted on the net
wage (workers have no choices or mobility is too costly); with an elastic supply curve (right-hand panel) the
same tax increase causes a large drop in employment with little reduction of the net wage.

In general, the burden of the tax is shifted to the side that is less elastic

The reverse policy is given by a tax cut: with a vertical supply curve there is no beneficial effect on
employment (workers have market power and claim all the income resulting from the tax cut).
e.g.: a cut of payroll taxes on female labour might have a large positive effect on female labour supply
because this is highly elastic
Labour Policies - G. Croce 19
Also with a flat labour demand curve the tax is fully shifted to the wage

Ls

A Ld
w0

B
w1

L
L0

A flat labour demand means that marginal productivity (marginal value of the job) is constant,
regardless of the quantity of labour employed: in this case the net wage in equilibrium must
fall by the same amount of the tax in order to keep marginal productivity equal to labour cost
(increased by the tax)

Labour Policies - G. Croce 20

 Pure tax model vs full valuation model
(see Boeri-van Ours box 4.1 and errata)

So far we have considered a pure tax policy, where no benefit derives from tax to the workers. Now let us
admit that taxes fund programs (pensions, unemployment benefits etc) which are beneficial to workers.
Here we consider the case when both employers and employees must pay a tax, but only employees are the
recipients of social benefits.

What is the effect on the wage?

Labour demand and supply are affected by payroll taxes

L d = L d (w (1 + t f ))
L s = L s (w (1 a w t e ) + a e wt f )

w (1 + t f ) is the labour cost for the firm

w (1 a w t e ) + a e wt f
is the total compensation including the wage, and the tax and benefits received by t
he worker

where 0aw 1 and 0 ae 1.

The demand Ld is reduced by the tax paid by the firm tf.

The supply Ls is reduced by the part of the tax paid by the worker te.

Labour Policies - G. Croce 21

Let us focus on the supply side

Ls = Ls (w(1 a wt e ) + ae wt f )

With aw=1 and ae=0
pure tax model: Ls(w(1-te))

the worker does not benefit at all from taxes or does not recognise that social benefits
are financed through payroll taxes.

while if aw=0 and ae=1
full valuation model: Ls(w(1+tf))

the worker appreciates the benefits received at the same value of the total tax

Labour Policies - G. Croce 22

Labour Policies - G. Croce 23
 The pure tax case
w
Ls
Ld Ls
Ld
A
w0 B
ws

L
L0

In the pure tax case the taxes cause lower employment and inefficiency.

Both curves shift leftward and the new equilibrium is at point B with a lower quantity of
employment.

Labour Policies - G. Croce 24

 The full valuation case
w
Ld Ls
Ld Ls
A
w0

ws C

L
L0

In the full valuation case, the workers appreciate the full value of the benefits accruing from
the payroll taxes. As a consequence they accept to work at a lower net wage: Ls shifts
downwards.
The benefits compensate the workers for lower take-home-pay.
At the new equilibrium C the take-home-pay has decreased by the same amount as the tax,
while employment is unaffected.

Labour Policies - G. Croce 25

To derive in a more formalised way the effect of the payroll tax on the wage, consider
that after the tax is levied a new equilibrium is reached implying an identical change in
the quantity of labour demanded and supplied, thus dLd=dLs.
By equating the total differentials of demand and supply we obtain the following result
(at tf =0)

Variazione % del salario a seguito dw w a e (1 a w t e )

=
dellintroduzione di una tassa dt f ( )(1 a w t e )
a carico dellimpresa

(where 1/ and 1/ represent the the elasticity of supply and demand, respectively).
This implies that an increase in the tax rate tf. is fully shifted to wage
(that is (dw w) / dt f = 1) in the following three cases:

1. The supply Ls is rigid (1/
0 that is
): vertical labour supply curve
2. The demand Ld is perfectly elastic (1/
that is
0): flat labour demand
curve
3. In the full valuation case (aw=0 and ae=1 ): all taxes are regarded as benefits by
workers
Labour Policies - G. Croce 26
 Why in some countries labour taxes are higher?
The differences in the labour market institutions can explain differences in the structure of
taxation across countries!

In particular, payroll taxes are higher in more corporatist countries (Scandinavian

countries): this can be explained as an application of the full valuation case.
In corporatist countries wage bargaining is highly centralised at the national level, then
unions bosses can easily recognise (and internalise) the benefits accruing to the workers
financed by the revenues of labour taxes: indeed both the wage bargained over by unions
and the benefits financed by taxes are targeted at the same population of workers.

When unions bosses bargain over the wage, they consider not only the loss but also the
benefits resulting from the tax. In corporatist countries large unions represent the entire
workforce, which benefits from the wage bargained by the unions as well as from social
policies financed through taxation: then unions may accept an exchange between wage and
social benefits: less wage is compensated by more benefits. As a consequence the
distortionary effect of the tax on labour supply is mitigated.

The higher the degree of centralisation of bargaining, the greater the perception of the link
between taxes paid and benefits received, the lower the reduction of labour supply: in
these countries the employment costs of labour taxes are lower.
Thats why there labour taxes are higher.

(Summers et al. 1992)

Labour Policies - G. Croce 27

 Glossary (OECD)
Tax wedge
Sum of personal income tax and employee plus employer social security contributions together
with any payroll tax less cash transfers, expressed as a percentage of labour costs.
Employees social contributions Employees social contributions are the amounts payable by
employees to social security funds and private funded social insurance schemes.
Employers actual social contributions Employers actual social contributions are the amounts
payable by employers for the benefit of their employees to social security funds, insurance
enterprises, autonomous pension funds or other institutional units responsible for the
administration and management of social insurance schemes.
Payroll taxes
Payroll taxes consist of taxes payable by enterprises assessed either as a proportion of the wages
and salaries paid or as a fixed amount per person employed. (the definition adopted in the slides
and in the textbooks includes also taxes payable by workers)
Direct taxes on income
Direct taxes on income are levies by public authorities at regular intervals, except social
contributions, on income from employment, property, capital gains or any other source. Real
estate and land taxes are included if they are merely an administrative procedure for the
assessment and collection of income tax.
Taxes on individual or household income
Taxes on individual or household income consist of personal income taxes, including those
deducted by employers (pay-as-you-earn
(http://stats.oecd.org/glossary/search.asp) taxes),
Labour and
Policies - G.surtaxes.
Croce 28
 References

Boeri, van Ours, ch. 4

Borjas G., Labor economics, McGraw-Hill

OECD, Taxing wages 2011

OECD, Employment Outlook 2007
Summers L., Gruber J., Vergara R., Taxation and the structure of labor markets: the
case of corporatism, NBER wp 4063, 1992
Ferrera M., Le politiche sociali, il Mulino, 2012

Labour Policies - G. Croce 29