Download Fiscal Drag – An Automatic Stabiliser?

Fiscal Drag – An Automatic Stabiliser?
Herwig IMMERVOLL*
*
Microsimulation Unit, Department of Applied Economics, University of Cambridge
Sidgwick Avenue, Cambridge CB3 9DE, UK.
Tel. +44 1223 335269
e-mail: [email protected]
Abstract
Inflation can alter the structure of tax systems and lead to higher real tax burdens. The ‘automatic
stabiliser’ argument assumes that increasing tax burdens reduce consumption and thereby
aggregate demand, acting as an automatic stabiliser which helps to ‘cool down’ the economy in
times of inflation. This argument, however, only looks at the demand side, ignoring any effects
that higher tax burdens may have on the cost of production. If employees bear less then the full
burden of higher taxes then real labour costs will go up as well, generating a cost-push upwards
pressure on prices and opening up the possibility of a wage-price spiral. This paper build on
analyses of the differential effect of marginal and average tax rates on the wage setting process in
an imperfect labour market. A preliminary version of EUROMOD, a European benefit-tax model
is used to derive distributions of inflation induced changes of effective tax rates for representative
samples of the population of four European countries. The approach takes into account both the
complexities of tax-benefit systems and the heterogeneity of taxpayers and benefit recipients in
the population. For illustrative purposes, the simulated changes in the marginal and average tax
burdens of employees are then combined with estimates from the literature on the sensitivity of
wages with respect to these variables. The results suggest that inflation combined with an unindexed tax-benefit system can produce a moderate upward pressure on wages. However, it is
argued that the wage equations on which these results are based are less than satisfactory since
they ignore that tax rates of different individuals are generally affected to different extents.
JEL Classification: E31; H24; H39; D31; C81
Keywords:
Automatic Stabiliser; Inflation; Income Tax;
Wage Setting; European Union; Microsimulation.
Fiscal Drag – An Automatic Stabiliser?
Herwig Immervoll1
Draft version (19.9.2000).
Please do not quote without the author’s permission.
Comments welcome!
1. Introduction
Inflation can alter the structure of tax systems and, thus, the incidence and overall levels of taxes
collected. There are several channels through which such distortions can operate. The most
evident and most thoroughly researched source is the influence of inflation on the tax schedule
commonly known as ‘bracket creep’ (Immervoll, 2000; OECD, 1986; Aaron, 1976). In the
absence of offsetting adjustments, a progressive tax schedule will cause real tax burdens to
increase as nominal incomes rise (‘fiscal drag’).
The dependence of the tax system on an a priory unknown variable is undesirable in many
respects. For example, inflation induced changes by-pass the democratic process, which is
otherwise obligatory for enacting tax changes. On a more pragmatic level, they may undermine
the social or economic purposes of the tax system. There have, therefore, been numerous
proposals to adjust the tax system for inflation in order to prevent inflation induced distortions
and many countries have, in fact, adopted one or another form of automatic inflation adjustment
(Immervoll, 2000; Messere, 1998; Tanzi, 1980; OECD, 1976). Apart from several assumed
practical difficulties in neutralising the effects of inflation, there has been one economic argument,
which has been used to justify inflation induced increases in real tax revenues. Increasing real tax
burdens are assumed to reduce consumption and thereby aggregate demand, acting as an
automatic stabiliser which helps to ‘cool down’ the economy in times of inflation.2 This
argument, however, only looks at the demand side, ignoring any effects that higher tax burdens
may have on the cost of production. If employees bear less then the full burden of higher taxes
then real labour costs will go up as well, generating a cost-push upwards pressure on prices and
opening up the possibility of a wage-price spiral (Jackson et al., 1972; Dernburg, 1974;
Malcomson and Sartor, 1987).
1 Microsimulation Unit, Department of Applied Economics at the University of Cambridge. This paper was
written as part of the EUROMOD project, financed by Targeted Socio-Economic Research programme of the
European Commission (CT97-3060). I am grateful for access to microdata from the Finnish Income Distribution
Survey (IDS) 1996 made available from Statistics Finland; the Living in Ireland Survey, 1994 (Wave 1) made available
by the Economic and Social Research Institute (ESRI), Dublin; the Socio-Economic Panel Survey (SEP) made
available by Statistics Netherlands through the mediation of the Netherlands Organisation for Scientific Research Scientific Statistical Agency; and the UK Family Expenditure Survey (FES), which have been made available by
the Office for National Statistics (ONS) through the Data Archive. Material from the FES is Crown Copyright and
is used by permission. Neither the ONS nor the Data Archive bear any responsibility for the analysis or
interpretation of the data reported here. An equivalent disclaimer applies to the other data sources and their
respective providers. I am grateful for helpful comments received from Cathal O’Donoghue, Frank Wilkinson,
Klaas de Vos and participants of the 56th Congress of the International Institute of Public Finance, held on August
28-31, 2000, in Seville, Spain. The views expressed in this paper as well as any errors are the author’s
responsibility.
2 see, for instance, the model presented in Zilberfarb (1981). Nowotny (1980) reviews the macroeconomic issues.
2
While, during most of the 1990s, inflation has not been a major problem in the industrialised
countries, it has been argued that recent developments in Europe and, especially, EMU, are likely
to lead to increasing inter-country variability of inflation. As long as there remain important
structural differences between different EMU countries, one would expect a unified monetary
policy to lead to differing price developments across countries. Indeed, the process of
‘convergence’ can itself contribute to such differences, at least temporarily (European
Commission, 1999). For EMU countries, the loss of control over monetary policy means that
there is less scope for national policy makers to control inflation. Small countries, such as Ireland,
may be particularly affected since their economic situation will frequently receive less attention in
the determination of monetary policy than that of larger ones. Given this scenario, it seems
important to discuss the stabilising properties of the fiscal system.
The present paper examines possible effects of inflation induced tax and benefit distortions on the
wage level. It builds on a recent literature explaining the consequences of changes in the level and
progressivity of (effective) tax rates for the wage-setting process. In particular, I draw on results
showing that changes in marginal and average tax rates influence wages in opposite directions.
Using a European tax-benefit microsimulation model, I decompose the effects of bracket creep
into changes in effective marginal and average tax rates. The contribution of the paper is
threefold. Firstly, it aims to demonstrate how an integrated European tax-benefit model can be
used to compute inter- and intra country distributions of effective average and marginal effective
tax rates in one consistent conceptual framework. Similar distributions are computed for a
‘before’ and ‘after’ inflation scenario in order to determine the effects of inflation on average and
marginal tax rates in a nominally defined tax system. Lastly, the paper discusses how the resulting
changes in marginal and average tax rates can be used to quantify likely cost-push effects of
bracket creep. The approach improves on previous studies in that it is able to capture the full
range of effects caused by tax changes in different parts of the population.
I proceed as follows. Section 2 reviews the channels through which taxes can influence the price
level and thus provides the theoretical framework for the following analysis. Section 3 describes
the microsimulation approach used in the empirical part of the paper. Both the model and the data
are discussed here. The results are presented in section 4. The next section discusses how they
can be used to estimate likely impacts on wages. Some caveats are highlighted. Section 6
concludes.
2. Theory
The extent to which tax increases (whether discretionary or caused by inflation) have a damping
effect on price increases will depend on numerous factors. The most obvious is the elasticity of
demand with respect to disposable income.3 But even if demand is responsive to tax changes, the
efficacy of tax increases will be limited in cases where inflation is not primarily caused by excess
domestic demand. In situations where inflation has been 'imported' or where price increases are a
consequence of supply disturbances, reducing domestic demand will not be the optimum counter
measure. Rather than inducing price adjustments, tax increases in such a situation are likely to
raise the level of unemployed resources in the economy (Dernburg, 1974). Another reason why
tax increases may not have the desired stabilising effects is that while higher taxes tend to reduce
3 If there is a certain extent of 'fiscal illusion', i.e., individuals do not (immediately) realise increased tax burdens,
then demand will not be as responsive to tax increases as the elasticity of demand would suggest.
3
household demand, aggregate demand is the relevant policy variable. As is well known, tax
financed public expenditure actually increases aggregate demand so long as the marginal
propensity to consume is less than unity. As a result, higher taxes only translate into lower
aggregate demand if lower private consumption is not overcompensated by increased public
expenditure made possible by additional tax revenues. To prevent expansionary multiplier effects,
intentional tax increases aimed at reducing inflation have sometimes been accompanied by
measures to ensure that additional revenues cannot be used to increase public spending.4 For
automatic tax increases caused by inflation, however, such attempts have not become known. It is
tempting to interpret the lack of such measures as suggesting that stability considerations are not
the primary reason for allowing inflation to increase the tax burden.
So far, the discussion has been limited to the demand side. On the supply side, it will be critical
how wages respond to higher tax burdens. In the absence of 'fiscal illusion' wage earners will
want to compensate higher taxes by demanding higher gross wages from their employers. There
is, thus, a possibility that tax increases lead to higher production costs and that inflation induced
tax increases in the past “may well have contributed to higher inflation rates.”5 Consider an
individual subject to an average tax rate τa and a marginal tax rate τm. To keep real after tax
earnings unaffected by inflation (π) induced 'bracket creep', the nominal gross wage w would have
to increase by ∆w:
∆w
1− τa
= π⋅
w
1− τm
,
(1)
(1-τa)/(1-τm) being the inverse of the Musgrave measure of progressivity (Musgrave and
Musgrave, 1976). Thus, the required wage increase does not depend on the magnitudes of τa and
τm but on the difference between them. The more progressive the tax schedule, the larger the
wage increase necessary to compensate for higher real taxes burdens. To the extent that wage
increases exceed inflation (even if they fall short of keeping the employees' real after-tax income
unchanged), they will, other things being equal, lead to higher real labour costs and to an
upwards pressure on prices which will tend to shift the aggregate supply schedule upwards.6
Combined with a lower aggregate demand due to higher taxes (i.e., assuming that the decline in
private demand is not exceeded by an increase in public spending) an upwards shift in the
aggregate supply curve will unambiguously result in lower output. The effect on the price level is
less clear. It depends on the slope of the relevant sections of the supply and demand curves.7 If,
on the other hand, aggregate demand remains unchanged (because of increased public spending),
we will see both lower output and higher prices.8
But to what extent do wages actually respond to changing tax burdens? Obviously, employees
must be aware of them in order to achieve any compensation for them in the labour market.
4 The German 'Stability Law' dating from 1973 has, for instance, introduced a temporary increase in the corporate
income tax for the years 1973 and 1974. The law specified that resulting additional tax receipts could not be spent
but had to be kept on reserve with the Bundesbank. See Pilz (1977), pp. 175-.
5 Hersoug (1984), p. 50.
6Whether and to what extent higher wages are, in fact, passed on to consumers in the form of price increases will
depend on the relative degrees of market power of producers and consumers. See Tarling and Wilkinson (1985)
for a discussion of the mechanisms of mark-up pricing.
7 See Blinder (1973).
8 Smyth (1983) formalises these relationships in a simple model.
4
Given this awareness, the impact on wages depends on the market structure. In a perfectly
competitive labour market, there is no involuntary unemployment and the only way taxes on
wages can alter the equilibrium wage level is through changes in individual working hours. This is
illustrated in figure 1. Given an hourly wage w, B0 is the individual’s initial budget constraint. In a
progressive tax system, the increase in after-tax income gained from working an additional hour
decreases with increasing hours (the budget constraint becomes flatter). Initially, the individual
chooses the optimum number of working hours h0. At the associated level of gross income, a+b,
the average tax rate is a/(a+b) and the marginal tax rate, illustrated by the tangency line, is mtr0.
Increasing the marginal tax rate (while keeping the average tax rate unchanged), by changing the
budget constraint to Bm, will lead to a reduction of working hours to hm (pure substitution effect).
An increase in the average tax rate (keeping the marginal rate unchanged) shifts the budget
constraint downwards (Ba).9 The effect on working hours will depend on the relative size of the
income and substitution effects. As long as the substitution effect dominates (positively sloped
labour supply curve) working hours will decrease (ha).
For most segments of existing labour markets in Europe, however, the standard competitive
model seems inappropriate. Where involuntary unemployment does exist, modern theories of
imperfect labour markets offer alternative and more differentiated analyses of the effects of tax
changes. Starting in the mid-1980s, there have been several influential theoretical papers on how
taxes impact on the wage setting process in an imperfect labour market.10 Results from more
recent empirical studies for several European countries tend to be consistent with these theories –
indicating that the imperfect labour market model is in fact appropriate in the European context
(e.g., Aronsson et al., 1997; Graafland and Huizinga, 1996). These theories focus on the
respective incentives of employees and employers in the wage-setting process, i.e., agents now
have some market power and are no longer seen as mere price-takers. In order to capture these
incentives, it is not sufficient to characterise tax changes in terms of their impact on the size of the
tax burden. Instead one has to consider the marginal and average tax rates separately. In addition,
it becomes important how the opportunity cost of participation in the labour market, usually
represented by the unemployment benefit, is affected by a tax change.
For example, union bargaining models assume a trade-off between unions' desire for lower
unemployment among the workers they represent and higher real after tax wages (Hersoug,
1984; Malcomson and Sartor, 1987; Lockwood and Manning, 1993; Holmlund and Kolm, 1995).
In other words, by trading wages for unemployment unions can influence the wage rate and, thus,
the slope of the budget constraint in figure 1.11 Assuming constant real net unemployment
benefits and unchanged progressivity at the relevant point of the tax schedule, increased average
tax rates reduce the relative value of labour income vis-à-vis unemployment benefits (i.e., the
replacement ratio increases).12 Unemployment will thus appear less painful to union members and
9 Note that it is impossible to change the average tax rate while keeping the marginal rate constant for all income
levels. In figure 1, marginal tax rates are left unchanged for all upper income levels, while for lower incomes, they
are increased (right hand part of Ba is flatter than B0).
10 References are provided in Hansen et al. (2000), Pissarides (1998) and Sorensen (1997).
11 Most earlier models take individual working hours as exogenously given. However, more recent studies have
modelled a bargaining process where unions and firms negotiate wages and working hours simultaneously. See
Fuest and Huber (2000), Hansen et al. (2000) and Hansen (1999).
12 For countries where unemployment benefits are non-taxable, a sufficient condition for the replacement ratio to
increase is that the benefit level changes by the same proportion as pre-tax wages (which is the case if the former
is a fixed percentage of the latter). If benefits are taxable then the replacement rate will still go up (even if the real
after-tax benefit decreases) as long as the real after-tax wage decreases by more (in relative terms). Whether this is
the case will depend on the specific structure of the (effective) tax schedule. It should also be stressed that, as
5
the unions' preferences will tend to shift away from avoiding unemployment towards securing
higher wage increases. On the other hand, an increase in the marginal tax rate will cause unions to
moderate their wage demands since changes in the before tax wage now have a smaller effect on
union members' after tax income. The actual outcome of the bargaining process will depend on
the respective target wages of employers and unions as well as their relative bargaining powers.
Since taxes on employment income do not change the target wage of the employer “it is not
unreasonable to assume that, as long as the union has some bargaining power, the effect of such
changes on the actual wage will be in the same direction as the effect on the union’s target
wage.”13 The two other popular imperfect labour market models, the search model and the
efficiency wage model, also predict that "increased tax progressivity (a rise in the marginal tax
rate for a given average tax rate) will moderate wages and promote employment, whereas a rise
in the average tax rate will tend to drive up the wage level."14 In the remainder of the paper,
however, I concentrate on the union bargaining model.
Given that tax changes in these models are predicted to have very different consequences
depending on how they affect average taxes and progressivity, it is essential to carefully separate
these two effects in any related analysis. This, however, is quite difficult for several reasons. First,
tax rules are often very complicated. Apparently minor details of the tax code often cause very
substantial ups and downs in marginal tax rates. Ignoring these details can therefore seriously bias
any incentive effects modelled on the relationship between average and marginal tax rates.
Secondly, it is the effective tax rates that determine the relative preferences in the above models.
It is therefore important to consider both income taxes and social insurance contributions.15 In
addition, effective tax rates are influenced by transfer payments as well so one has to also include
state benefits in the analysis. The rules of these benefit payments are, however, frequently even
more complicated than tax rules. Finally, different types of taxpayers will face very different
effective tax rates and will therefore favour different target wages. Previous studies have simply
computed the relevant tax rates for a ‘typical’ household type with average earnings (e.g.,
married couple with a single breadwinner and two ‘children’). Such an approach ignores the
obvious influence of the household type on effective tax rates. Equally important, it ignores the
fact that different earnings levels will be affected differently by any real-world change of the tax
system. The union, however, must decide on one relevant change in effective tax rates in order to
decide on its target wage. Once the union aggregates all the different changes in effective tax
rates among its membership, the resulting target wage may be very different from one that would
be optimal for someone with average earnings. The reason, as Lockwood and Manning (1993)
Graafland and Huizinga (1996) and others have argued, the actual impact of the replacement rate on the wage
outcome is likely to depend on the unemployment rate.
13 Malcomson and Sartor (1987), p. 1583. As far as the bracket creep phenomenon is concerned, however, this
statement should be extended in one respect. The effective burdens resulting from employer social insurance
contribution are, in fact, potentially distorted by inflation. But since contribution schedules are usually regressive,
inflation reduces the employer’s effective contribution burden. So in this case, there is even more reason to expect
the union’s target wage and the actual wage to move in the same direction.
14 Sorensen (1997), p. 229.
15 There are two (related) complications here. One is that compulsory social insurance contributions could be seen
as not reducing take-home pay if there is a perceived relationship between the amount paid and any (potential)
social insurance benefits received. If this is the case then any contributions paid by the employer would also need
to be included in the ‘take-home pay’ income concept. In the remaining part of the paper, I disregard these
considerations for reasons of simplicity. In most countries, not distinguishing between income taxes and
contribution payments can probably be justified on the grounds that there exist substantial tax-financed subsidies
for social insurance funds.
6
note, is that “the average marginal and the average average tax rates will in general not be equal
to the marginal and average tax rates evaluated at the average earnings.”16
3. Methodology
I use a tax-benefit microsimulation model to compute taxes and benefits for each household in a
representative micro data set. The model contains very detailed tax- and benefit rules including
the interaction between different instruments. Using micro data sets which are representative of
the respective country’s population it captures the actual variation of household types and
earnings levels. The approach therefore addresses all three difficulties described above. On the
basis of the computed taxes and benefits, I calculate average effective tax rates (AETRs) and
marginal effective tax rates (METRs). The calculations result in a detailed picture of the
distribution of AETRs and METRs. Rather than averaging across very different earnings levels
and household situations, the approach produces results which reflect the diversity of the
underlying population. To determine the effect of inflation, the calculations are performed for a
“before inflation” and “after inflation” scenario. AETRs and METRs for the "after inflation"
scenario are computed under the assumption of (1) unadjusted tax rules but adjusted benefit rules
(7%_IT) and (2) unadjusted tax and benefit rules (7%_IT&BEN). An important advantage of the
simulation approach is that it is able to isolate the effects of inflation on AETRs and METRs
while keeping everything else constant. Using results from the literature on the elasticity of wages
with respect to average and marginal tax rates as a starting point, I then discuss how the change
in effective tax rates can be used as a basis for an estimate of potential wage pressures caused by
inflation induced distortions of taxes and benefits.
It is important to note that the scenarios explored here are hypothetical. This approach is
necessary because the aim is to determine possible cost-push effects of fiscal drag in un-indexed
tax-benefit systems.17 However, in three of the countries examined here, ‘automatic’ inflation
adjustments of the tax-benefit system are in force (the exception is Ireland).18 In addition, the rate
of inflation used in the simulations is 7%. For many countries, this may seem rather high.
However, as pointed out in the introduction, fiscal stabilisers are especially important for
countries such as Ireland whose economy has not yet ‘converged’ and who therefore experience
larger price level movements than other countries.
The model used is a preliminary version of EUROMOD, an integrated European tax-benefit
model, which, at the time of writing, is under construction. EUROMOD provides us with a
Europe-wide perspective on social and fiscal policies that are implemented at European, national
or regional level. It is also designed to examine, within a consistent comparative framework, the
impact of national policies on national populations or the differential impact of co-ordinated
European policy on individual Member States. Within the context of the present paper, the most
relevant feature of EUROMOD is that it can provide conceptually consistent and, thus,
comparable output for different countries. See Immervoll et al. (1999) for more details.
16 p. 11. Emphases are in the original.
17 While it would be interesting to also explore the effects of fiscal drag given existing uprating regimes, it is not
possible to examine the ‘automatic stabiliser’ argument in a tax-benefit system where the fiscal drag has been
neutralised by adjusting tax-benefit rules for inflation. The interested reader is referred to Immervoll (2000) where
I analyse the extent to which inflation distorts tax burdens given existing uprating regimes.
18 The scope and extent of indexing does, however, vary considerably between countries. See Immervoll (2000)
for a description of indexing schemes (of income taxes and social insurance contributions) in the Netherlands and
the UK.
7
Simulations are run for four countries: Finland, Ireland, the Netherlands and the UK. The micro
data sets underlying the simulations are derived from the 1996 Finnish Income Distribution Survey
(IDS), the Living in Ireland Survey, 1994 (Wave 1), the 1996 wave of the Dutch Socio-Economic
Panel (SEP) and the UK 1995/6 Family Expenditure Survey. For detailed information regarding
sample sizes, coverage, non-response, etc. the reader is referred to Sutherland (1999). In each
case, the samples are weighted to adjust for non-response bias and to bring the results up to
population levels. The simulations are based on the systems of tax and benefit rules current in
June 1998 and all monetary variables in the micro-data are updated to this year using the most
appropriate uprating index available for each type of income.
Given the limitations of the underlying data, not all the relevant components of the respective taxbenefit systems lend themselves to simulation. I simulate income taxes, social insurance
contributions, child benefits and other family benefits, and income-tested benefits.19 In computing
income, components that are not simulated in the model are taken directly from the data. In
particular, this is the case for contribution based payments, such as contributory pensions.
For each country, there are three scenarios. The “base-line” scenarios use 1998 rules and data.20
In the “7%_IT” scenarios, all income variables in the data are increased by 7% to simulate an
inflationary shock. In simulating tax and benefit instruments, income tax and social contribution
rules remain unchanged, i.e., all amounts such as tax band limits, thresholds, deductions, etc.
remain at their nominal 1998 values. In order to capture the pure ‘bracket creep’ effect caused by
unadjusted income tax and social insurance contribution rules, all benefit rules are indexed for
inflation (i.e., all amounts in the relevant benefit rules are also increased by 7%).21 To explore the
consequences of different scopes of “indexing”, I also simulate a scenario where benefit rules are
subject to inflation-induced distortions. In these scenarios, called “7%_IT&BEN”, the unadjusted
1998 benefit, income tax and contribution rules are used.22
For each scenario, AETRs and METRs are then computed for all employees in the data set of the
respective country.23 The model allows these rates to be computed at any level of analysis that is
supported by the data. It is, for example, possible to compute average tax rates at the level of the
individual, the couple, the family (however defined), or the entire household. For marginal tax
rates, there are even more alternative measurement approaches. For instance, decisions need to
be taken regarding the sign and appropriate size of the margin, the income variable(s) to be
altered, the relevant unit of analysis, and how the marginal income change is to be shared among
members of this unit. For the purpose of this paper, AETRs and METRs are computed at the
19 Housing benefits are only simulated in Ireland, the Netherlands and the UK. For Finland the simulation
routines for housing benefits have not been implemented yet and the housing benefit values recorded in the data
are taken instead. However, at a later stage, EUROMOD will be able to simulate housing benefits for all countries
where they exist.
20 As explained above, the original period to which the data refer to is not 1998. However, data are uprated from
the original year to 1998 to construct a quasi-1998 population.
21 The rules are only adjusted for simulated benefits. Benefits that are not simulated, such as insurance-based
transfers, are simply increased in line with inflation.
22 Note that leaving benefit rules unadjusted is not the same as leaving the nominal benefit amounts unchanged.
Due to non-linearities in the benefit rules, not adjusting the rules may lead to larger changes in benefit amounts
than the simple erosion caused by inflation. For example, income tested benefits may stop being paid altogether as
a consequence of the (nominal) means exceeding some unadjusted threshold.
23 I define employees as persons working more than 10 hours per week and whose employment income represents
their main source of earnings (i.e., it is higher than any self-employment income).
8
individual level. This means that one needs to decide sharing rules for instruments, which operate
at a level other than the individual. For example, social assistance benefits influence effective tax
rates since they affect disposable income. However, social assistance is normally paid at the
family or household level. The actual impact on individuals’ effective tax rates therefore depends
on how these benefits are shared among individuals.
In the simulations I make the assumption that all benefits that do not clearly accrue to one
specific person (such as pensions) are shared equally among all adults in the unit which is relevant
for computing the benefit. Any taxes that are paid jointly are assumed to be split in proportion to
the tax base of each individual of the tax unit (this is, for example, important in Ireland, where
there is joint income taxation for married couples). The income variable to be varied for
computing marginal taxes is, obviously, employment income. The size of the margin is taken to
be plus 3%.24 One of the advantages of an integrated European tax-benefit model is that
consistent income concepts can be used across countries. For the current exercise I use the
following definition of disposable income (Y): wage and salary income (including sick pay paid by
government and any lump-sum components of employment income), plus self-employment
income, plus property income (rent, dividends, interest), plus other cash market income and
occupational pension income plus regular private transfers, alimony and child maintenance, plus
contributory (insurance-) benefits (state pensions, unemployment benefits, sickness benefits, etc.)
plus non-contributory benefit payments (universal and social assistance benefits), minus direct
taxes and (employee) social insurance contributions. This income concept is used for computing
AETRs, effτa, and METRs, effτm, as follows.25
τ = d(T-B) / d(Y+T-B)
(2)
τ = (T-B) / (Y+T-B)
(3)
eff m
eff a
where T is the sum of income taxes and employee contributions, and B is the sum of all benefit
payments.
4. Simulation Results
The resulting distributions of AETRs and METRs for employees are presented in figures 2 and 3.
The distribution of marginal rates is more concentrated in the UK than in the other three
countries. Ireland shows the widest dispersion of rates. On average, METRs are lowest in the UK
(about 32%) followed by Ireland and the Netherlands while in Finland, the average marginal
burden (47%) is only slightly below the 50% mark. Turning to average rates (figure 2), the rate
intervals where the largest shares of employees are located differs between the Ireland, the
Netherlands and the UK on one hand and Finland on the other. In Finland, the largest number of
24 For some analyses it may make sense to compute the marginal tax rate for both a positive and a negative
margin and use, say, their mean. However, in the majority of cases, inflation will cause tax burdens to increase
(Immervoll, 2000). So the appropriate margin is one that is relevant for the union in deciding by how much the
wage should be increased to compensate for higher taxes. The relevant question is therefore what proportion of a
wage increase goes to union members (as increased take-home pay) in return for a higher risk of unemployment.
Clearly, to answer this question a positive margin is needed.
25 Contributory benefits are not simulated because the necessary contribution records are not in the data. In the
simulations, it is assumed that these benefits increase in line with inflation. Indirect taxes, and therefore any
inflation induced erosion of the real value of excise taxes, are disregarded in the simulations presented here.
However, a later version of EUROMOD will allow indirect taxes to be simulated.
9
employees is faced with effective tax rates of between 30-35%. More than 19% of Finnish
employees pay more than 35% whereas in the other countries, this is only true for 2% (IR), 8%
NL and 1.6% (UK) of employees. It is also worth noting that due to generous social benefits, a
very large number of Finnish employees benefits from highly negative average tax burdens (less
than -50%).
Although it would clearly be interesting to explore these results further, the main interest of this
paper is how, as a result of inflation, rates would change in an unadjusted tax-benefit system.
Theories of imperfect labour markets stress the opposite effects of marginal and average tax rates
in the wage setting process. Clearly, in an un-indexed progressive tax schedule inflation will
increase the average tax rate for all taxpayers. On the other hand, in a large number of cases,
taxpayers will remain in the same tax bracket. They will, thus, be confronted with higher average
tax rates while the marginal tax rates will remain unchanged. In these cases, the theoretical and
empirical results discussed above would point towards increasing real labour costs. Whether and
to what extent inflation raises the marginal tax rates for a significant number of tax payers will be
determined by the rate of inflation and the proximity of taxpayers' nominal incomes to the next
higher tax band limit. An increase in the marginal tax rate will obviously be more likely if tax
26
bands are narrow or inflation is high. The tax schedules of the countries considered here are
rather wide. In most cases, one would therefore expect the number of taxpayers with unchanged
marginal tax rates to dominate in cases of low to moderate inflation.
Figures 4 to 7 show that this is indeed the case. The graphs show how, in an unadjusted taxbenefit system, employees’ METRs and AETRs change following a uniform 7% increase in all
their primary incomes. The METRs of between 64% (IR) and 85% (UK) of employees are
exactly the same after inflation as they were before. Even though most employees whose METRs
do change are confronted with a larger marginal burden, some actually experience decreasing
METRs. This is because, as their nominal incomes rise, individuals may no longer be eligible for
tax credits or benefit payments that are subject to an income taper. They are thus no longer
affected by the high withdrawal rates (and therefore effective marginal rates) caused by theses
instruments. As means tested social assistance benefits are the main contributor to high
withdrawal rates, the numbers of employees facing decreasing METRs are higher for the scenario
where benefit rules are not adjusted for inflation (7%_IT&BEN). AETRs, on the other hand, go
up for almost everybody.
Looking first at the ‘7%_IT’ scenarios, employees face higher income tax burdens as inflation
erodes the real value of tax free allowances, deductions, tax credits, and tax rate bands. In most
cases, any decrease in AETRs caused by regressive social insurance contribution systems less
than compensates for the rise in average income tax rates. However, despite a very progressive
income tax schedule, more employees in the Netherlands (fig. 6) benefit from decreasing AETRs
(and METRs) than in other countries.27 In Finland (fig. 4) the federal income tax is quite
26 For tax schedules where the marginal tax rate rises continuously rather than in steps, every tax payer will face
higher marginal tax rates as a result of rising nominal incomes. The case of Germany, where marginal rates do
rise continually rather than in steps, would therefore be an interesting one to examine. It is planned to include
Germany in a later version of this paper.
27 This is because in the Netherlands the regressive social insurance contributions are, in terms of total receipts,
considerably more important than income taxes. They are also more regressive than in other countries. Employee
and employer health insurance contributions are no longer payable once employment income exceeds a certain
upper limit. On one hand, this reduces employee health insurance contributions to zero. On the other hand,
employer contributions are part of taxable income. The regressive effect of employee contributions is therefore
amplified by decreasing income taxes. See Immervoll (2000) for a more detailed description of the Dutch and
10
progressive with the largest number of tax bands (six plus a zero-tax band) of the countries
considered here. There are also no upper contribution limits and one part of the contribution
system (health insurance) actually exhibits a progressive rate structure. As a result, a large
number of employees are confronted with METR increases exceeding 5%. However, a large part
of the tax revenue is generated by the local income tax system, the tariff of which is proportional.
This dampens the effect on AETRs. Turning to Ireland (fig. 5), a larger number of taxpayers are,
compared to the other three countries, at the upper end of the income tax schedule (which
consists of only two tax bands). More persons are therefore affected by the erosion of deductions
and tax-free allowances. In addition, many employees have income below but close to the lower
limit of the upper income tax band. Consequently, bracket creep from the lower (24%) to the
upper (46%) marginal tax rate band has a larger effect than in other countries. Taken together,
these effects account for the large number of employees facing an increase in their average tax
rate of more than 5%. The large bracket creep effect also causes very substantial METRs
increases (>40%) for a substantial number of taxpayers. In the UK (fig. 7), the number of
employees whose METRs are unaffected by inflation is considerably higher than in other
countries. This is due to the wide income tax bands in this country. There are, however, a
relatively large number of employees with decreasing marginal rates. This can be explained by the
relative importance of income dependent benefits (see below).
In the ‘IT&BEN’ scenarios, AETRs show a further increase as the real value of benefits
decreases since, in these scenarios, benefit rules are no longer indexed to the price level. Child
benefits have the largest impact in this respect: 34% and 40% of all employees receive child
benefit in the UK and the Netherlands respectively; in Finland and Ireland, the fractions of
employees receiving the benefit are 42% and 40%. However, as discussed above, the effect of
unadjusted benefit rules on METRs often goes in the opposite direction. It is well known that,
because benefits are withdrawn as incomes increase, income tested benefits can cause very high
METRs. Once incomes exceed the level where the benefit is tapered to zero, the METR will
therefore drop significantly (often all the way to zero since for these low income levels, the tax
system may not ‘bite’ yet). If the benefit rules are not adjusted for inflation, a certain number of
benefit recipients are no longer eligible for income tested benefits after inflation causes their
nominal incomes to increase. These persons are therefore no longer affected by high withdrawal
rates and their METRs fall. This effect is documented by the difference in METRs between the
‘IT’ and ‘IT&BEN’ scenarios. Clearly, in this paper the impact of income tested benefits in this
respect depend on how many employees actually receive them in the baseline scenario. In 1998,
around 6.5% of UK employees working more than 10 hours received means tested benefits
(Income Support, Housing Benefit, Council Tax Benefit). A further 2.9% benefited from the
income and working hours related in-work benefit (Family Credit), causing a noticeable reduction
of METRs between the ‘IT’and the ‘IT&BEN’scenario.
In the Netherlands, the METR reducing effect of income dependent benefits is also considerable
since about 1.4% and 4.0% of employees are, respectively, in receipt of social assistance and rent
subsidy.28 With 0.2%, a much smaller fraction of Irish unionised employees receive social
British income tax and contribution rules. The 1998 tax and benefit rules and details about their simulation in the
model are described in the EUROMOD country reports, which are currently being produced. They will be
available from the author on request.
28 However, it is possible that the effect of rent subsidy is overestimated here. The reason is that there may be a
take-up issue, which is currently not taken into account in the simulations. The simulated 4% in receipt of housing
benefits contrast with a mere 1.3% who have claimed to receive this benefit in the 1996 microdata. A validation
exercise, which is currently underway for all 15 countries, is designed to clarify the sources of such deviations.
11
assistance (Family Income Supplement).29 As a result, not adjusting benefit rules for inflation has
only a minor effect on the number of employees with decreasing METRs: the bars in figure 5 are
almost identical for the 7%_IT and the 7%_IT&BEN scenarios. The same is true for Finland (fig.
4) where only 0.4% of employees receive social assistance. However, the changes in METRs
shown in the table should be interpreted with some caution. The Finnish microdata show that
housing benefit is received by a considerable number of unionised employees (7%). However, the
version of EUROMOD used here does not yet simulate Finnish housing benefits. The decrease in
METRs is therefore likely to be larger than indicated by the results presented here.
5. Discussion and Interpretation
In a recent study Auerbach and Feenberg (2000) look at the labour market effects of inflation
induced tax distortions in the context of a competitive labour market. They focus on how bracket
creep leads to rising marginal rates as taxpayers move across tax band schedules. In cases where
the average and marginal rates move in the same direction30, the focus on marginal rates is
justified because, as shown in figure 1, as long as the substitution effect is greater than the income
effect, changes in marginal and average tax rates will influence labour supply, and thus wages, in
the same direction. As argued above, however, models of imperfect labour markets predict that
marginal and average tax rates influence the outcome of the wage setting process in different
directions. Table 1 presents results, for three of the countries covered in this paper31, of empirical
studies of the impact of marginal and average tax rates on the real wage level. All three results
confirm the theoretical predictions.
How can these results be combined with the detailed information, discussed in the previous
section, on tax rate changes following inflationary distortions of the tax-benefit system?
Unfortunately, there is no straightforward way to do this. It is evident from the simulation results,
that inflation induced changes in METRs and AETRs vary considerably among employees.
Focusing again on the union wage setting model, this makes it likely that the tax rates of
employees of different unions will be affected differently. But the elasticities shown in table 1 are
not available at a disaggregated level. Furthermore, in estimating them, the variation in tax rates
necessary for eliciting elasticities has only been measured in relation to one employee who is
deemed to be representative: Studies estimating wage equations typically take an approach as
follows (e.g. Lockwood and Manning, 1993). First, it is assumed that the distribution of tax rates
is the same in all unions. As a result, it is not necessary to identify who belongs to which union.
Secondly, the union is supposed to base its target wage on the tax rates faced by an employee
with average earnings living in a household which is considered to be ‘typical’. It follows that it is
sufficient to know the tax rates faced by the employee with average earnings - calculating the tax
rates of a large number of different employees can thus be avoided.32
29 Housing benefits are not important in this group either.
30As demonstrated above, this is not the case for all individuals.
31I am not aware of any empirical studies for Ireland.
32Resorting to this latter assumption also means that it is not necessary to specify an aggregation rule for the
different preferences faced by the members. By only considering the tax variables of the 'typical' employee, one
implicitly assumes that the union's preferred wage is identical with the 'typical' employee's. See Booth (1985),
Oswald (1982) and Oswald (1985) for different approaches to aggregating preferences across the membership of a
union.
12
The currently available elasticities of wages with respect to marginal and average tax rates do, in
other words, not support the level of disaggregation at which changes in AETRs and METRs
have been computed here. Yet, since benefits and taxes are strongly dependent on earnings, the
family situation and other characteristics, ignoring the influence of the distribution of these
characteristics on employee's tax rates and, thus, the union's target wage can clearly produce
misleading results. In order to still be able to speculate on possible influences of 'bracket creep' on
the wage level I have, nevertheless, used the elasticities from table 1 for illustrative purposes.
Despite the fact that elasticities have been generated by using the tax rate changes of the average
union member (rather than the average tax rate changes of all union members) as explanatory
variables, I have used them to compute the effect on real wages of the mean change in AETRs
and METRs. The results are reported in table 2. They indicate that inflation induced distortions of
the tax-benefit system do cause cost-push effects through real wage increases. However, for
reasons stated above, these results leave much to be desired and the numbers can therefore not be
regarded as reliable estimates.33
It is useful in this context to highlight the desirability of enriching the specification of microeconometric models through the incorporation of tax-benefit microsimulation.34 As is evident
from the difficulties discussed here, this seems necessary because in practice, “trade union
members have different labour and non-labour incomes, different family characteristics, etc. and
face different marginal and average tax rates [… ] The empirical studies of tax effects on wage
formation normally use aggregate time-series and do not allow for the microeconomic diversity
that microeconometritians would like to emphasize.”35
6. Conclusion
This paper has described an approach to the detailed measurement of changes in marginal and
average effective tax rates following inflation induced distortions of the tax-benefit system. A
preliminary version of EUROMOD was used to compute inflation induced changes of effective
tax rates for representative samples of the population of four European countries. The approach
therefore takes into account both the complexities of tax-benefit systems and the heterogeneity of
taxpayers and benefit recipients in the population and produces results for both the levels and the
distribution of marginal and average effective tax rates. Furthermore, the simulation method is
33A few other limitations should be noted here. The most important is probably that the range of results obtained
from different studies of the wage effects of taxes in imperfect labour markets is considerable. Recently there have
been some studies extending the wage setting model used in earlier studies (Anderson et al., 1999; Hansen et al.,
2000; Hansen, 1999; Fuest and Huber, 2000). Even though these recent results do not necessarily overturn the
qualitative results obtained in earlier papers, they do illustrate the need for a more refined understanding of the
wage setting process. It seems particularly important to establish how trade unions elicit and aggregate union
members’ preferences. Unless the target wage is voted on (in which case preferences are elicited automatically), it
is not clear to what extent unions take into account the complexities of the tax-benefit systems, which affect their
members’ tax rates (however, in voting models, a similar problem arises in that union members may themselves
not perceive the tax-benefit system ‘correctly’. See, e.g., Arrazola et al. (2000)). In some sense, therefore, there is
a possibility that detailed tax-benefit modelling may be ‘too detailed’. For a detailed discussion on more general
issues relating to the reliability of microsimulation results for population sub-groups see Pudney and Sutherland
(1994).
34Numerous studies examining the role of tax-benefit systems in labour supply decisions have successfully done
this. See for example Blundell et al (2000), Callan (2000), Duncan and Weeks (1997), Callan and van Soest
(1993).
35 Christiansen, V. (1997), ‘Discussion’, in: P.B. Sorensen (1997), op cit., p. 252.
13
able to isolate the effect of distortions of unadjusted tax and benefit rules, while holding
‘everything else’constant.
It has been argued that the extent to which inflation induced tax increases (and benefit reductions)
potentially contribute to a cost-push effect through higher real wages will crucially depend on the
actual structure of the labour market. In addition, however, it has become apparent that however
the wage setting process is being modelled, the effect on the wage outcome will be a function of
(1) the detailed structure of the tax-benefit system; (2) the extent and scope of adjustments of the
tax-benefit system to price-level changes; and (3) the structure of the population. Using taxbenefit microsimulation it is possible to capture these three dimensions.
The main contribution of the present study is to give a detailed picture of the joint effects of
inflation and an unadjusted tax-benefit system on marginal and average effective tax rates. The
most important result is that the impact varies considerably between employees. Estimates from
existing studies on the role of marginal and average tax rates in the wage setting process have
then been applied to the simulated tax rate changes. The results indicate that in an unadjusted taxbenefit system, inflation does tend to exercise a moderate upward pressure on labour costs.
However, it has been argued that the methodology underlying available elasticities of wages with
respect to marginal and average tax rates are too simplistic since models used to estimate them
only focus on the 'representative' tax payer. They ignore the fact that tax rates will be subject to
quite different changes depending on taxpayers’ earnings, family situation, etc. Tax-benefit
microsimulation can provide a remedy in this context. It can be used to enrich econometric
models used for estimating elasticities of wages by providing detailed tax and benefit estimates
separately for each observation.
14
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16
Table 1. Sensitivity of real wages with respect to marginal and average tax rates.
Country
Elasticity of real pre-tax wages wrt1
FI
average retention ratio
(1-ta)
-1
marginal retention ratio
(1-tm)
0.3
NL
-0.61
0.18
UK
[-0.64, -1.40]
[0.65, 1.40]
1
The elasticities given for Finland, the Netherlands and the UK are those estimated by Tyrväinen (1995) taken
from Sorensen (1997); Graafland and Huizinga (1996); Lockwood and Manning (1993), respectively. Where
intervals are shown, they represent the maxima and minima found in studies using alternative estimation
approaches or measurement periods.
Table 2. Changes in pre-tax wages following inflation.
Country
FI1
average change in
METRs
7%_IT
7%_IT&BEN
+2.17%
+2.00%
average change in
AETRs
7%_IT
7%_IT&BEN
+16.05%
+20.45%
change in real pre-tax
wage
7%_IT
7%_IT&BEN
+0.4%
+0.8%
IR1
+4.53%
+4.12%
+5.25%
+6.29%
NL2
+0.75%
-0.13%
+3.21%
+6.03%
+0.4%
+0.9%
UK2
+1.34%
+0.37%
+4.19%
+6.41%
[-0.1%;
+0.1%]
[+0.6%;
+1.3%]
Source: EUROMOD and own calculations based on table 1.
1
Changes in METRs and AETRs are averaged across unionised employees only.
2
Changes in METRs and AETRs are averaged across all employees (no union membership information is
available in the micro-data used).
17
Figure 1. The role of marginal and average tax rates in a competitive labour market.
net income
1
1
(1- mtr 0) ⋅w
a
w
B0
Bm
Um
Ba
U0
Ua
b
hm
leisure
ha
h0
18
Source: EUROMOD
.7 t
o
.75
.7
.65
.65
to
.6 t
o
.6
.55
.55
to
.5 t
o
.5
.45
.45
to
.4 t
o
.4
.35
.35
to
.3 t
o
.3
.25
.25
to
.2 t
o
.2
.15
.15
to
.1 t
o
.1
.05
.05
to
0 to
0
<0
Share
Figure 2.
Distribution of Marginal Effective Tax Rates (Employees)
60%
50%
40%
30%
20%
10%
0%
Source: EUROMOD
.2 t
o
.25
.2
.15
.15
to
.1 t
o
.1
.05
.05
to
0 to
0
-.05
-.05
to
-.1
to
-.1
-.15
-.15
to
-.2
to
-.2
-.25
-.25
to
-.3
to
-.3
-.35
-.35
to
-.4
to
-.4
-.45
30%
-.45
to
-.5
to
<-.5
Share
Figure 3.
Distribution of Average Effective Tax Rates (Employees)
35%
UK
Finland
Netherlands
Ireland
25%
20%
15%
10%
5%
0%
Figure 4.
FI: Distribution of Changes in Marginal Effective Tax Rates
20%
18%
7%_IT Scenario
16%
7%_IT&BEN Scenario
14%
0% Change:
65.4% (7%_IT Scenario)
65.1% (7%_IT&BEN Scenario)
Share
12%
10%
8%
6%
4%
2%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
0
-5 t
o
-5
-10
to
-10
-20
-15
-15
to
-20
to
-25
-25
to
-30
to
-30
-35
to
-35
-40
to
<-4
0
0%
Change [%]
FI: Distribution of Changes in Average Effective Tax Rates
85%
80%
75%
70%
65%
7%_IT Scenario
60%
7%_IT&BEN Scenario
55%
Share
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
=0
<0
0%
Change [%]
Source: EUROMOD
21
Figure 5.
IR: Distribution of Changes in Marginal Effective Tax Rates
20%
18%
Share
16%
7%_IT Scenario
14%
7%_IT&BEN Scenario
12%
0% Change:
64.3% (7%_IT Scenario)
64.1% (7%_IT&BEN Scenario)
10%
8%
6%
4%
2%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
0
-5 t
o
-5
-10
to
-10
-20
-15
-15
to
-20
to
-25
-25
to
-30
to
-30
-35
to
-35
-40
to
<-4
0
0%
Change [%]
IR: Distribution of Changes in Average Effective Tax Rates
85%
80%
75%
70%
65%
7%_IT Scenario
60%
7%_IT&BEN Scenario
55%
Share
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
=0
<0
0%
Change [%]
Source: EUROMOD
22
Figure 6.
NL: Distribution of Changes in Marginal Effective Tax Rates
20%
18%
7%_IT Scenario
16%
7%_IT&BEN Scenario
14%
0% Change:
65.8% (7%_IT Scenario)
64.2% (7%_IT&BEN Scenario)
Share
12%
10%
8%
6%
4%
2%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
0
-5 t
o
-5
-10
to
-10
-20
-15
-15
to
-20
to
-25
-25
to
-30
to
-30
-35
to
-35
-40
to
<-4
0
0%
Change [%]
NL: Distribution of Changes in Average Effective Tax Rates
85%
80%
75%
70%
65%
7%_IT Scenario
60%
7%_IT&BEN Scenario
55%
Share
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
=0
<0
0%
Change [%]
Source: EUROMOD
23
Figure 7.
UK: Distribution of Changes in Marginal Effective Tax Rates
20%
18%
7%_IT Scenario
16%
7%_IT&BEN Scenario
14%
0% Change:
85.2% (7%_IT Scenario)
84.4% (7%_IT&BEN Scenario)
Share [%]
12%
10%
8%
6%
4%
2%
>40
35
40
25
to
25
to
30
to
30
25
20
to
20
15
to
10
15
10
to
5 to
5
0 to
0
-5 t
o
-5
-10
to
-10
-20
-15
-15
to
-20
to
-25
to
-25
-30
to
-30
-35
to
-35
-40
to
<-4
0
0%
Change [%]
UK: Distribution of Changes in Average Effective Tax Rates
85%
80%
75%
70%
65%
7%_IT Scenario
60%
7%_IT&BEN Scenario
Share [%]
55%
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
>40
40
25
to
35
30
to
30
25
to
25
20
to
20
15
to
15
10
to
10
5 to
5
0 to
=0
<0
0%
Change [%]
Source: EUROMOD
24