The fiscal effects of work-related tax expenditures in Europe

The paper examines the fiscal impacts, and the associated welfare cost, of marginal reforms to work-related tax relief in five European countries. We combine a theoretical model of labour supply with micro-simulation results from an EU-wide model, which allows us to capture the interaction between the specific tax incentive and other relevant provisions of the tax-benefit system along the entire earnings distribution. We find that changes in labour supply decisions – both at the extensive (participation) and at the intensive margin (hours worked) – have significant impacts on the revenue gain from the simulated reforms. Our results suggest that at least one-fourth of the extra tax revenues collected through a reduction in work-related tax incentives is washed away following labour supply adjustment, notably due to lower participation by individuals most at risk of exclusion. In some instances, the erosion of the initial revenue gain becomes substantial. For policies strongly targeted at the bottom of the earnings distribution, the reform might even bring about a net revenue loss, depending on the calibration of the labour supply elasticities to reflect heterogeneity across types of workers. The welfare effect of contractions to these tax schemes could be far from negligible.