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Does Formal Work Pay? The Role of Labor Taxation and Social Benefit Design in the New EU Member States

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  • Koettl, Johannes

    ()
    (World Bank)

  • Weber, Michael

    ()
    (World Bank)

Abstract

The analysis presented in this paper defines three different synthetic measurements of disincentives for formal work: two standard measurements, namely the tax wedge and the marginal effective tax rate (METR); and a new, innovative measurement called formalization tax rate (FTR). The novelty of the latter is that it measures disincentives stemming not only from labor taxation, but also from benefit withdrawal due to formalization. A descriptive analysis across a large number of OECD and Eastern European countries reveals that the disincentives for formal work – when measured through the FTR – are especially high for low-wage earners. This suggests that formal work might not pay in this segment of the labor market, in particular for the so-called mini-jobs and midi-jobs (low paying part-time work). Another novelty of the paper is its empirical approach. Using EU-SILC 2008 data and OECD Tax and Benefit data for six Eastern European countries (Bulgaria, Czech Republic, Estonia, Latvia, Poland, and Slovakia), we match disincentives for formal work to individual observations in a large data set. Applying a probit regression, the analysis finds a significant positive correlation between FTR or METR and the incidence of being informal. In other words, controlling for individual and job characteristics, the higher the FTR or the METR that individuals are facing is, the more likely they are to work informally. The tax wedge, on the other hand, yields a negative correlation. This indicates that the tax wedge is not sufficiently capturing disincentives for formal work. We also conclude that in cross-country analysis, it might be more useful to use the tax wedge that applies to low wage earners as opposed to average wage earners.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 6313.

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Length: 35 pages
Date of creation: Jan 2012
Date of revision:
Publication status: published in: Research in Labor Economics, Vol. 34, 2012
Handle: RePEc:iza:izadps:dp6313

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Related research

Keywords: formalization tax rate; measurement of work disincentives; informal employment; non-wage labor costs and benefits; tax evasion;

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References

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  1. Benno Torgler, 2003. "Tax Morale and Institutions," CREMA Working Paper Series 2003-09, Center for Research in Economics, Management and the Arts (CREMA).
  2. Andrea Bassanini & Romain Duval, 2006. "Employment Patterns in OECD Countries: Reassessing the Role of Policies and Institutions," OECD Economics Department Working Papers 486, OECD Publishing.
  3. Jaime Saavedra & Alberto Chong, 1999. "Structural reform, institutions and earnings: Evidence from the formal and informal sectors in urban Peru," Journal of Development Studies, Taylor & Francis Journals, vol. 35(4), pages 95-116.
  4. Benno Torgler, 2003. "Tax Morale in Transition Countries," Post-Communist Economies, Taylor & Francis Journals, vol. 15(3), pages 357-381.
  5. Hazans, Mihails, 2011. "Informal workers across Europe : evidence from 30 European countries," Policy Research Working Paper Series 5912, The World Bank.
  6. Herwig Immervoll & Mark Pearson, 2009. "A Good Time for Making Work Pay? Taking Stock of In-Work Benefits and Related Measures across the OECD," OECD Social, Employment and Migration Working Papers 81, OECD Publishing.
  7. Steven J. Davis & Magnus Henrekson, 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," NBER Working Papers 10509, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Gill, Indermit & Koettl, Johannes & Packard, Truman, 2013. "Full Employment: A Distant Dream for Europe," IZA Discussion Papers 7663, Institute for the Study of Labor (IZA).
  2. David Robalino & Michael Weber, 2013. "Designing and implementing unemployment benefit systems in middle and low income countries: beyond risk-pooling vs savings," IZA Journal of Labor Policy, Springer, vol. 2(1), pages 1-20, December.
  3. H. Lehmann & A. Muravyev, 2012. "Labor Market Institutions and Informality in Transition and Latin American Countries," Working Papers wp854, Dipartimento Scienze Economiche, Universita' di Bologna.
  4. Oral, Isil & Santos, Indhira & Zhang, Fan, 2012. "Climate change policies and employment in Eastern Europe and Central Asia," Policy Research Working Paper Series 6294, The World Bank.

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