Study on the effects and incidence of labour taxation. Final report

In the aftermath of the financial crisis most European countries are continuing to face employment problems. In a number of Member States government intervention has further resulted in increasing debt levels and high tax burdens overall and in particular on labour. Therefore well-targeted tax reforms seem to be in order to improve the labour market outcomes. It is often implicitly assumed that a decrease on the employee side, i.e. in the personal income tax rate or the employee part of social security contribution, leads to a higher labour supply. Similarly, a decrease in the employer labour taxes is often assumed to raise the demand of labour. However, the economic literature argues that in the presence of labour market imperfection economic incidence of a tax change is often different from the legal incidence. In this case the impact of a tax change on labour market outcomes depends on the interaction of the demand and the supply side of the market. This interaction is determined by the behaviou al responses of economic operators, measured by elasticities. Higher (demand or supply) elasticities will cause larger responses to tax changes, with the relatively less elastic side bearing a higher tax burden. Against this background four main goals of this study emerge. First, is to identify from the literature which labour market imperfections result in employment problems and to attribute them to the labour supply or on the labour demand side. Given the heterogeneity in the labour market situation of different groups, we also set out to identify which socioeconomic groups are most vulnerable to employment problems. The next step is to review the literature which assesses the short-run and long-run economic incidence of labour taxation. To further break down the incidence into its underlying determinants we also review the literature on the (tax) elasticities of labour supply and labour demand. Then the literature on the influence of the economic environment on the tax incidence outcome, most notably the wage setting mechanisms and the institutional background, is reviewed. Finally the findings of the literature review are brought together in a framework of indicators to identify the potential of tax reforms to reduce tax related employment problems.