Fiscal Implications of Personal Tax Adjustments in the Czech Republic

We investigate the fiscal implications of the changes in personal income tax implemented in the Czech Republic in January 2006. In addition to evaluating the direct effect of this tax reform, our analysis takes into account its employment effect on the government budget due to individuals entering or leaving employment. We first estimate the probability of working (labor supply) as a function of the effective net wage and then simulate the impact of the changes in paid taxes and received benefits on employment. We find that a 10 percent rise in the net wage increases the probability of working by 0.55 and 0.18 percentage points for women and men respectively. These estimates suggest that the employment effect is unlikely to substantially alleviate the fall in net budget revenues. We predict that, for the sub-population of prime age employees, net government revenues decline by roughly 8 billion Czech korunas (CZK) as a consequence of the implemented income tax cuts. The employment effect counteracts the decline by only CZK 0.4 billion. The stimulating effect of the tax reform on employment is reduced by the current benefit system: the incentive to work due to the higher after-tax wage is partially offset by the fall in social benefits once people start working.