Beyond the Labour Income Tax Wedge: The Unemployment-Reducing Effect of Tax Progressivity

In this paper we argue that, for a given overall level of labour income taxation, a more progressive tax schedule increases employment. From a theoretical point of view, higher progressivity increases overall employment through a wage moderating effect and also because employment of low-paid workers is more elastic to wages. We test these theoretical predictions on a panel of 21 OECD countries over 1998-2008. Controlling for the burden of taxation at the average wage, our estimates suggest that a more progressive tax schedule reduces the unemployment rate and increases the employment rate. These findings are confirmed when we account for the potential endogeneity of both average taxation and progressivity. Overall, our results suggest that policy-makers should not only focus on the detrimental effects of tax progressivity on in-work effort, but also consider the employment-enhancing effects.