Tax cuts and employment: Evidence from Finnish linked employer-employee data

We analyse taxes and employment in a system of firm-level labour demand and industry-level regional labour supply, using linked employer-employee data from Finland in 1990- 2003. We show that virtually all of the wage tax burden is borne by employers since wages fully adjust. Labour demand also responds with short lags within a year or two to cuts in taxes and labour costs. A unit decrease in wage tax rate (2.2% lower taxes) leads to an average long-run employment improvement of 0.8%, while an equivalent cut in social security payments has effects that are nearly twice as low. Tax cuts thus explain a substantial part of the recent improvement in employment since the deep recession of the early 1990s (besides the release of firms liquidity constraints). Nearly half of the tax revenue loss due to wage tax cuts is paid back in the form of higher employment and lower unemployment costs. Tax cuts with emphasis on low-wage, low-productivity firms may appear undesirable, as tax cuts cure employment of low- skilled workers especially in skill-intensive firms.