Informality, inactivity, and the role of labor taxes and social benefits

Johannes KoettlEurope and Central Asia Region – Human Development SectorThe World Bank

Brussels December 15, 2010

Does formal work pay in the Western Balkans?

Motivation Missing link between social benefits and

work incentives Tax wedge on formal work

Welfare dependency? Working poor? Inactivity? Informality?

Focus on: Informal employment (and inactivity) Measurements of disincentives (marginal

effective tax rate and formalization tax rate)

Characteristics of informality and inactivity

Typical informal worker: Self-employed, employee, or unpaid

family worker Aged 40 to 64 With completed primary education

Also inactive have low educational attainment

Low earnings potential for informal and inactive

Labor taxation Income taxes and social security contributions

increase the difference between labor costs and take-home pay (tax wedge)

increase therefore the incentives for informality Tax wedge: the share of taxes in total labor

costs:

The higher the tax wedge, the higher incentives for informal employment

At low-wage levels, high tax wedge in BH-FED and Serbia

Source: OECD Tax and Benefit Model

Tax wedge for singles at 33 percent of average wage in OECD and Western Balkans (2008/09)

Two concepts to measure work disincentives Marginal effective tax rate (METR): how

much is taxed away by earning 1 additional dinar? Takes into account

Taxes and social security contributions But also benefit withdrawal

Formalization tax rate (FTR): how much is taxed away from informal income if compared to same worker with formal income? Takes into account

Taxes and social security contributions But also benefit withdrawal

Are benefits gained from formal work worth the cost?

Serbia: For singles, tax wedge (minimum social security contributions) drives implicit costs of formal work

Source: OECD Tax and Benefit Model

Single with no children, working part-time at average wage

In addition, 1-to-1 withdrawal of social assistance increases FTR to 80%

Source: OECD Tax and Benefit Model

Single with no children, working part-time at average wage

For families, minimum social security contributions and income tax drive high costs of formal work

Source: OECD Tax and Benefit Model

One-earner couple working part-time at average wage, with two children

In addition, withdrawal of social assistance and family benefits provide disincentives for formal work

Source: OECD Tax and Benefit Model

One-earner couple working part-time at average wage, with two children

Additional disincentives for formal work

Unemployment insurance: complete loss of benefits, even because of limited part-time work

Allow for part-time work (or in-work benefits)

Municipal benefits Health insurance for the unemployed Should not be based on formal income,

but on (proxy) means testing

Conclusions High informal employment in private sector

Among agricultural workers Among low-wage earners

Low labor force participation Does formal work pay for low-wage earners?

Relative high taxation on lower-wages (minimum social security contributions in Serbia)

Sudden loss of social benefits (social assistance, family benefits, municipal benefits) from formal income

Some benefits (health insurance) available for free to informal workers

Formal “mini-jobs” and ”midi-jobs” don’t pay

Policy implications Consider lowering tax wedge on lower wages

Abolish minimum social security contributions, allow adjustment for part-time work

Balance with fiscal concerns More progressive labor taxation?

Streamline social benefit design Means testing instead of formal income testing No sudden withdrawal of benefits, but phased-in

withdrawal (make work pay) Reform health insurance for unemployed