Journal Issue
IMF Working Paper Summaries (WP/95/1 - WP/95/61)

Summary of WP/95/17: “Excess Wages Tax”

International Monetary Fund
Published Date:
August 1995
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Excess wages tax (EWT) is a tax-based incomes policy instrument used by some countries in transition. Under EWT, the government taxes the excess of the wage bill above the norm, calculated typically on the basis of inflation and some multiple of the prevailing minimum wage. The main goal of EWT is to curb inflationary pressures by penalizing through taxation the “excessive” wage awards granted by enterprises in the course of wage and price liberalization. This paper examines the effect of EWT on enterprise behavior, wages, and profits, and its possible impact on inflation.

First, EWT’s impact on the profit-maximizing enterprise under monopsony is examined as a benchmark. The paper shows that EWT increases the marginal cost of labor. Consequently, although EWT serves to lower the wage award, this is achieved at the cost of lower output and employment, and smaller profits. Also. EWT penalizes more productive enterprises. The impact of EWT on total tax revenue (standard corporate tax revenue plus EWT revenue) is ambiguous because even though the statutory tax base with EWT is broader, taxable profit is smaller. Furthermore, although EWT can curb enterprises’ wage awards in the face of inflation, EWT can be pro-inflationary and even result in stagflation, depending on the government’s minimum wage policy.

A more realistic model for enterprise behavior in the economies in transition is provided by the labor-dominated enterprise. In this case, with homogeneous labor, it is shown that EWT results in a decline in wages. With heterogeneous labor (managers and workers), wages will also decline, regardless of whether labor shedding is feasible. However, the paper argues that the impact of EWT on wages is moot and that the main determinant of wage awards is the degree of fiscal discipline imposed by the government or the extent to which the government subsidizes the enterprise. It is further argued that EWT does not necessarily curb asset stripping by the employees to pay for larger wage awards.

The experience with EWT in some countries in transition is reviewed briefly. Notably, the evidence from Poland suggests that while EWT has reduced wage awards, it has penalized more productive enterprises, is likely to be highly distortionary, and is not directly correlated with asset stripping. The evidence concerning the impact of EWT on inflation is inconclusive.

The paper suggests that the only role for EWT might be as a temporary measure implemented on the way to privatization and competition. However, even in this role, the distortions introduced would be likely to slow the pace of transition, discourage rapid adaptation, and penalize efficiency and innovation. It is better to control credit expansion, impose credible budget constraints and performance requirements on state-owned enterprises, permit bankruptcy when necessary, and expose the protected enterprises to competition and privatization.

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