Abstract
This Selected Issues paper and Statistical Appendix on Ireland examines the productivity growth in Irish traded and nontraded goods, and provides some rough estimates of the sort of wage and inflation differentials that would be predicted by a Balassa–Samuelson framework under certain growth assumptions for the future. The paper provides a framework for judging what sort of wage growth and inflation could be sustained over the medium term without leading to a loss of competitiveness. The paper also examines traded and nontraded productivity in Ireland.
IV. Work Incentives and Recent Labor Market Policies36
A. Introduction
1. At a time when jobs are abundant and labor shortages are intensifying, long-term unemployment, although gradually diminishing, remains high. With the long-term unemployed comprising almost half of all individuals out of work, the major challenge of labor market policies has shifted from job creation to improving labor skills and work incentives.
2. This note examines changes in incentives to work in 1997–99, and looks into potential implications of the introduction of the national minimum wage (NMW) for employment. In the last two budgets the government made significant efforts to improve incentives to work for low wage earners and the unemployed by reducing the burden of personal income taxation, extending the eligibility for certain social welfare benefits for the first three years of their employment, and by raising the level of personal tax allowances above the tax exemption limit. In September 1998, the government introduced interviews for young benefit claimants—under 25 years of age—which led to a significant reduction in the number of benefit recipients. In the first six months of interviews, 61 percent of those contacted left the Live Register, with a substantial portion of the leavers never turning up for the interviews. This, however, is not the first-best solution, since only about half of those leaving long-term unemployment are progressing to work, education, or training, while the rest leave the labor force.
3. The current government considers the introduction of the minimum wage as a priority step in addressing the issue of social exclusion, marginalization, and poverty. The National Minimum Wage Commission, appointed in July 1997, recommended that a minimum wage be set at the rate of two-thirds of the median wage for full-time workers, which at that time was equivalent to IR£ 4.40 per hour. The Commission also recommended setting a lower rate of 70 percent of the full rate for young workers under 18 years of age, and also a separate training rate for job entrants without experience, regardless of age. This reduced rate was proposed to apply on the basis of a sliding scale—at 75 percent of the full rate in the first year of work, increasing to 80 percent and 90 percent of the full rate in the second and third years, respectively.
4. The next section of the paper gives a brief summary of the composition of unemployment in Ireland, and the third part examines the effects of changes in social welfare and tax systems on incentives to work, faced by unemployed and low-income workers. The fourth section of the paper studies the potential demand and supply effects of the introduction of the NMW, and the last section is the conclusion.
B. Composition of Unemployment
5. Changes in Ireland’s economic structure—rapid expansion of high technology sectors and modernization and restructuring of indigenous industries—have shifted labor demand in favor of skilled labor, and reduced employment opportunities for unskilled workers.
6. The figure below indicates that the incidence of low educational attainment is much higher among unemployed, than those at work—almost two-thirds of unemployed have only a primary or a low secondary level of education, in contrast with 39 percent among employed.
Education Level by Employment Status
(In percent of total number in the employment category)
Citation: IMF Staff Country Reports 1999, 108; 10.5089/9781451818772.002.A004
Source: OECD.7. Almost half of the group of people whose educational attainment is limited to a primary education are young—from 15 to 39 years of age—and unemployed. The share of the young and unemployed increases to 75 percent for the group whose educational attainment is limited to a lower secondary education.
Age Distribution of Unemployed with Low Educational Attainment
(In percent of total number in the educational category)
Citation: IMF Staff Country Reports 1999, 108; 10.5089/9781451818772.002.A004
Source: OECD.8. The high proportion of young poorly educated unemployed people is a particular problem, since their chances of finding a job without additional training will diminish over time. The 1997 Annual School Leavers’ Survey found that economic status of young people one year after leaving school was strongly related to the level of educational attainment, and that frequency of unemployment increased with low level of education.
9. Apart from work incentives, the economic status of working age people depends on market demand for certain types of labor, which determines an individual’s employability in general, and the wage rate the person can command, in particular. As market demand shifts toward more skilled labor, the incidence of unemployment among unskilled workers would tend to increase and the differential between the wages of skilled and unskilled workers would tend to widen.
C. Changes in the Tax and Social Welfare Systems and Incentives to Work
10. The supply side of the labor market is affected by tax and benefit systems through their effects on incentives to work. Incentives to work are usually measured by replacement ratios, which are defined as the ratio of income when unemployed, to the net income from work—after taxes and transfers. Replacement ratios indicate the opportunity cost of staying out of work, compared with that of being employed. Both high levels of social welfare benefits and low levels of net earnings raise the opportunity cost of working and translates into high replacement ratios.
11. Individuals at low levels of income in Ireland face high replacement ratios, especially when the values of non-cash benefits are included. Replacement ratios in Ireland have been declining during the 1990s, and currently stand at an average rate of 51 percent, broadly in line with the European Union (EU) average. For low-income households, however, the average replacement ratio in Ireland is the second highest in the EU after Denmark.37 As in other EU countries, people with low education in Ireland tend to have higher replacement ratios (76 percent) than those with high level of education (32 percent).38 The proportion of unemployed persons among low-income households with replacement ratios in excess of 100 percent is strikingly high in Ireland—23 percent, compared with the EU average of 16 percent.
12. The designs of the tax and social welfare systems are important determinants of incentives to work. As suggested by the Report of the Expert Working Group on the Integration of the Tax and Social Welfare Systems, tax and social welfare policies had not been well coordinated in the 1980s and early 1990s, and multiple policy objectives of the government had also contributed to high replacement ratios. For example, significant increases in social welfare benefits and personal income taxation were responsible for high replacement ratios in the 1980s. By introducing a system of marginal tax relief and tax exemption limits in mid-1980s, as well as a family income supplement for low-paid workers, the government tried to offset the detrimental effect of high replacement ratios on work incentives. 39 This attempt, however, was not entirely successful since the combination of tax exemption limits, marginal tax relief and child additions resulted in a poverty trap—a situation, when individuals are worse off at higher, rather than lower gross income levels, because as gross incomes rise incomes net of taxes may fall. In addition, the policy of wage moderation tended to be supportive of high replacement ratios, since social welfare benefits increased in line with earnings.
13. Government measures directed at strengthening work incentives introduced in the last three budgets (1997–99) can be assembled in two broad categories: (1) changes in personal income taxation and social security contributions; and (2) changes in eligibility and levels of social welfare benefits. In the 1997 and 1998 budgets, tax measures included narrowing the gap between general tax exemption limits and personal tax allowances, widening the standard income tax band, and reducing the standard rate of personal income tax and that of the pay-related social insurance contributions. The income threshold to qualify for a Family Income Supplement was raised, and calculation of entitlement to the benefit was switched from gross to a net basis.
14. The replacement ratios, calculated by the Department of Finance, are broadly based. They take into account cash and non-cash payments received by the unemployed, including the value of the medical card and that of other secondary benefits. Net income from work is calculated, including the family income supplement and excluding any amount for travel costs.
Replacement Ratio Differentials
(1995-98, in percentage points)
Citation: IMF Staff Country Reports 1999, 108; 10.5089/9781451818772.002.A004
Source: The Department of Finance, OECD, and staff estimates.15. As suggested by the figure above work incentives increased most for households with two children on incomes in the range of IR£10,000–13,000, while work incentives for single people did not improve significantly.40 Changes in replacement ratios in 1995–98 were broadly in line with changes in average marginal rates of taxation (for all groups of taxpayers), but a larger decline in replacement ratios of married people with two children was the most likely to reflect changes in the calculation of entitlements to the family income supplement.41
16. In the 1999 budget, personal tax allowances were raised to the level in excess of general exemption limits for people under 65 years of age, and it was announced that these measures would allow the government to remove more than 80,000 taxpayers from the tax net. The personal income tax measures are expected to reduce the average rate of taxation of a single person by about 3 percent, and that of a married individual with two children by 1.5 percent. The figure below illustrates effects of the tax package of the 1999 budget across different income groups.
Changes in Average Rates of Taxation, 1999 budget measures over 1998
(In percentage points)
Citation: IMF Staff Country Reports 1999, 108; 10.5089/9781451818772.002.A004
Source: The Department of Finance, and staff estimates.17. These measures, however, are not expected to have a significant effect on replacement ratios (See figures below). Gains from increases in social welfare benefits would in many cases offset at least, partially, improvements arising from the tax package.
D. Labor Market Effects of the Introduction of the Minimum Wage42
18. The government has announced its intention to set the minimum wage at IR £ 4.40 per hour when it is introduced early next year. However, unions are currently pressing for a realignment of the rate to two-thirds of current median earnings—approximately IR£5 per hour as of December 1998.
19. Even at IR£4.40 per hour, the proposed NMW rate appears high compared with minimum wages of other industrialized countries (see table below). In addition, although the share of employees affected by the introduction of the NMW has fallen by more than 40 percent in comparison with that estimated in 1997, it is still high by international standards: about 13.5 percent of all employees would have a wage rate below IR£4.40 per hour in 2000, which is broadly in line only with Mexico and France, where the share of employees affected by minimum wages was 17.6 percent and 11 percent, respectively.43 As suggested by OECD, in all other cases the share of those affected by minimum wages was significantly lower than that in Ireland, varying in the range of 3.7–5.1 percent of total employment, which suggests that the effects of the NMW on the wage structure in Ireland could be larger than in other countries.
Minimum Wages in 1998
Minimum Wages in 1998
| U.S. Dollar/hour | As a ratio of average earnings | |
|---|---|---|
| Ireland (proposed) | 6.0 | 0.58 |
| France | 7.2 | 0.55 |
| United Kingdom | 5.4 | 0.38 |
| United States | 5.2 | 0.39 |
Minimum Wages in 1998
| U.S. Dollar/hour | As a ratio of average earnings | |
|---|---|---|
| Ireland (proposed) | 6.0 | 0.58 |
| France | 7.2 | 0.55 |
| United Kingdom | 5.4 | 0.38 |
| United States | 5.2 | 0.39 |
20. An Inter-Departmental Group commissioned by the government to study the likely impact of the NMW on employment, competitiveness, and inflation, however, found that the employment effects of the NMW are likely to be relatively limited. In the long run the introduction of the NMW was expected to result in a reduction in employment of less than 1 percent, and an increase in the unemployment rate of 0.5 percentage points. The Group’s report suggests that the introduction of the NMW would also improve incentives to work and be instrumental in raising the labor supply, although the effects on the labor demand appear to be downplayed. The effect on prices would also be limited with consumer prices estimated to rise by 0.5 percent. However, the NMW is not likely to meet its ultimate objective of poverty reduction, given that most families gaining from the minimum wage in terms of disposable income are in the middle of the income distribution. These findings are discussed in greater detail below.
NMW and incentives to work
21. While most families gaining from the NMW in terms of disposable income are in the middle of the income distribution, low-paid workers and the unemployed are also expected to benefit. The work incentives of these two groups will improve significantly, and thus replacement ratios will decline, since the level of wages they face on the free market is significantly below the proposed NMW rate. The figure below shows how the distribution of replacement ratios for the unemployed shifts when the NMW is introduced. In particular those currently experiencing a replacement ratio above 50–60 percent (i.e., most unemployed, low-wage earners) would find their ratio pushed down below 50 percent (peaking at 40–50 percent).
22. Gains from the introduction of the NMW vary by the composition of the household. The majority of those gaining from the introduction of the NMW are single employees or two-earner families, and only 3 percent of single earner families are likely to be affected by the NMW. The effect is likely to be particularly significant for younger men with low education levels. However, the tax implication of returning to work and the reduction in social welfare payments are likely to weaken the incentives for people with more children.
23. The report estimates that the NMW will have a positive supply effect on labor force participation. (See table below.) Increased labor force participation itself was expected to generate an increase in unemployment of 23,700 (a 1.4 percentage point increase in unemployment rate), but this figure was scaled down by a factor of 10 on the assumption that only one-tenth of the potential labor market entrants will succeed in finding employment, and the rest will remain in their current non-participant status. Although not articulated in the report, there could be stronger effects on unemployment in the short run since even if only one-tenth of potential entrants succeed in finding jobs, many more previous nonparticipants would be looking for jobs, which automatically brings them into the labor force. If they do not succeed in finding a job, they would boost unemployment rates at least for the period of the job search.
Summary of the Long-term Effects of the Minimum Wage on the Labor Market
Direct demand effects include changes in demand for labor arising from an increase in labor costs, associated with the introduction of the NMW.
Indirect demand effects include reduction in labor demand caused by a loss of competitiveness and/or restoration of wage relativities, triggered by the NMW.
Supply effects reflect increase in labor supply as a result of improved by the NMW incentives to work.
Summary of the Long-term Effects of the Minimum Wage on the Labor Market
| Employment | Unemployment | Labor Force | ||||
|---|---|---|---|---|---|---|
| In thousands of people |
As percent of total effect on employment (In percent) |
In thousands of people |
As percent of total effect on unemployment (In percent) |
In thousands of people |
As percent of total effect on the labor force (In percent) |
|
| Overall change | −13.5 | 100.0 | 8.9 | 100.0 | −4.6 | 100.0 |
| Direct demand effect 1/ |
−6.2 | −45.8 | 4.6 | 51.3 | −1.6 | −35.3 |
| Indirect demand effect 2/ |
−7.3 | −53.8 | 1.9 | 20.9 | −5.4 | −116.2 |
| Supply effect 3/ | 0.0 | 0.0 | 2.5 | 27.7 | 2.5 | 52.1 |
Direct demand effects include changes in demand for labor arising from an increase in labor costs, associated with the introduction of the NMW.
Indirect demand effects include reduction in labor demand caused by a loss of competitiveness and/or restoration of wage relativities, triggered by the NMW.
Supply effects reflect increase in labor supply as a result of improved by the NMW incentives to work.
Summary of the Long-term Effects of the Minimum Wage on the Labor Market
| Employment | Unemployment | Labor Force | ||||
|---|---|---|---|---|---|---|
| In thousands of people |
As percent of total effect on employment (In percent) |
In thousands of people |
As percent of total effect on unemployment (In percent) |
In thousands of people |
As percent of total effect on the labor force (In percent) |
|
| Overall change | −13.5 | 100.0 | 8.9 | 100.0 | −4.6 | 100.0 |
| Direct demand effect 1/ |
−6.2 | −45.8 | 4.6 | 51.3 | −1.6 | −35.3 |
| Indirect demand effect 2/ |
−7.3 | −53.8 | 1.9 | 20.9 | −5.4 | −116.2 |
| Supply effect 3/ | 0.0 | 0.0 | 2.5 | 27.7 | 2.5 | 52.1 |
Direct demand effects include changes in demand for labor arising from an increase in labor costs, associated with the introduction of the NMW.
Indirect demand effects include reduction in labor demand caused by a loss of competitiveness and/or restoration of wage relativities, triggered by the NMW.
Supply effects reflect increase in labor supply as a result of improved by the NMW incentives to work.
NMW and labor demand
24. The report of the Inter-Departmental Group also looked at the demand implications of the NMW. As indicated by the table, the minimum wage will have a limited impact on employment which would decline by 13.5 thousand persons (or almost 1 percent). However, job losses would not automatically translate into an increase in unemployment since it is assumed that better skilled workers would leave the country in search of job opportunities elsewhere, and others would probably drop out of the labor force. Thus only two-thirds of those who lose their jobs would move into unemployment. Again, there could be higher effects on unemployment in the short run until the changes in the labor force take place.
25. The report takes the view that the direct implications of the NMW for labor demand will be different in tradable and nontradable sectors. In the tradable sector, where firms are price-takers, NMW is expected to raise labor costs, worsen competitiveness and reduce demand for labor. In the nontradable sector, where firms are price-setters, the demand for labor would not be affected by the NMW, since higher wages will be passed on to consumers in the form of higher prices. Increases in wages in the nontradable sector would translate into price inflation, which would have a dampening effect on real wages in the economy in general, assuming no attempts are made to restore wage relativities.
26. As suggested by the report, substitution and scale effects are much higher in the traded, rather than in the non-traded sector. Thus the long-run elasticity for labor demand is expected to be significantly higher in the traded (−2.2 in food processing, for example), than in the nontraded sectors (−0.5 in traditional sectors).44
27. Notwithstanding the view that nontradable sectors overall would not shed labor in response to an increase in the wage rate, sectoral model simulations indicated that employment in the building and construction sector is likely to suffer most from the NMW (−2.5 thousand workers). Tradable sectors would also cut employment—in the high technology sector about 1.4 thousand workers are expected to be laid off, and another 1.2 thousand workers would lose their jobs in the traditional sector. The report estimated that almost 60 percent of the decline in employment in the traditional and food sectors would arise from a loss of competitiveness vis-à-vis the United Kingdom. An estimated increase in unit labor costs of 0.5 percent is expected to hit the international competitiveness of the traditional sector.
Summary of Firms’ Survey
28. The survey of businesses undertaken by the Inter-Departmental Group is the only source of information on the potential reaction of employers to the introduction of the NMW. In the survey, respondents were asked to consider a situation in which the hourly wage of adult employees who were paid less than IR£4.50 were to rise to a minimum basic hourly rate of IR £4.50. The table below summarizes the results of the survey, indicating the share of those who gave positive responses to the respective questions.
Summary of Positive Replies to the Survey Questions
Summary of Positive Replies to the Survey Questions
| Potential measures in response to the introduction of the NMW |
Proportion of respondents who answered positively (In percent) |
|---|---|
| Cut back profit margins | 59.7 |
| Improve staff morale | 61.8 |
| Substitution of capital for labor | 7.7 |
| Productivity increase | 22.0 |
| Going out of business | 16.7 |
| Retraining/ upgrading staff | 27.4 |
| No effect on business | 40.1 |
| Reduce non-wage labor costs | 15.1 |
| Improve industrial relations | 38.9 |
| Reduce staff turnover | 28.2 |
Summary of Positive Replies to the Survey Questions
| Potential measures in response to the introduction of the NMW |
Proportion of respondents who answered positively (In percent) |
|---|---|
| Cut back profit margins | 59.7 |
| Improve staff morale | 61.8 |
| Substitution of capital for labor | 7.7 |
| Productivity increase | 22.0 |
| Going out of business | 16.7 |
| Retraining/ upgrading staff | 27.4 |
| No effect on business | 40.1 |
| Reduce non-wage labor costs | 15.1 |
| Improve industrial relations | 38.9 |
| Reduce staff turnover | 28.2 |
29. As suggested by the table, private sector views were mixed regarding the impact of the minimum wage on their businesses: almost 60 percent of respondents did not rule out the possibility of the need to cut back profit margins, with the highest share of positive responses coming from the companies operating in the manufacture of textiles and apparel. Respondents also took an optimistic view on the effect of the NMW on the staff morale. Only 16.7 percent of all respondents considered the possibility of going out of business as a result of the introduction of the NMW. The reaction was particularly strong on the part of the manufacturers of textiles and apparel businesses and the hotel and restaurant sector—with respectively 37 percent and 25 percent of respondents deeming a bankruptcy possible.45 The responses of the hotel and restaurant sector are noteworthy, given that the macro analysis implied that nontradable businesses would not be significantly affected by the introduction of the NMW, reflecting the assumption that they would be able to pass additional costs on consumer prices. A relatively low proportion of respondents believed that the introduction of the NMW would improve labor productivity, or would force workers to upgrade their skills.
E. Conclusion
30. The long-term unemployed are most likely to be low skilled and poorly educated individuals, with a potential “free market” wage rate close to the subsistence level of living. Wage rates of low skilled workers are likely to decline as the demand for low skilled labor weakens. This makes the objective of improving work incentives of the unemployed more challenging, as the level of social welfare benefits converges to their “free market” wages. The government has made progress in reducing the tax distortions for people on the low end of the wage structure. The replacement ratios, however, did not change significantly, in part because social welfare benefits were increasing in line with average earnings.
31. The study of the Inter-Departmental Group founds that the introduction of the NMW is not likely to be important for poverty alleviation, but would help to improve the work incentives of low-paid workers and unemployed. The study also found that the long-term effect of the NMW on employment and the unemployment rate is likely to be limited, but the transitory effect could be stronger.
REFERENCES
Collins, Claire, and Williams, James., 1998, 1997 Annual School Leavers’ Survey, Department of Education and Science, Dublin.
Economic and Social Research Institute, 1999, The Impact of the Minimum Wage in Ireland: report of the Inter-Departmental Group on the Implementation of a National Minimum Wage, Dublin.
Government of Ireland, 1996, Report of the Expert Working Group on the Integration of the Tax and Social Welfare Systems (Dublin).
OECD, 1999,1998–1999 Annual Review-Ireland, Paris.
Salomäki, Aino, and Munzi, Teresa., 1999, “Net Replacement Rates of the Unemployed. Comparisons of Various Approaches”, in Economic Papers, Number 133 (February), European Commission, Directorate-General for Economic and Financial Affairs.
Prepared by Natasha Koliadina.
Salomäki and Munzi, p. 38.
Ibid., p. 40. A low level of education means that an unemployed person has a primary education and perhaps vocational training at work, but no institutional vocational training; a high level of education means college, or university.
Exemption limits are income thresholds below which the taxpayer pays no income tax, and child additions increase this limit for every dependent child. Marginal relief is designed to avert a sharp increase in tax liability (if computed by applying the standard rate to income net of allowances) as income passes the exemption limits. The system of marginal relief ensures that only income in excess of the relevant exemption limit is taxed at a maximum rate of 40 percent.
Replacement ratios estimated by the Department of Finance do not take into account all special schemes designed to improve work incentives of the long-term unemployed. For example, a new program Job Assist, which is a special tax allowance for the long-term unemployed, was introduced in 1998, and is not reflected in the estimation of replacement ratios. Under this program an employee receives a tax break of IR£ 3000 and additional IR£ 1000 for each additional dependent child. This tax break tapers off over a three-year period.
However, in reality its importance for improving incentives to work is limited by a low uptake of this benefit.
The section is based on the study of “The Impact of the Minimum Wage in Ireland”, prepared by the Inter-Departmental Group on the Implementation of a National Minimum Wage.
OECD.
Report, p. 68. The substitution effect reflects the substitution of a more expensive factor of production with a less expensive one, under the assumption that total income remains unchanged. The scale effect is the effect of the decline in output on employment.
While the share of the manufacture of textiles and apparel and the hotel and restaurant industry in total employment is not large—about 13 percent—the number of employees, whose wages are below the perceived IR£ 4.50 is high—33.2 percent and 49.3 percent, respectively.
