This Selected Issues paper analyzes Spain’s sustainable growth rate. It sheds some light on Spain’s medium-term growth prospects by looking into the key factors driving potential growth, both in the past and likely in the future, and international experience of countries in the aftermath of financial crisis. The paper suggests Spain is likely to face a long period of moderate growth (about 1½–2 percent) and high unemployment, but policy action—especially that directed toward reducing structural unemployment and raising productivity—could lead to much better outcomes.

Abstract

This Selected Issues paper analyzes Spain’s sustainable growth rate. It sheds some light on Spain’s medium-term growth prospects by looking into the key factors driving potential growth, both in the past and likely in the future, and international experience of countries in the aftermath of financial crisis. The paper suggests Spain is likely to face a long period of moderate growth (about 1½–2 percent) and high unemployment, but policy action—especially that directed toward reducing structural unemployment and raising productivity—could lead to much better outcomes.

A Targeted Cut in Social Security Contributions in Spain—Can it Boost Employment?1

Yes, it can. A reduction in employer’s social security contributions targeted to low-wage earners has been an important ingredient in past and on-going job-rich recoveries in Europe. The scope for such reform in Spain is considerable in light of relatively high employer’s social contributions and low indirect tax revenues. A reduction in employer’s social security contribution of 1 percent of GDP offset by an increase in consumption tax revenue of similar magnitude would allow contribution rates on the low paid to be almost halved (a reduction of 12 percentage points) and is estimated to increase employment by 0.5–1.5 percent after 3–7 years. The proposed measure allows for a temporary increase in transfers to the most vulnerable of society of about ½ percent of GDP. It does not compromise Spain’s fiscal consolidation and could be implemented by graduated reductions on employer’s social security contributions to the low-paid delivered through a tax credit. Because the reduction would be via a tax credit from the general budget rather than lower rates, the social security system would not be affected.

A. The Unemployment Challenge

1. Boosting employment among low-paid/low-skilled workers is critical to ensure a strong and sustainable economic recovery in Spain (Figure 1). Unemployment is currently at 26 percent, second only to Greece in the EU. The labor market slack in Spain has been mostly a story of increases in unemployment, especially long-term, rather than declines in labor force participation. It affected mainly low-skilled/low-paid workers2. Young workers have been particularly affected, further compromising their employability and fueling (through hysteresis) increases in structural unemployment and lowering potential growth. Eliminating obstacles that prevent the low-paid/low-skilled returning to work should, therefore, be one of the policy priorities to ensure a strong, job-rich, economic recovery.

Figure 1.
Figure 1.

Spain’s Unemployment Challenge

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: OECD.Notes: Unemployed: working-age individuals out of work and actively looking for a job. Short-term (long-term) unemployment: unemployment lasting less than 12 months (one year or more). Unemployment rate: percent of working-age individuals unemployed. Inactivity rate: percent of working-age individuals neither in employment nor searching for a job. Non-employment rate: percent of working-age individuals that are inactive or unemployed. Unemployment gap: difference between the unemployment rate and the NAIRU (Non-accelerating inflation rate of unemployment).

B. A Targeted Cut in Social Security Contributions Can Help

2. Tax reforms that increase labor demand can boost employment more expediently than those tackling labor supply constraints. Tax reform can help create jobs by reducing disincentives to work (labor supply) and hire (labor demand). In the short term, policies to increase labor demand are usually more effective in increasing employment than policies that increase supply, which usually take time to materialize in light of downward rigidities in nominal wages (IMF, 2012). In fact, reforms that increase labor supply such as reductions in personal income taxes (PIT) and employees’ social security contributions may have a more limited effect on employment and may even increase unemployment until wages adjust.3 They could still be considered in the short-run as part of compensatory measures for more effective reforms, as shown below. With limited scope to reduce nominal wages in the short-run, boosting labor demand would have to rely on reducing non-wage labor costs, mainly through reductions in business taxes and other social contributions levied on firms.

A05ufig46

In the short-term, policies only increasing labor supply would not help reduce unemployment.

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

1: Pre-shock W0E0 equilbrium with no unemployment.↙2: Negative output shock → wage floor at W0, labor demand shifts downward to W0E1 → unemployment increases to (E0-E1).↗3: Demand side policy → Labor demand shifts upwards back to preshock equilibrium→ unemployment back to zero.↘4: Supply-side policy→ Labor supply shifts downward—wage floor at W0, equilibrium remain at W0E1 → unemployment increases to (E2 - E1).

3. Reductions in non-wage labor costs are most effective if targeted to the low-paid. Empirical evidence suggests that the demand for low-paid labor is relatively elastic (Hammermesh, 1993) and therefore reacts more strongly to policy measures. This is so because targeted reductions can relax wage floor constraints in countries where high labor costs limit job openings for low-skilled workers (OECD, 2011).

4. Reductions in business taxes can boost labor demand, but are likely to favor more skilled workers. By lowering the cost of capital, reductions in the effective tax rate on business income have a two-sided effect on labor demand: substitution from labor to capital reduces labor demand, while higher investment raises output and therefore labor demand. On balance, most empirical studies suggest that labor demand expands (Chirinko, 2002). Still, as substitution between capital and labor tends to be easiest for low-skilled labor (Duffy and others, 2004), reducing corporate taxes might have a relatively weaker effect on labor demand for low-skilled workers.

5. A targeted cut in employers’ social security contribution (ESSC) has been a common element of previous and on-going reform packages to reduce unemployment (Box 1). When financed by higher consumption taxes (or higher recurrent property taxes) in a revenue-neutral way, reductions in ESSCs have been shown to mimic the impact of exchange rate devaluations in open economies with a fixed exchange rate in a process commonly referred to as “fiscal devaluations” (Fahri and others, 2013). Fiscal devaluations could speed up convergence to long-run equilibrium by reducing real labor costs and improving competitiveness, thus raising employment temporarily (IMF, 2011). This adjustment may be lengthy (De Mooij and Keen, 2012). Moreover, in line with other tax shifts from labor income to consumption, the long-term effects of a fiscal devaluation on growth and employment could also be permanent (IMF, 2012) owing, among other things, to permanent increases in the rate of return to labor or to permanent reductions in equilibrium unemployment. This is confirmed by model simulations (Auerbach and Kotlikoff, 1987) as well as empirical studies (Daveri and Tabellini, 2000; Arnold, 2008).

Targeted ESSC Cuts—International Experience

Targeted ESSC cuts have been associated with past job-rich recoveries. France and Netherlands share similar experiences. Both tried to address rising unemployment rates during the nineties (and early 00s in the case of France) with reform packages including significant ESSC cuts targeted to low-paid hires (50 and 60 percent reductions, respectively). Unemployment rates declined by about 4 percentage points in both cases, a result that was partly attributed to such targeted cuts along with other reforms in labor and product markets — Bakker and Halikias 1999, and Annett, 2007 (Netherlands); IMF, 2002 Espinoza and Perez Ruiz, forthcoming (France).

A number of EU countries implemented targeted ESSC cuts during the great recession (OECD, 2011). They have been targeted to low-paid workers in Austria, Belgium, France, and Germany. Unemployment seems to have been better contained in some of these countries, (Germany, in particular), with some concrete and positive evidence in the case of France (Noveau and Ourliac, 2012).

Concrete examples of fiscal devaluations are not abundant; only one has been targeted. Denmark (1988) and Germany (2007) are the only cases where ESSC cuts been financed by increases in VAT and other indirect taxes. In the case of Denmark, the ESSC was abolished with corresponding benefits financed by a VAT levy of 3 percentage points (OECD, 1988). Germany raised the VAT rate from 16 to 19 percent and used about one third of the additional revenues to cut employer contributions to their unemployment insurance scheme. Denmark’s ESSC abolition was across-the-board, leaving Germany as the only example of a targeted fiscal devaluation.

C. The Scope for a Targeted Cut in Spain

6. The scope for a targeted cut in ESSC is considerable. Measured by the tax wedge, the difference between labor costs to the employer and worker’s take-home pay, Spain’s labor tax burden has increased since the outset of the global financial crisis and is converging to the higher EU and EA averages. Employer’s social security contributions account for more than half of the tax wedge and are above EU and OECD averages. Owing to a flat ESSC schedule (i.e. statutory rates do not increase with workers’ earnings), firms employing low-wage workers in Spain do not seem to benefit from reduced contribution rates as much as those in other countries (Box 2). Targeted cuts on employee contributions seem less of a priority as social security contributions levied on employees are only a fraction of those levied on employers and are below regional averages.

A05ufig47

Spain’s labor tax burden is large, including for the low-paid…

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: OECD, Taxing Wages.1 100 percent of average workers’ earnings.
A05ufig48

…and dominated by employers‘ social security contributions.

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

7. A targeted ESSC cut could be financed by increases in consumption and other indirect taxes. Indirect taxes, VAT in particular, are low by EU standards. Official estimates of total indirect tax expenses in the form of exemptions and preferential rates stand at €18 billion, about 2 percent of GDP (Ministry of Finance, 2013). A report by an expert committee for tax reform released in March 2014 estimates VAT expenses alone at almost twice that value (€33 billion, about 3 percent of GDP). This report estimates that about 1 percent of GDP of indirect tax revenues could be mobilized by (i) raising reduced VAT rates to the standard rate, excluding those levied on tourism, transport, and housing goods and services (0.6 percent of GDP), (ii) bringing excise duties on alcohol, tobacco closer to the EU average, and increasing diesel and other energy taxes. (0.4 percent of GDP).4 An additional 1 percent of GDP could be raised if reduced rates for selected items, which are currently significantly below the EU average, are also increased.

A05ufig49

Indirect taxes, VAT in particular, are low by EU standards.

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: Eurostat.

Spain vs. EU: Super-reduced and reduced VAT rates, selected goods and services (%)

article image
Source: EC, list of VAT rates applied in Member States of the European Union, January 2014.

Average of the simple country average of all applicable VAT rates for each given category.

Social Security Contributions in Spain: Features and Facts

Social security contributions rates are a fixed proportion of worker’s covered earnings between a floor and a ceiling. Nominal rates vary according to the earmarked benefit, but not with earnings (i.e. are flat/not progressive). Floor and ceilings vary by professional categories. Earnings, until last year, excluded a number of in-kind and fringe benefits, such as per diem, transport supplements, relocation expenses, included under Spain’s personal income tax base and in standard payroll taxes. Contribution rates, floors, and ceilings are determined every year in the budget law.

Spain: Floor and Ceiling for Employers’ Social Security Contributions by Professional Category, 2014

article image
Source: Ministry of Employment.

Spain: Social Security Contribution Rates by benefit, 2014

(percent)

article image
Source: Ministry of Employment.

Contribution schedules in Spain are not as progressive as in other countries…

Spain’s flat contribution rate contrasts with the more graduated schedule adopted in a number of EU countries. In France, ESSC rates for workers earning half the average wage were about 60 percent lower in 2012 than it is was for the average earner. Employers in Spain must pay social security contributions even for their least paid employees (no ESSC floors). Minimum contributions are set by applying the flat rate to the minimum wage. Unlike most EU countries, Spain sets a ceiling to ESSC. At less than €13,000, this ceiling is not particularly high. In Italy, where ESSC rates are equally flat and just 2 percentage points higher than in Spain, the ceiling is almost three times higher.

A05ufig50

Employing the low-paid in Spain is costly owing to a flat contribution schedule.

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: OECD, Taxing Wages.

…Leading to almost half of employers’ social security contributions being collected on behalf of workers earning less than three times the minimum wage

About 1 percent of GDP alone is estimated to have been collected on behalf of workers earning less than twice the minimum wage.

Spain: Employer Social Security Contributions by Wage Level

article image
Sources: INE (earnings distribution); Ministry of Employment (social security rates and thresholds); and IMF staff estimates (social security contributions).

Number of workers earning between 1 and 1.5 times the minimum wage and 1.5 and 2 times the minimum wage are IMF estimates.

D. Simulating a Targeted Fiscal Devaluation

8. The economic impact of a targeted fiscal devaluation was simulated using IMF’s Global Integrated Monetary and Fiscal Model (GIMF).5 The IMF’s GIMF was used to simulate the impact of a reduction in employer’s social security contributions targeted to low-income households and financed by an increase in consumption taxes, hereby referred to as a “targeted fiscal devaluation”. GIMF has two types of households—intertemporally-optimizing (overlapping-generations) and liquidity-constrained ones, generally corresponding to higher- and lower-income households.6 The model was calibrated to match the current conditions of Spain’s labor market, characterized by a large pool of underutilized, non-employed labor willing to work at the prevailing wage rate should labor demand pick up, by (i) by augmenting the share of liquidity-constrained agents above that dictated by country-specific earning distributions, (ii) by increasing the labor supply elasticity to 1–1.5, and (iii) by allowing a permanent positive shock in labor force participation. GIMF builds sticky wages—a pre-condition for an active fiscal devaluation channel—through the gradual path through which unions set real producer wages following consumer price increases.7 The model was also calibrated to match Spain’s recent national accounts and fiscal data.

9. Against this background, an uncompensated and a compensated targeted fiscal devaluation were simulated. The uncompensated targeted fiscal devaluation consists of a reduction in the average effective labor tax rate equivalent to a reduction in employer’s social security contributions of about 1 percent of GDP, as envisaged in the report prepared by the tax reform expert committee. The compensated targeted fiscal devaluation adds a temporary (two-year) increase in transfers to liquidity-constrained agents of about 0.5 percent of GDP (to simulate support for the most vulnerable). Both experiments are revenue neutral and financed by increases in the average effective consumption tax rate.8

10. Employment increases by 0.5 percent and 1.5 percent relative to the baseline after, respectively, three and seven years under both scenarios (Figure 2). In particular,

  • Average effective tax rates on labor decrease permanently by about 1.6 percentage points (pps) and are accompanied by permanent increases in consumption tax rates of the same magnitude, both with and without compensation.

  • Average consumption tax rates increase by 2.3 pps in the first two years following the implementation of a compensated targeted fiscal devaluation to cover additional expenses with transfers to liquidity-constrained households.

  • Higher employment is accompanied by output increases of similar magnitudes, reflecting the positive impact on private consumption and aggregate demand of higher household income (of liquidity-constrained agents in particular) following lower income tax rates.

  • The employment and output impact is slightly larger under the compensated targeted fiscal devaluation than under the uncompensated one in the short-term. This is because transfers to liquidity-constrained agents dampen the negative effect of higher consumption taxes and prices on household incomes, which, in turn, increase more vigorously.

  • Both scenarios induce an internal devaluation reflected by a real exchange rate depreciation and an improvement in the trade balance.

Figure 2.
Figure 2.

Targeted Fiscal Devaluation

(Percent difference relative to the baseline)1

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: IMF staff estimates.1/ For valued added taxrate, difference in percentage points relative to the baseline.

11. The results are broadly in line with recent simulations done for Spain. Recent simulations have found total employment increasing up to 1.3 percent following a targeted fiscal devaluation with a fiscal cost at 1–1.5 percent of GDP (Bosca, Domenech and 2013, EC, 2014, Tax Reform Committee). GIMF results are broadly the same as those obtained by the EC and the Tax Reform Committee, all of which assume the same fiscal cost of 1 percent of GDP. GIMF delivers a lower employment impact over the short-term relative to that obtained in Bosca, Domenech, and Ferri (2013), mainly as the result of the larger fiscal cost (and hence larger shock) assumed in the latter (1.5 percent of GDP), with results broadly similar over the medium and long-term.

Spain: Fiscal Devaluation Impact—Alternative Analyses

article image
Sources: EC (2014); Tax Reform Committee Report; Bosca, Domenech, and Ferri (2013).

Increase is revenue-neutral (i.e. equals the reduction in effective labor tax rate in percent of GDP).

12. After a brief initial period, a targeted fiscal devaluation delivers a stronger employment impact than a tax shift that combines reductions in both labor and capital income taxes. Reductions in labor and capital income nominal tax rates accompanied by measures to broaden the base of both these taxes through the elimination of exemptions and special treatment have also been recommended by the tax expert committee. When financed in a revenue-neutral way by increases in VAT and other indirect taxes, they are also expected to positively impact employment directly by reducing the fiscal costs to work and hire and indirectly as aggregate demand increases from higher households’ disposable income and private investment, reflecting higher after tax returns on labor and capital. Simulations using GIMF of a permanent reduction in labor and capital income taxes amounting to 1 percent of GDP (0.7 and 0.3 percent of GDP, respectively) financed by an increase in consumption taxes of the same amount, as proposed in the report of the tax expert committee, deliver a permanent impact on employment. The employment impact of this proposed tax shift is stronger than the impact of the targeted fiscal devaluation in the first two years after the reform is implemented. This reflects the strength of the indirect impact on employment referred to above under the tax shift proposal relative to the targeted fiscal devaluation. This impact, however, declines over time and the impact of the larger cut in labor income taxes under the targeted fiscal devaluation dominates, resulting in a significantly higher employment.

Figure 3.
Figure 3.

Fiscal Devaluation vs. Tax Shift1

(percent difference relative to the baseline)

Citation: IMF Staff Country Reports 2014, 193; 10.5089/9781498330862.002.A005

Source: IMF staff estimates1/ Tax shift defined as reductions in effective tax rates on labor and capital income amounting respectively to 0.3 and 0.7 percent of GDP accompanied by a 1 percent of GDP increase in consumption taxes. Liquidity-constrained agents are compensated with transfers of about 0.5 percent of GDP under both reforms.

E. Design and Implementation Issues

13. A graduated reduction of ESSC restricted to low-paid, employed workers within a well-defined range has been shown as cost-effective scheme. The range of low-paid workers covered by the wage-subsidy scheme will ultimately depend on available budgetary resources. However, attempts to heavily restrict coverage may backfire, as some firms will attempt to over-report the number of eligible low-paid workers under their payroll.9 A wage-subsidy scheme with less strict coverage and where the subsidy rate tapers as wages moves further from the least paid has been shown to dampen firm’s over-reporting incentives (Phelps, 1997). Therefore, from an efficiency standpoint, they could be a better option than purely exempting social security contributions for workers earning less than a given wage-rate threshold (e.g. by adopting a contribution floor).

14. Reductions in ESSC—graduated or not—should be in the form of a tax credit rather than reductions in statutory rates. Unlike general taxes, social contributions are generally earmarked to specific social benefits. Reductions in statutory rates will break this link and may result on the under provision of the corresponding benefits, which at the same time will bring the contribution closer to a tax increasing distortions, or to unfunded mandates. A tax credit would help preserve the link between social security contributions and benefits thus preserving the coverage and fiscal sustainability of the system as well as minimizing the economic distortions it creates.10

15. An illustrative exercise suggests a graduated cut for Spain. A ESSC cut targeting the low-paid through graduated reductions inversely proportional to worker’s earnings (the graduated scheme) delivers a smoother path of marginal rates than a cut with the same ex-ante fiscal cost (1 percent of GDP) delivered by creating a contribution floor to exempt individuals earning up to 1½ times the minimum wage (the Floor scheme). The graduate scheme envisages a smoother path of ESSC cuts for individuals earning up to three times the minimum wage. Effective rates are halved for workers earning up to 1 ½ times the minimum wage. This cut is of similar magnitude to those implemented in France during the nineties. The cost-effective merits of a graduated schedule would, however, need to be weighed against the more straightforward implementation and administration of the Floor measure. The latter would only involve the creation of a contribution floor by raising the minimum contribution with no other changes in the current social security contribution system.

Spain: Alternative Wage Subsidy Schemes1

article image
Source: IMF staff estimates

Illustrative scenarios based on wage distribution set up in Box 2.

Effective social security contribution rate paid by the employer upon receipt of the tax credit.

Social security ceiling.

Reduction in employer’s social security contributions (ESSC), percent difference to status quo.

16. A targeted ESSC cut should not be attached to new jobs, firm size, or specific contracts. Wage subsidies for new jobs are notoriously difficult to monitor, end-up in low take-up (Neumark, 2011), and have small employment effects (Chirinko and Wilson, 2010). If badly targeted, they can be particularly costly, as subsidized workers would have been hired even without the subsidy. The economic rationale for having special tax advantages for small and medium-sized firms (SME) is also not clear (International Tax Dialogue, 2007). Wage subsidies to new jobs under permanent employment contracts (particularly pervasive in Spain) have been shown to be generally ineffective as they have mainly led employers to substitute workers under the unsubsidized temporary contract by those under subsidized permanent contracts with little or no impact on total employment (Box 3).

17. The increase in consumption taxes may require identifying compensatory measures for the most vulnerable and the fiscal space to implement them. A fiscal devaluation will improve income equality by increasing employment among the low-skilled. But the increase in consumption taxes, which are usually slightly regressive, may increase inequality. For example, pensioners will not benefit from higher employment but would suffer from higher VAT rates. This may require offsetting measures to address poverty and equity concerns. Such measures may come in form, for example, of direct transfers (e.g. pensions for widows, disabled individuals) or reductions in income taxes. Providing additional public transfers would reduce the scope for lowering social security contributions rates given that some of the additional indirect tax revenues would have to be used to fund such transfers. Improving the targeting of public transfers through better means-testing would be important to help finance those measures while preserving the fiscal space for the targeted ESSC cut. Increasing the ESSC for the top earners by removing or increasing the ESSC ceiling could also provide additional funding.

18. Bundling targeted ESSC cuts in a package of reforms will help to prolong the impact of a fiscal devaluation. The impact may only be temporary as, over time, increased labor demand feeds into higher wages and the beneficial effects on employment would be mitigated. An additional dampening effect comes from the labor supply side, as over time, firms are able to shift their tax burden to workers. Labor market reforms that allow for more decentralized wage-setting could moderate wage increases. Product market reforms, in turn, by limiting price-mark ups will reduce the speed with which tax burdens are shifted to workers and consumers thus moderating work disincentives and supporting real incomes. Reforms that facilitate corporate sector deleveraging, should also be included in this package, as this would give more space for highly indebted companies’ to use labor cost savings to hire rather than build liquidity buffers for debt service.

Wage Subsidies in Spain

Spain has a history of using wage subsidies to reduce the costs of hiring under permanent employment contracts. Wage subsidies have been granted mainly as reductions in employer social security contributions in the form of rebates. The key objective has been to reduce the duality that started to prevail in Spain’s labor market after the introduction of temporary contracts in 1984. Wage subsidies have been subjected to numerous changes, most as part of labor market reforms (1997, 2010, 2012), but remained conditioned on the hiring of individuals under a permanent contract.

Spain: Rebates for Employers’ Social Security Contributions for Permanent Contracts, selected groups

article image
Sources: Law 43/2006; Law 35/2010; Royal Decree 3/2012.

Only applies to small firms (less than 50 employees).

Social security rebates have not targeted the low-paid. Targeting has been mainly on socio-demographic characteristics, particularly age and gender. The amount of rebates varied according to these criteria as well as whether new hires were formerly unemployed or under a temporary contract. Recent laws have reduced the number of age categories, but added disabled individuals to the beneficiary list. The duration of rebates initially varied by category and former employment status, but more recent laws have harmonized them, and reduced their duration to no more than three years.

The impact of wage subsidies on total employment seems negligible, due to substitution effects. Hires under subsidized permanent contracts have tended to be netted out by dismissals under temporary contracts and non-subsidized permanent contracts (Mendez, 2008). Wage subsidies had a positive impact on the transition from unemployment to employment and from temporary to permanent employment, particularly for women and young people, but less so for low skilled workers (Arranz, Serrano, and Hernanz, 2013). But transitions from permanent employment to non-employment increased for older men (Kugler, Jimeno, and Hernanz, 2002) and the duration of subsidized permanent contracts have tended to be smaller than for non-subsidized permanent contracts, particularly among less skilled workers (Cebrian and others, 2011).

A new subsidy targeting new hires under permanent contracts set up this year may also not be particularly effective. Unlike previous subsidies, this is not granted as a rebate, but limits ESSC to a small fee (€100 for full-time hires) regardless of the income of the employee. All contracts signed between February and December 2014 would benefit for this flat fee for two years. As it is a flat fee, however, the low-skilled are not targeted; indeed the opposite, with the biggest benefit accruing to the higher-paid. Substitution effects, as per above, can also be expected to reduce the net employment impact.

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1

Prepared by Victor Lledó (FAD) and Keiko Honjo (RES).

2

Low-skilled (high-skilled) individuals are defined here as those without upper secondary education (with tertiary education). Low (high)-paid and low (high)-skilled will be used interchangeably hereafter. Although the association is far from perfect—low-skilled workers in Spain earn on average just over half of high skilled wages (OECD, 2013)—, it will likely be reinforced following recent increases in the skill premium (Bonhomme and Hospido, 2012).

3

This will be particularly the case if the indirect impact of such tax reductions may have on labor demand through increases in aggregate consumption fails to materialize.

4

See Informe Comisión de Expertos para la reforma del Sistema Tributario Español. Available via the Internet: http://www.abc.es/gestordocumental/uploads/economia/fe007a24af859ec8ce790387ba6b7755.pdf

5

Kumhof and others (2010) for a description of the model.

6

Heterogeneity is, therefore, only captured indirectly, a limitation of the model that should be acknowledged.

7

Absent sticky wages, the increase in labor demand following a reduction in labor costs brought with lower labor taxes would have no employment impact, as it would be immediately reversed by instantaneous wage increases.

8

As it is standard in other macro-simulation models tax rates are defined as implicit or average effective tax rates. Such rates capture more closely the actual burden from major taxes once exemptions, allowances, credits, progressive schedules, and other specificities of the tax are taken into account. They are not equivalent to statutory or nominal rates. The average effective labor tax rate is measured as the ratio of total revenues from labor income taxes and social security contributions to total wages. The average effective consumption tax rate is defined as the ratio of general consumption taxes on goods and services, including value-added and excise taxes, to total consumption.

9

Firms could do that to reduce their contribution liabilities by reporting as low-paid, workers with salaries above the contribution threshold. They could also agree to pay such workers a reported salary below the contribution threshold to be complemented by an unreported additional payment. This would, of course, not hold if the government could fully observe reported and unreported wage payments among the beneficiaries of the targeted ESSC. Firms would also have fewer incentives to misreport the larger their demand for truly low-paid workers would increase as the result of reductions in ESSC. Full government information about firm payrolls and high demand elasticities for the low-paid would favor a less graduated approach.

10

This depends of course on how distortionary social contributions are in the first place. The weaker the link between contributions and entitlements the more distortionay they are, the greater the employment impact of a reduction in ESSC is likely to be.

Spain: Selected Issues
Author: International Monetary Fund. European Dept.
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    Spain’s Unemployment Challenge

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    In the short-term, policies only increasing labor supply would not help reduce unemployment.

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    Spain’s labor tax burden is large, including for the low-paid…

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    …and dominated by employers‘ social security contributions.

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    Indirect taxes, VAT in particular, are low by EU standards.

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    Employing the low-paid in Spain is costly owing to a flat contribution schedule.

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    Targeted Fiscal Devaluation

    (Percent difference relative to the baseline)1

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    Fiscal Devaluation vs. Tax Shift1

    (percent difference relative to the baseline)