Selected Issues

Abstract

Selected Issues

Work-Welfare Trade-Offs and Structural Unemployment in Luxembourg1

Job creation is strong in Luxembourg, but unemployment is declining gradually and many newly created jobs go to cross-border workers. The employment rate of residents is relatively low, especially for low-skilled, young, and older workers. Moreover, female attachment to the labor market is weak, and the share of the long-term unemployed has increased over the last ten years, but seems to have come down somewhat in recent months. In addition to skills mismatches, work disincentives inherent to the tax-benefits system are a factor in explaining structural unemployment.

This chapter first reviews developments in the Luxembourg labor market, taking into account the challenges faced by different groups of workers. Thereafter, it turns to stylized facts on the impact of the tax-benefit system on labor market performance. Finally, it presents an empirical model to assess the effect of the tax-benefit system on unemployment and activity rates.

The results indicate that low employment of older workers and women is largely driven by low participation rates among these groups, while both higher unemployment and lower participation contribute to the low employment rates of low-skilled workers. The relative importance of the different benefit schemes varies across groups of workers. The high unemployment of young and low-skilled workers reflects substantial unemployment traps inherent to the tax-benefits system, while high disincentives for second earners contribute to lower participation of women, and weak labor market attachment of seniors is predominantly driven by the generosity of the pensions system. Substantially increasing employment requires efforts to reduce skills mismatches and to make work more rewarding.

A. Overview of the Labor Market

1. A decade after the financial crisis, the unemployment rate remains higher than its pre-crisis-level, and the employment rate lags behind the national target. Unemployment is low by European standards but has substantially increased compared to its historical level. For instance, in 2001, the unemployment rate was less than 2 percent or third of the average rate in neighboring countries. After a surge between 2001 and 2005, it stabilized at around 4V2–5 percent during 2005–10. From 2011, the unemployment rate steadily increased, reaching a peak of 7.1 percent in 2014. Currently, it remains two percentage points or more above the pre-crisis level. The strong net employment creation also benefits cross-border workers who represent more than 40 percent of the employed. Meanwhile, the employment rate of workers aged 20–64 years continuously increased from 67.5 to 70.7 percent in 2016, but remains below the national target of 73 percent and also below the European objective of 75 percent.2

A03ufig1

Unemployment and Employment Rates

(Unemployment rate 15-64, employment rate 20-64)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

*Comparators include Belgium, France, Germany, and The Netherlands.Source: Eurostat.

2. Unemployment is persistent for young, low-skilled and older workers (Figure 1). Compared to the pre-crisis period, unemployment did not change substantially for workers who hold a tertiary education degree, but has significantly increased for youth, low- and medium-skilled workers, and non-native resident workers, suggesting that these groups are facing greater difficulty to succeed in the labor market. For illustration, workers with less than a secondary education represent less than 20 percent of the labor force but more than 50 percent of registered jobseekers at ADEM, the national employment agency, at the end of December 2017. Moreover, the share of unemployed who have been out of a job for 1 year or more has steadily increased since 2009, and accounted for more than 45 percent of the unemployed in 2016. In addition, unemployment persistence is the highest for workers older than 45 years, increasing the risk of discouragement and human capital deterioration. The recently introduced measure to facilitate employment of long-term unemployed is welcome but subsidized employment should be closely monitored to avoid providing windfalls to employers without creating durable jobs.3

Figure 1.
Figure 1.

Unemployment and Skills Mismatches

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig2

Unemployment and Share of LT Unemployed by Groups

(Percent)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: Eurostat.

3. For these groups, participation and employment rates also lag behind those in neighboring countries. (Figure 2). The overall participation rate of 70 percent is below the neighbors’ average of 74 percent. Despite innovative measures by ADEM to activate senior workers, the employment rate of older workers at around 40 percent remains far below EU peers.4 Notwithstanding the Youth Guarantee Program as well as training and apprenticeship programs, activity rates of young and low-skilled workers are substantially below those in neighboring countries. The youth participation rate at 30.7 percent, two-thirds of the neighbors’ average, is relatively low even when taking into account the high share of 18–24 years old enrolled in education. Lower participation rate of natives compared to non-natives indicates that existing skills are underused in Luxembourg. The gender gap in activity rates is close to that in the neighboring peers, but labor market attachment is marginal for women who represent more than 80 percent of part-time workers. Low participation among these groups of workers is the main factor driving their low employment, suggesting that efforts are needed to increase incentives to work.

Figure 2.
Figure 2.

Participation and Employment Rates

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig3

Participation (15–64), and Employment (20–64) Rates, 2016

(Percent)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: Eurostat.

4. Substantially improving the labor market prospects for these groups remains challenging due to skills mismatches and stiff competition from cross-border workers. The demand for skills is changing drastically with employment shifting further to high value-added sectors that employ high-skilled workers. Consequently, the demand for skills needed to perform abstract tasks and non-routine manual tasks has increased strongly at the expense of routine manual jobs, and this has worsened the labor market prospects of low-skilled and older workers who lack the necessary capabilities to succeed in the digital economy (Marcolin et al., 2016). Despite initiatives by ADEM,5 the integration of the low-skilled and long-term unemployed remains challenging, in part due to increasing competition from cross-border workers. As a result, unemployment remains relatively high while the job vacancy rate is increasing, suggesting substantial mismatches between the qualification of the jobless and the skills required by the job openings. At the individual level, a skills mismatch could imply lower job satisfaction and a higher risk of unemployment relative to well-matched workers, and can contribute to discouragement and labor market withdrawal (Montt, 2015). At the macro-level, it can lead to high inactivity, a vicious circle because inactivity contributes to the under-utilization of skills, suggesting that reducing skills mismatches should be a key policy objective.

A03ufig4

Change in Total Employment by Occupation Categories

(Annual average, thousand employed persons, 15-64)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Sources: Eurostat (2017), and OECD Economic Surveys, 2017.

5. Given the characteristics of the vulnerable groups, Active Labor Market Policies (ALMP) alone will not suffice to substantially reduce unemployment (Figure 3). While policies to improve the matching of workers and jobs, and to avoid that the unemployed lose their attachment to the labor market are key to increasing unemployment outflows, supply side policies are also important in Luxembourg due to the particularly low participation rate of some groups. In addition, a high share of women, young, low skilled and older workers are in part-time work. Average hours worked per worker have declined compared to the pre-crisis period, more so than in neighboring countries, possibly related to the rise in part-time work. Moreover, nominal wages have decelerated, reducing the financial incentives for work, and suggesting that a broader reform of the tax and benefit system is needed to make work more rewarding, especially for low wage earners. The next section assesses the tax-benefits system in Luxembourg in comparison to other countries, and evaluates its impact on work incentives across workers’ groups.

Figure 3.
Figure 3.

Incidence of Part-Time Work

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

B. How Does the Tax-Benefits System Affect Work Incentives?

6. Two main trade-offs reside at the heart of the tax-benefit system. First governments face a trade-off between equity and efficiency. Governments want to raise tax revenue for public good provision, to redistribute income from higher to lower income individuals and families, and to provide a temporary safety net for people who are unemployed or unable to work. However, in doing so they reduce work incentives especially for low-income earners, thereby reducing labor supply and in turn the total amount of income available to be redistributed. Second, while many factors affect individual labor supply decisions, work requires a sacrifice at least of leisure, and the individual worker’s decision on whether to enter the labor force, the number of hours they will work if they do enter the labor force, and how long they will stay in the labor force is underpinned jointly by the tax and benefit systems, at least in economies endowed with a safety net. The incentive problems inherent to the tax-benefits system create a work-welfare trade-off in which not working could be a rational choice if the net income increase from working does not justify the sacrifice of leisure, especially for low earners.

7. The taxation of labor income affects both the level of unemployment and the size of the labor force (Pissarides, 1998, Nickell and Layard, 1999, Bovenberg, 2006, Bassinini and Duval, 2006, 2009). Labor taxes distort labor supply and demand, and could generate lower labor market participation and higher unemployment. For instance, the interaction between the tax-benefit structure and other labor market characteristics may push wages above market-clearing levels, generating long-run unemployment. Independently of the level of unemployment, the tax and benefits system may affect the size of the labor force by reducing incentives to work, at least in the formal sector. In a nutshell, the financial incentives for people to take up work or to work longer hours, and for firms to hire new staff or grant salary increases are largely determined by the joint effects of the tax and benefits system. These financial incentives are measured through several indicators defined by the OECD tax-benefits model (Annex 1).

8. The analysis focuses particularly on low-income workers, older workers, and second earners, identified as more vulnerable to inactivity or unemployment in Luxembourg. Empirical and theoretical research suggests that the labor supply of these groups is more responsive to taxation than that of other groups of workers (Diamond, 1980; Saez, 2002; Brewer et al., 2010, OECD 2011, Dorley, 2015). Diamond and Saez (2011) also find that marginal tax rates highly distort labor market supply when applied to points in the income distribution where there are many taxpayers and labor supply elasticities are large. The empirical evidence in Luxembourg supports these results and indicates that low skilled and young, mostly low-income earners have lower employment and participation rate in Luxembourg. In addition, the labor market attachment is weak for older workers and marginal for women, suggesting that these groups of workers deserve particular attention.

9. The average tax wedge is broadly in line with neighboring countries, but penalizes single parent at the margin (Figure 4). The tax wedge between total labor costs to the employer and the corresponding net take-home pay for single workers without children, at average earnings levels, is 38 percent in Luxembourg, slightly higher than the average tax wedge in OECD countries but lower than in neighboring countries. Across family situations, the lowest tax wedge is observed for one earner married couples for levels of income above 50 percent of average earnings. On average, a single person without children bears the highest tax wedge at lower income levels. Beyond 1.75 times the average earnings level, the highest tax wedge is observed for a single parent with two children. At the margin, the combined effect of increasing personal income tax, employee and employer (including payroll taxes) social contributions and decreasing cash transfers, is the highest for single parents with two children at all income levels above 60 percent of average earnings, while married couples with or without children face the lowest marginal tax wedge at all levels of earnings.

Figure 4.
Figure 4.

Tax Wedge and Social Spending

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig5

Average Tax Wedge Decomposition, 2016

(Percent of total earning, single without children at average earning)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

10. Social spending is substantial in Luxembourg, with a high share of family benefits. Total social spending, at 32.6 percent of GNI, is among the highest in Europe reflecting in particular sizable old age pension benefits. Compared to other countries, Luxembourg has the highest share of family benefits expenditure, mirroring the generous family/children benefits embedded in the tax and benefits system.

A03ufig6

Social Receipts and Expenditures, 2015

(Percent of GNI)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

11. Effective implementation of tighter entitlement and eligibility criteria could act as a positive incentive for participation (Langenbucher, 2015). Empirical evidence shows that countries with more stringent unemployment benefit systems are more likely to record lower unemployment levels. The impact of eligibility criteria on employment outcomes and benefit recipient status relies heavily on the implementation of activation measures in which participation is required, for example the procedures for reporting and verification of job search and obligations to participate in ALMPs. Initial entitlement criteria reduce unemployment inflows as they may exclude certain groups from receiving unemployment benefits, while ongoing eligibility may increase outflows by specifying the requirements for remaining eligible for unemployment benefits (Immervoll and Richardson, 2011). Together, entitlement and eligibility criteria are destined to counter the work disincentive effects. Benefit generosity is measured by the benefits level and duration. Maximum duration is important because longer duration may generate benefit dependency and increase unemployment duration especially for low income earners, but also for older workers with a long contribution period (Krueger and Meyer, 2002 Van Ours and Vodopivec, 2005, Lalive, 2008; Caliendo et al., 2009). The level of income is a key element of the architecture of unemployment benefits systems as high replacement levels create financial disincentives to work (. Layard et al, 1991, Nickell, 1998; Krueger and Meyer, 2002).

A03ufig7

Strictness of UB System and Unemployment rate

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

12. In Luxembourg, entitlement and eligibility criteria, and benefits duration are close to those in most European countries (Figure 5). Eligibility criteria refer mainly to a range of behavioral requirements which must be met to establish a right to receive unemployment benefits. Unemployment benefits’ entitlement and eligibility criteria in Luxembourg are among the strictest across OECD countries, reflecting the continuous adaptation of AMLPs by ADEM Figure 6). In particular, the sanctions that may be imposed on jobseekers in cases of voluntary unemployment, refusal of a “suitable” job offer, or failure to participate in ALMPs are the most strict across countries. Available information indicates that the maximum duration of unemployment insurance is 12 months in Luxembourg, as in Germany, against 24 months in France.

Figure 5.
Figure 5.

Strictness of the Unemployment Benefit System

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Figure 6.
Figure 6.

Trend in the Recipient of Social Benefits

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig8

Strictness of Unemployment Benefits System

Average across components, (2014 Score from 1 (least strict] to 5 (most strict))

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD

13. But the number of benefit recipients has grown at a faster pace than in neighboring peers except for disability benefits. As in most countries, the surge in the number of unemployed since 2007 is almost matched by an equally strong increase in the number of unemployment-benefit recipients. In 2014, the number of unemployment-benefits recipients was more than 1.5 times the number of recipients in 2007 for Luxembourg, the fastest increase among neighboring peers. As more people are becoming long-term unemployed, many of them have exhausted their unemployment benefits and turned to social assistance for income support, resulting in a fast growth of recipients of social assistance. While the number of recipients of old-age pensions grew at the same pace or slower than the elderly population in most neighboring countries, the rise was significantly higher in Luxembourg, suggesting that many people are benefiting from early retirement schemes. In contrast to Belgium, Germany or France where the number of disability benefits recipients increased, it fell in Luxembourg. This downward trend is more likely to be driven by the reclassification program which re-integrates partially disabled workers to the labor market.

A03ufig9

Recipients of Social Assistance

(Trends as variations with respect to 2007=100)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

14. The social safety net in Luxembourg is large, covering a broad set of benefits. It

consists of a means-tested guaranteed minimum income (RMG) and covers a broad range of unemployment, health, sickness, maternity, child, family, housing, disability, old-age and invalidity pension benefits6 Of the 10,087 households which received the RMG in 2016, almost 55 percent are single-person households, a higher proportion than their share in the total population.7 A planned reform of the RMG will replace it by the Social Inclusion Income (REVIS). The new benefit scheme consists of two part—the inclusion allowance and the activation subsidy—and introduces the condition of being registered as a jobseeker with ADEM, while providing controls and anti-fraud measures to limit subsidy dependency.8 To dissuade beneficiaries from the idea that it is preferable to live on state subsidies rather than looking for work, REVIS beneficiaries can work more than ten hours a week, and 25 percent of the possible income will not go towards the calculation of the amount of compensation.

15. Welfare benefits are generous enough to possibly make not working a rational choice for low earners (Figure 7). The welfare system in Luxembourg is more generous than in most neighboring. While receiving benefits equivalent to almost 50 percent of median income for not working, some individuals might choose to remain out of work as working bears the additional burden of paying taxes on earned income. Participation tax rates are among the highest in OECD countries for inactive people when they take a full-time job, especially at a low wage, creating substantial inactivity traps. As illustration, for a one-earner married couple with 2 children taking a job at 67 percent of the average wage, taxes and benefits reduce the financial gain by more than 86 percent. Given the expenses associated with work and the loss of leisure and family time, not working could be a rational choice if the increase in net income does not justify the sacrifice.

Figure 7.
Figure 7.

Inactivity Traps

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig10

Participation Tax Rate from Inactivity, 2015

(Married couple with 2 children, 67% of AW)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

16. Generous unemployment benefits reduce incentives to actively search and take up jobs, especially for some family situations (Figure 8). Generous unemployment benefits might reduce incentives to work and create long-term benefit dependency (Mortensen, 1997; Shavell and Weiss, 1979). In addition, Krueger and Meyer (2002) conclude that a 10 percent increase in unemployment benefits raises the average duration of unemployment by around 5 percent and that the impact is likely much higher in countries with relatively weak eligibility condition s. In Luxembourg, unemployment benefits, measured by net replacement rates, are relatively generous, with an initial net replacement rate among the highest across OECD countries. For instance, a one-earner married couple with 2 children earning previously 67 percent of the average wage9 is better-off living on unemployment benefits than taking a job as its net replacement tax rate is more than 100 percent. Such a high participation tax rate reduces the incentives to look for a job when unemployed, and generates unemployment traps especially for low-skilled, low-wage workers.

Figure 8.
Figure 8.

Unemployment Traps

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig11

Participation Tax Rate from Unemployment Benefits

(Married couple with 2 children, 67% of Average Working)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

17. The labor supply of young, and of low-skilled workers is particularly sensitive to the generosity of the tax benefits system. Cross-country scatter plots suggest that higher unemployment rates are more likely to be observed in countries with more generous unemployment benefit systems, although the correlation is relatively weak. Across age-groups, the elasticity of the unemployment rate to the generosity of the tax benefits system is higher for young workers than for prime-age workers. In the same vein, the unemployment rate of workers with lower secondary education is more responsive to the generosity of the unemployment benefits system than that of workers with a university degree. One reason is that as high skilled-workers earn high wages, they are less likely to be content with unemployment benefits and actively search for a new position when they lose their job.

18. High marginal effective tax rates (METR) reduce incentives to work more hours, generating low-wage traps (Figure 9). Cross-country comparison suggests that higher METR are associated with higher shares of women working part-time. In Luxembourg, METR are high across family situations for part-time workers, especially at the bottom of the income distribution. Among OECD countries, it is the highest for a one-earner married couple with two children who will not obtain any increase in net income, after accounting for the loss of benefits, when increasing work hours from 33 percent to 67 percent of the average wage as its METR is more than 100 percent. With such METRs, it is not surprising that part-time work is widespread, especially among women.

Figure 9.
Figure 9.

METR and Low-Wage Trap

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

19. Work disincentives are substantially high for second earners. Empirical evidence highlights the high elasticities of hours worked elasticities of second earners, mostly women, to the disincentives inherent to the tax benefits system. Cross-countries scatter-plot indicates that higher tax wedges on second earners are associated with higher unemployment rate for women working part-time. This result suggests that hours worked by second earners, mostly women, are responsive to the tax disincentives inherent to the tax benefits system corroborating the existing empirical evidence. The 2016 tax reform will likely have a limited impact on the tax wedge on second earners, although, evidence from policy changes in several countries indicate that breaking the link between a husband’s income and a wife’s tax rate increases female labor market participation.10 For instance, any additional incentive received by the second earner under the optional individual taxation is at the cost of the principal earner, mainly because the tax scale applied to the first earner under the joint taxation is more favorable than that under individual taxation implicitly subsidizing couples who file jointly. Further steps are then needed to increase work incentives for women.

A03ufig13

Unemployment Rate and Tax Wedge for Second Earner

(Percent)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Source: OECD.

20. Further expanding the daycare and after-school programs could improve the labor market attachment of women (Figure 10). There is a clear consensus from the literature that the labor market participation of women, especially lone mothers, is highly responsive to work incentives.11 In Luxembourg, the net cost of childcare bore by workers are relatively high, reducing incentives for women with young child to participate to the labor market. The recently introduced free weekly 20 hours multilingual childcare is a step in the right direction. Additional steps to enlarge the availability of daycare and after-school programs could further encourage women labor market participation.

Figure 10.
Figure 10.

Work Incentives for Women

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

21. Incentives for older workers to keep working should also be improved (Figure 11). While the decision to work or retire is likely to be influenced by many factors, empirical evidence suggests that the financial incentives to retire faced by older workers play a significant role both for men and women. Taxation will affect the financial incentive to retire by affecting both the financial return to continued work, and the level of net retirement income. In Luxembourg, the generous pension system with several options of early retirement discourages older workers’ labor market participation, excites them to exit early, and generates lower duration of work life.

Figure 11.
Figure 11.

Work Incentives for Older Workers

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

A03ufig14

Average Net Pension Replacement Rate, 2014

(Percent of Earnings)

Citation: IMF Staff Country Reports 2018, 097; 10.5089/9781484350041.002.A003

Sources: OECD

C. Modeling the Effects of the Tax-Benefits System on Labor Market Outcomes

To assess the role of tax and benefits systems on labor force participation and unemployment, this section estimates and compares, across specific groups of workers, the relationship between these variables.

22. Related literature. The vast literature on labor supply offers a large number of models, with various explanatory factors, depending on the group of workers considered. Blanchard and Wolfers (2000), Bassanini and Duval (2006, 2009), de Serres and Murtin (2012, 2014), and Gal and Theising (2015) among others study the drivers of unemployment/employment for different groups. Jaumotte (2003), Duval (2004), Duval et al (2012), Christiansen et al (2016), Olivietti and Petrangolo (2017), and WEO (2018, forthcoming) analyze the determinants of labor market participation.

23. Empirical specification. To assess the role of tax-benefits structure, this section estimates a reduced-form specification of labor market participation (or unemployment) that relate the participation (or unemployment) rate of specific groups of workers to indicators of tax-benefits system, controlling for all differences across countries that are constant over-time and all shocks affecting equally all countries. Although the potential set of drivers of participation and unemployment rates is large and their importance may vary across worker groups, the analysis focuses predominantly on tax-benefits factors. More precisely, the analysis is based on the estimation of the following equation:

LMIk,tg=βgXk,tg+δgZk,tg+γkg+θtg+ɛk,tg

in which LMIk,tg refers to the labor market indicator—here participation rate or unemployment rate—of worker group g in country k at time t. X represents the set tax-benefits indicators considered in the analysis - the participation tax rates from unemployment or inactivity, the tax wedge, and the net replacement rate of unemployment benefits over 5 years. Z includes an indicator of the cyclical position of the economy (output gap/GDP growth rate) and other determinants of labor supply (share of population with secondary/tertiary education).

24. Data, sample, and variable definition. The estimation sample covers 35 advanced OECD countries over the period the period 2001–15. Tax-benefits indicators come from the OECD tax-benefits data and are simple-averages across all levels of income and all family situations to focus on measures that are comparable for all groups of workers. The groups include the whole working age population (15–64), as well as the following subgroups: young (15 to 24), prime-age (25–54), and senior (55–64); education attainment: low secondary, upper secondary, and tertiary; and gender: women and men.

25. Estimation strategy. The reduced form equation is estimated using cross-country panel regressions with country and time fixed effects. The standard errors are corrected using Hubert/White method to control heteroskedasticity and intragroup correlation. The use of cross-country panel regression provides average elasticities for the set of countries in the regression sample which may not be necessarily appropriate for all individual countries in the sample. To address this issue, the analysis re-conducts the estimations while excluding Luxembourg from the country sample. The results remain broadly unchanged, suggesting that the estimated coefficients are appropriate for Luxembourg. In addition, we augment the baseline specification with an interaction term between tax-benefits variables and a country dummy for Luxembourg. For almost all the results, the coefficient on the interaction term is not statistically significant, implying that the cross-country coefficient is valid for the individual case of Luxembourg. The results for the baseline specification are presented below.

26. Results. The estimated coefficients describe how changes in taxes and benefits cause changes in the unemployment rate or labor force participation. Table 1 (respectively Table 2) presents the effects of a 1-percentage point increase in each indicator of work disincentives on the unemployment rate (respectively the participation rate) across groups of workers in Luxembourg.

Table 1.

Effects on Unemployment Rate

Dependent Variable: Uneployment Rate

article image
Table 2.

Effects on Participation Rate

Dependent Variable: Participation Rate

article image
Note: ***, ** and * denote significant at 1%, 5% and 10% respectively.

27. On average, a 10-percentage points reduction in the participation tax rate from unemployment benefits would reduce the overall unemployment rate by 2.2 percentage points. A similar reduction in the net replacement rate of unemployment benefits would lower the unemployment rate by 2.6 percentage points. The highest elasticity is estimated for the tax wedge: a 10-percentage reduction in the average tax wedge would reduce the unemployment rate by 3.3 percent.

28. These aggregate elasticities conceal significant differences among sub-groups of workers. Across age-groups, the elasticity of the youth unemployment rate to the tax benefits system is more than double that of prime-age or older workers, irrespective of the indicator considered. Between skill groups, low-skilled workers are more responsive to the financial disincentives inherent in the tax-benefits structure than high-skilled workers. Men’s unemployment rate has a relatively larger elasticity than that of women. This gap could be explained by the fact that the female labor supply is more determined by other factors such as the accessibility of childcare, and the size of spouse-dependent and family benefits.

29. Only the labor supply of older workers is significantly responsive with the correct sign to either the participation tax rate from inactivity, or the tax wedge. More precisely, a 10-percentage point reduction in the participation tax rate from inactivity would increase the seniors’ labor market participation rate by 3.6 percentage points. The responsiveness of the older workers’ activity rate to the tax wedge is even higher. The relatively high elasticity of seniors’ labor supply to financial disincentives mirror the generosity of the pension system as well as the existence of early retirement options.

D. Conclusions

30. Overall job creation is strong, but unemployment of young and low-skilled workers declines only gradually and activity rates of women and seniors remain low. Despite robust employment growth, resident employment remains below the national target, and lags behind European peers, and a rising share of unemployed workers face longer spells without a job. Compared to the pre-crisis level, unemployment has increased for young, low skilled, and non-native resident workers, and is highly persistent for seniors. Labor market attachment is weak for seniors, and marginal for women who work mostly part-time.

31. Skills mismatches are a predominant factor in explaining structural unemployment, but work disincentives inherent to the tax-benefits system are also important. Weakening demand for routine manual jobs increases unemployment persistence, especially for low-skilled workers. High unemployment rates among the young and low-skilled reflect significant unemployment traps. The relatively low participation rate of women and the high gender-gap in part-time work mirror the high marginal effective tax rates for second-earners, especially at lower wages. Low participation of seniors is driven by the generosity of the pension system.

32. Making work more rewarding, especially for low earners, would improve their employment prospects. Refocusing unemployment and welfare benefits to promote active job search and vacancy acceptance, and a greater use of in-work tax credits would ensure that the unemployed are better off taking up a job than remaining unemployed, and hence reduce unemployment traps, especially for the low-skilled. The introduction of the Revenu d’Inclusion Sociale (REVIS) is a step in this direction.

33. Improving participation of women and seniors. The 2016 tax reform has introduced optional individual taxation for married or co-habiting workers. Consideration should be given to increasing the second-earner income tax-deduction. Moving to fully individual income taxation would make the tax system more gender neutral by reducing the marginal tax rate applied to the earnings of second earners, often women. Further expanding the availability of daycare and after-school programs could also improve women labor market participation. Raising the participation of seniors would also require limiting access to benefits for early retirement.

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Annex I. Definition of Tax and Benefit Indicators1

Financial incentives to work or to hire can be captured through several tax and benefits indicators mainly defined by the OECD. This annex focuses mainly on those used in this chapter.

The total labor cost is the sum of gross wage earnings of employees, employer social security contributions and - in some countries - payroll taxes.

The personal average tax rate is defined as income tax plus employee social security contributions as a percentage of gross wage earnings.

The net personal average tax rate is the personal income tax and employee social security contributions net of cash benefits as a percentage of gross wage earnings. The net personal average tax rate of the second earner is the increase in income tax and employee social contributions (net of in-work benefits) paid by the family because of the second earner entering workforce divided by the increase in family gross income because of the second earner entering in the workforce.

The tax wedge, the difference between the total labor cost of employing a worker and its net earnings, is calculated by expressing the sum of personal income tax, employee plus employer social security contributions together with any payroll tax, minus benefits as a percentage of labor costs.

The average tax wedge measures the part of total labor costs which is taken in tax and social security contributions net of cash benefits. The marginal tax wedge is the percentage of the marginal increase in labor costs that is deducted through the combined effect of increasing taxes and social security contributions and decreasing cash benefits.

The marginal effective tax rate measures what part of an increase in earnings, due to an increase in the number of hours worked or to a change in employment situation, is “taxed away” by the imposition of personal income taxes and employee social security contributions, considering the possible withdrawal of social and other earnings-related benefits.

The net cost of childcare is the difference in “family net income” of a family who uses center-based childcare and an otherwise identical family who does not as a percentage of net family income before deducting any childcare expenses.

The net replacement rate is the net income of an unemployed person receiving unemployment and possibly other benefits, expressed as a share of the income earned previously in the job before becoming unemployed and is calculated at different points in time because unemployment benefits decline over unemployment spell. Similarly, the net pension replacement rate is defined as the individual net pension entitlement divided by net pre-retirement earnings, considering personal income taxes and social security contributions paid by workers and pensioners.

The average effective age of retirement is defined as the average age of exit from the labor force during a 5-year period calculated as a weighted average of (net) withdrawals from the labor market, net labor force exits being estimated by the difference in the participation rate for each 5-year age group (40 and over) at the beginning of the period and the rate for the corresponding age group aged 5-years older at the end of the period.

The participation tax rate, the proportion of gross earnings taken in tax or reduced benefits, is measured by one minus the financial gains to working (net income in work - net income out of work) as proportion of gross earnings, and is calculated for moving form inactivity (or unemployment benefits) to work.

The trap, calculated as the share of additional gross income of such a transition that is taxed away by the combined effects of higher taxes and lower benefits, refers to the financial incentive to move from one labor market situation to another. Hence, the inactivity (unemployment) trap measures the incentive for an inactive person (an unemployed person) not entitled to unemployment benefits but potentially receiving other benefits such as social assistance (receiving unemployment benefits) to move to paid employment. The low-wage trap measures the financial incentive to increase a low level of earnings by working additional hours.

Both these measures attempt to capture the incentive to work at all, or to progress in work and are defined for different income levels, and family situations. Low numbers correspond to stronger financial incentives, but are different and behave differently following different sorts of changes in income. For example, an increase in the gross hourly wage will strengthen incentives according to the net replacement rate, but will have ambiguous effects according to the participation tax rate. Moreover, as tax and benefits vary greatly across countries, international comparisons should be made cautiously and based on a broad range of measures.

Annex II. Estimation Results

Table 1.

Dependent Variable: Unemployment Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTRUB (respectively NRR5Y) is the participation tax rate from (repectively net replacement rate of) unemployment benefits averaged across all levels of income and family situations.
Table 2.

Dependent Variable: Participation Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* Denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTR Inactivity is the participation tax rate from inactivity averaged across all levels of income and family situations.

Annex III. Introducing Interaction Terms

Table 1.

Dependent Variable: Unemployment Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* Denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTRUB (respectively NRR5Y) is the participation tax rate from (repectively net replacement rate of) unemployment benefits averaged across all levels of income and family situations.
Table 2.

Dependent Variable: Participation Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* Denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTR Inactivity is the participation tax rate from inactivity averaged across all levels of income and family situations.

Annex IV. Excluding Luxembourg

Table 1.

Dependent Variable: Unemployment Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* Denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTRUB (respectively NRR5Y) is the participation tax rate from (repectively net replacement rate of) unemployment benefits averaged across all levels of income and family situations.
Table 2.

Dependent Variable: Participation Rate

article image
Source: IMF Staff Calculation.Notes: Standard errors are in parentheses.* Denotes significant at the 10 percent level, ** at 5 percent, *** at 1 percent.PTR Inactivity is the participation tax rate from inactivity averaged across all levels of income and family situations.