Fiscal Policy and Employment in Advanced and Emerging Economies

This paper discusses tax and expenditure policy reforms to raise employment. Using data for 58 advanced and emerging economies, the paper provides a unified assessment of tax and expenditure measures that have usually been addressed separately. The focus is on incentives to increase labor demand and supply rather than on the impact of fiscal policy on employment through aggregate demand effects. It also discusses policies to improve the matching of labor supply and demand, and the principles which should guide the design of country-specific fiscal reforms to boost employment. A comprehensive set of tables on fiscal policies and labor market outturns for advanced and emerging economies is provided, permitting cross-country comparisons to facilitate the design of reform strategies.

Abstract

This paper discusses tax and expenditure policy reforms to raise employment. Using data for 58 advanced and emerging economies, the paper provides a unified assessment of tax and expenditure measures that have usually been addressed separately. The focus is on incentives to increase labor demand and supply rather than on the impact of fiscal policy on employment through aggregate demand effects. It also discusses policies to improve the matching of labor supply and demand, and the principles which should guide the design of country-specific fiscal reforms to boost employment. A comprehensive set of tables on fiscal policies and labor market outturns for advanced and emerging economies is provided, permitting cross-country comparisons to facilitate the design of reform strategies.

I. Introduction

1. The low employment rates currently experienced by many economies reflect both cyclical conditions and deep-rooted weaknesses in labor market institutions and fiscal policies. Substantial job losses since the onset of the global financial crisis have contributed to a decline in employment rates by 3% percentage points in advanced Europe and 3 percentage points in emerging Europe. More than four out of every 10 persons of working age is now without a job in Greece, Italy, and Spain. In the United States, employment rates reached a 25-year low in 2010, and remain at depressed levels in early 2012. However, in many advanced economies, employment rates were low even before the crises, pointing at underlying structural problems. In many emerging economies, particularly in the Middle East, the labor-market situation continues to be dire, with economies like Egypt, Morocco, and Jordan having employment rates of less than 50 percent even without having been greatly affected by the crisis. High rate of joblessness among the young risks reducing the human capital of an entire generation of workers in a number of countries.

2. Increasing employment is an important policy goal. Reducing involuntary unemployment—which occurs when those who actively seek work are unable to find it— increases welfare. Involuntary unemployment creates an unambiguous loss, both in direct human terms and by reducing economic output (Dao and Loungani, 2010). Increasing labor force participation can also potentially enhance welfare if it goes hand-in-hand with higher employment. Raising formal sector employment is especially important for three working-age groups: (i) “discouraged workers” who withdrew from the labor market because of a lack of jobs; (ii) those who do not seek work because of high taxes and available social benefits; and (iii) those employed in the informal economy. In general, a shift into formal employment improves public finances through higher revenues and can also create “better” (i.e., more stable and productive) jobs. This said, country preferences, including the choice between work and leisure, also matter and various policy goals may be competing. Thus, this paper suggests tools for policy-makers that wish to achieve a higher employment rate, and is not prescriptive about the level of employment that, in general, countries should aim at.

3. This paper discusses tax and expenditure policy reforms to raise employment.

Using data for 58 advanced and emerging economies,1 the paper provides a unified assessment of tax and expenditure measures that have usually been addressed separately.2 It focuses on policies that increase labor demand in the short run and labor supply (through higher labor force participation rates) over the medium term,3 recognizing that policies that may be appropriate to promote employment in the context of depressed aggregate demand may be ineffective over the medium term. It also discusses some regulatory issues regarding labor markets, as well as policies to improve the matching of labor supply and demand (which reduces frictional unemployment). The appropriate reform strategy will differ from country to country, depending, among other things, on the functioning of the labor market, the nature of the employment challenges, existing administrative capacity, and fiscal constraints.

4. The paper is structured as follows. Section II reviews some labor market facts in advanced and emerging economies, and assesses trends in the level and structure of tax and social spending programs that can affect employment. Section III discusses the impact of these policies on labor-market outcomes, distinguishing between policies that aim primarily to stimulate labor demand or labor supply. The role of fiscal policies relative to other determinants of labor market outcomes (such as labor market regulations) is also assessed. Section IV formulates broad guidelines for policy reform across advanced and emerging economies. A comprehensive set of tables on fiscal policies and labor market outturns for advanced and emerging economies, permitting cross-country comparisons to facilitate the design of reform strategies, is included in Appendix 2.

II. Trends in Labor Markets, Taxation, and Social Spending

5. Fiscal policy affects labor markets both through the design of tax systems and the structure of social benefits. Labor market performance can be gauged in a stylized way by looking at three key indicators—who wants to work (labor force participation), has work (employment), and does not have work (unemployment)—and the policies that shape them.

A. Key Labor Market challenges Patterns and trends in labor markets

6. Average labor force participation rates—percentages of the population aged 15-64 that are either employed, or unemployed and actively seeking work—have risen over the past 20 years, primarily due to females entering the work force. An exception is emerging Europe, where female participation rates actually declined (Figure 1). Still, across all countries, average female participation rates remain almost 20 percentage points lower than those for men. Increasing female participation rates thus represents a large potential source of future labor force growth in many countries, especially in emerging economies.

Figure 1.
Figure 1.

Labor Force Participation, 1990-2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: IMF staff estimates, based on ILO Key Indicators of the Labor Market (KILM) and the Labor Force Surveys of Eurostat and the OECD.Note: Based on 3-year moving averages.

7. The labor force participation of older males is substantially below that of other age groups. Despite recent increases, participation rates of men between 55 and 64 remain fairly low at an overall average of 67 percent, compared with 92 percent for the 25-54 age group. Participation rates of older men decreased considerably during the 1970s and 1980s, largely reflecting the gradual lowering of statutory retirement ages, the introduction of early retirement schemes, and an increased take-up of disability and unemployment benefits as alternative routes to early retirement. Since the 1990s, many countries have implemented reforms designed to offset this by encouraging older workers to delay retirement, but additional reforms are warranted (IMF, 2011a).4

8. Unemployment rates have risen almost everywhere since the onset of the global economic crisis (Figure 2).5 By 2011, unemployment rates had risen to 9 percent in advanced Europe, 6 percent in other advanced economies, and 10% percent in emerging Europe. Only other emerging economies avoided a sharp uptick in unemployment, reflecting the more limited effects of the crisis on overall economic activity. Trends in youth unemployment show a similar pattern as total unemployment, although at a higher level.

Figure 2.
Figure 2.

Unemployment Rates, 1990-2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: IMF staff estimates, based on ILO-KILM, Labor ForceSurveys of Eurostat, OECD, and IMF World Economic Outlook (WEO) database.Note: Based on 3-year moving averages.

9. Since the onset of the global economic crisis, employment rates—that is, the combined results of labor force participation and unemployment—have fallen almost everywhere. In 2010, employment rates (the employed population as a share of the working-age population) reached a ten-year low in one of every three advanced economies, especially as many economies were hit hard by the crisis (Figure 3). Although employment losses were—not surprisingly—greatest in economies experiencing the most dramatic declines in output, there was considerable variation in how sharply employment fell in response to output declines (Figure 4).

Figure 3.
Figure 3.

Employment Rates, 2007 and 2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: IMF staff estimates, based on ILO-KILM and Labor Force Surveys of Eurostat and the OECD.
Figure 4.
Figure 4.

Change in Real GDP and Employment, 2007-2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: IMF staff estimates, based on ILO-KILM, Labor Force Surveys of Eurostat and the OECD and IMF-WEO. Note: See Appendix 1 for list of country abbreviations.1Countries in circle: Brazil, Colombia, Jordan, Kazakhstan, Kenya, Malaysia, Morocco, Pakistan, the Philippines, Poland, Saudi Arabia, and Thailand.

Challenges by region

10. Employment outcomes vary markedly across regions. Among the advanced economies, differences in employment rates between the high-employment economies of Scandinavia and Switzerland and low-employment economies of southern Europe are over 15 percentage points (Figure 3). In the emerging economies, employment rates are lowest in the Middle East and North Africa (MENA), South Africa, and Turkey. They are relatively high in some Latin American countries (Brazil, Peru) as well as some emerging European economies (Kazakhstan, Russia).

11. Specific labor-market problems also differ across regions. Table 1 provides a disaggregated overview of regional performance on various indicators of unemployment (total, youth, unskilled, and long-term) and labor force participation by gender and age group. Key areas of concern are:

Table 1.

Key Labor Market Challenges for Different Country Groups, 2010/111

article image
Sources: ILO-KILM, Labor Force Surveys of Eurostat and OECD and IMF-WEO.

Data for unemployment rates refer to 2011, while other data are for 2010. Green = relatively good performance with limited room for improvement (Unemployment: Total < 5; Youth < 15; Long < 20; Low < 10. Participation: Total > 75;

M25–54 > 90; M55–64 > 70; F25–54 > 75; F55–64 > 55).

= intermediate performance, with some room for improvement;

= relatively weak performance with large room for improvement (Unemployment: Total > 10; Youth > 20; Long > 40; Low > 20.

Participation: Total < 55; M25–54 < 80; M55–64 < 60; F25–54 < 60; F55–64 < 40).

South-4 = Greece, Italy, Portugal, Spain; East-4 = Czech Republic, Estonia, Slovak Republic, Slovenia;

North-5 = Denmark, Finland, Iceland, Norway, Sweden; Other-8 = Austria, Belgium, France, Germany, Ireland, Netherlands,

Switzerland, United Kingdom; US-CAN = United States and Canada; Other-5 = Australia, Israel, Japan, Korea, New Zealand;

MENA-4 = Egypt, Jordan, Morocco, Saudi Arabia; Latin-6 = Argentina, Brazil, Chile, Colombia, Mexico, Peru; Asia-8 = China, India,

Indonesia, Kazakhstan, Malaysia, Pakistan, Philippines, Thailand; Africa-3 = Kenya, Nigeria, South Africa.

Total unemployment numbers are for 2011, based on the most recent estimates of the IMF-WEO.

Youth = unemployed aged 15–24, emerging Europe excluding Ukraine; Asia excluding China.

Long = share of long-term unemployment, exceeding one year, in total unemployment; emerging Europe excluding Russia and Ukraine.

Low = low skilled, less than upper secondary education, data for 2009; other advanced excluding Japan, emerging Europe only

Hungary, Poland and Turkey; Latin America only Brazil, Chile and Mexico.

M25–54 = males between age 25 and 54; M55–64 = males between age 55 and 64, F25–54 = females between age 25 and 54;

F55–64 = females between age 55 and 64.

  • High youth unemployment, especially in Southern and Eastern Europe, and the Middle East and North Africa. Youth unemployment is often over twice the national average, but in these country groups is especially elevated.

  • Elevated rates of long-term unemployment, especially in Southern, central, and Eastern Europe. This is less of an issue in Scandinavian countries and in other advanced economies—although an increasing problem in the United States. Long spells of unemployment may lead workers to drop out of the labor force and lose human capital.

  • High rates of unemployment among the unskilled in advanced economies (approximately 50 percent above the average). Rates are also high in Central and Eastern European countries, where they often exceed 20 percent. High unemployment in this group contributes to higher inequality.

  • Low participation rates among women less than 55 years of age, most notably in emerging economies and Southern Europe. Female participation rates in the 25-54 age group are approximately 60 percentage points lower than those for males in the Middle East and North Africa, 30 percentage points lower in Latin America and Asia, and 20 percentage points lower in Southern Europe.

  • Low participation rates of older segments of the population in the Middle East and North Africa and parts of Europe. Rates for those in the 55-64 age group are generally between 30 and 40 percentage points lower than those for prime-age groups in these regions—although this partly reflects poorer health and ability to work at this age.

B. Fiscal Policies Affecting Labor Markets

12. Two key areas of fiscal policy affecting employment performance are the design of tax systems and the structure of social benefit schemes.

  • Taxes on labor (personal income taxes and social security contributions) directly reduce labor demand by driving up labor costs and reduce labor supply by lowering after-tax wages. Less directly, final consumption taxes, such as VAT or excises, can have much the same effect by reducing real wages. Corporate taxes can affect employment by reducing investment and production, and by reducing labor supply to the extent that firms pass on these taxes to employees in the form of lower wages.

  • Social benefits (government spending on pensions and welfare benefits, including family, unemployment-related, and social assistance benefits) affect labor markets in much the same way as taxes do, by weakening the link between labor supply and incomes. The availability of pensions, for example, affects retirement decisions. The availability of unemployment benefits affects labor force participation, job search, and job acceptance behavior. Similarly, social assistance can reduce work incentives, especially if benefits are withdrawn as earnings rise (i.e., are means-tested).

The rest of this sub-section looks at trends in the levels of taxes and social benefits. Taxes

13. There are striking differences in the tax mix across country groups. Advanced Europe has relatively high tax-to-GDP ratios for all major taxes (Figure 5), including for direct labor taxes. Other advanced economies also have high income tax ratios, but much lower social security contributions and lower general sales taxes, with the reverse holding true for emerging Europe. In other emerging economies, personal income taxes and social security contributions are relatively insignificant, while corporate income taxes represent a larger source of revenues. The low revenues from personal income taxes and social security contributions in these economies reflect significant labor market informality.

Figure 5.
Figure 5.

Tax to GDP Ratios, 1980-2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Source: IMF Tax Revenue Database.

14. Since the early 1980s, the burden of taxation has shifted away from personal income and toward consumption, except in other emerging economies. Concerns about large labor-market distortions from high personal income tax rates have sparked considerable reform of tax systems in advanced economies. While personal income tax ratios have declined as a result, receipts from consumption taxes have risen. Between 1980 and 2010, for example, personal income tax revenue declined by about 1% percentage points of GDP in other advanced economies, while consumption tax revenues rose by a similar amount. Despite a gradual lowering of statutory rates, corporate tax revenues have increased as a percentage of GDP owing to a gradual broadening of tax bases. In other emerging economies, tax-to-GDP ratios have been increasing across the board, with the exception of trade taxes.

Social benefits

15. The welfare state is much larger in advanced and emerging Europe than elsewhere. In 2007, average spending on social benefits (i.e., pension benefits and other “welfare” benefits) in advanced and emerging Europe stood at around 15 and 12 percent of GDP respectively, compared with 9 percent in other advanced economies and 6 percent in other emerging economies. With the exception of other emerging economies, pension spending accounts for over two-thirds of social benefit spending. High pension spending in European economies reflects higher levels of benefits than in other advanced economies, as well as greater pension coverage than in other emerging economies (Figure 6). However, welfare spending in emerging Europe is substantially lower than in advanced economies and even below the spending levels of other emerging economies, although welfare spending in the latter often includes large spending on price subsidies (rather than, say, family or unemployment benefits), which are less important for labor supply incentives.

Figure 6.
Figure 6.

Social Benefits, 1970-2010

(Percent of GDP)

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: OECD, ECLAC, Eurostat, IMF, and ILO databases. See Appendix 3 for details.Note: For welfare spending, other emerging comprises Argentina, Brazil, Chile, Egypt, and Mexico.

16. The size of the welfare state has been increasing everywhere over the past four decades, but especially in European countries. The increase in social benefit spending is predominantly due to increasing outlays for pensions (Figure 6). The sharp increase in pension spending in advanced economies and emerging Europe between 1970 and 1980 reflected increased population coverage. While pension spending stabilized thereafter at around 6 percent of GDP in other advanced economies, it continued to increase in European countries owing to increased levels of benefits and population aging. The pension reforms adopted in Europe after the mid-1990s have stabilized spending at around 9-10 percent of GDP. The steady increase in pension spending in other emerging economies reflects a gradual increase in the coverage of pension systems from relatively low levels.

17. Following a period of steady decline, welfare spending has recently increased sharply in many countries owing to the economic crisis. Between the early 1990s and 2007, increased pension spending was more than offset by declines in other components of welfare spending, reflecting lower unemployment as well as reforms (especially in high-spending Nordic countries such as Denmark, Finland, and Sweden). However, between 2007 and 2009, welfare spending increased in virtually all countries, especially in those hit hard by the crisis, such as Estonia, Iceland, Ireland, and Lithuania (Figure 7), where welfare spending increases exceeded 2 percentage points of GDP. On average, over 60 percent of the increase in advanced Europe was due to higher unemployment-related benefits.

Figure 7.
Figure 7.

Welfare Spending, 2007 and 2009

(Percent of GDP)

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: OECD, ECLAC, Eurostat, IMF, and ILO databases.

III. How Fiscal Policy Affects Employment

18. The conceptual framework used here to assess the effect of fiscal policies on employment focuses on the interaction between labor demand and supply. It recognizes that the initial state of the labor market can be one of involuntary unemployment and that the relative effectiveness of fiscal policy measures can differ over the short and medium term. As discussed in Box 1, involuntary unemployment implies an excess of labor supply over demand, and labor demand policies are usually more effective in raising employment in the short run. Such policies might also raise employment in the medium term, although the wage increases they induce would moderate the effects. In the medium term, stimulating labor supply will be important to move employment to permanently higher equilibrium levels.

Policy Options for Boosting Employment: Conceptual Framework

For countries faced with weak labor demand in the wake of a large output shock, policies that directly boost labor demand are the best option for increasing employment. Over the longer term, increases in labor supply are essential for bringing employment to a new, higher equilibrium level ALMPs that improve the matching of labor supply and demand can also have permanent effects on employment by reducing labor market frictions.

In the short term, policies to increase labor demand are usually more effective in increasing employment than policies that increase supply. To illustrate this conceptually in a stylized framework, assume that labor demand declines from an initial equilibrium level (W0E0) after a large shock to output, so that the labor demand curve shifts to the left. This creates unemployment (E1E0). Even assuming full wage flexibility (which is usually not the case in the short term) to restore the equilibrium between demand and supply, employment would not recover to the initial level. Policies to increase labor demand can increase employment and output (and reduce unemployment) by shifting the labor demand curve back. However, policies that increase labor supply do not raise employment as long as wages do not adjust.

In the medium term, both demand-side and supply-side policies can increase employment and output. Lower labor taxes or lower social benefits can improve incentives for labor force participation and hours worked and shift the labor supply curve to the right. With flexible wages, a higher labor supply will gradually moderate wages so that the additional supply gets absorbed by additional labor demand. If so, equilibrium is restored and employment is increased. As capital adjusts in response to increased employment, wages may ultimately return again to a higher level.

Improving job matching can help reduce unemployment and help raise employment and output to permanently higher levels. Even when there are no cyclical weaknesses in economic activity, there will be some unemployment due to frictions in the matching of workers and vacancies, accompanied by time-consuming search and screening by workers and firms. Such imperfections and frictions lead to structural unemployment (Mortensen and Pissarides, 1994). The strengthening of job-search assistance, training programs, and other such reforms can address these structural market imperfections and reduce the natural rate of unemployment.

Finally, measures to improve the match between labor demand and supply can be effective both in the short and the long run by reducing frictional unemployment.

19. Empirical evidence supports the view that fiscal policies have a significant impact on employment and unemployment, while research on the effects of institutions is less conclusive (Table 2). Taxes and social benefits can affect participation rates, hours worked, and unemployment. Also, microeconomic studies, in particular, provide evidence that certain ALMPs, like job search assistance and training programs, can help to reduce unemployment (Card and others, 2010; Spevacek, 2009). Institutional variables, including minimum wages, also matter for employment, but the empirical results are often less robust (Appendix 3). For instance, studies often report insignificant effects of employment protection legislation on unemployment, while indicators for trade union coordination often come out with a favorable impact.6 Non-economic factors, such as social preferences, also influence labor market outcomes (Blanchard, 2004).

Table 2.

Effect of Fiscal Policies and Institutions on Structural Unemployment

article image
Sources: Staff analysis based on reviews in OECD (2006) and recent studies.

20. Three caveats should be kept in mind when assessing the implications of the literature for the formulation of country-specific policy advice (see Section IV):

  • Empirical evidence on the impact of tax and expenditure policies on employment has mainly focused on advanced economies, reflecting both data availability and the relatively large size of their welfare systems. These results may not be fully applicable to emerging economies, which still need to expand the coverage of workers under the income tax and social security systems, and do so without curtailing employment or exacerbating incentives for informality.

  • The evidence presented in this section reflects the results of studies on the average impact of specific policies across countries. This may hide important variations in the effectiveness of reforms for a given economy because of differences in labor market institutions, initial employment conditions, and administrative capacity.7

  • Some policies may face diminishing returns, i.e., programs that work well on a small scale should not necessarily be expanded. Hiring subsidies, for example, can lose effectiveness as they expand beyond target groups with high rates of long-term unemployment.

A. Policies to Boost Labor Demand

21. Labor demand might expand both through higher aggregate demand, including exports, and by raising the labor-intensity of production. Advanced and emerging economies have been trying to mitigate the unemployment effects of the crisis-induced drop in aggregate demand, including by reducing (non-wage) labor costs and setting up new programs aimed at creating or maintaining jobs (Box 2). While possibly stimulating labor demand in the short run, some of these measures may not increase employment over the medium term and may need to be phased out, particularly as economic activity recovers. This sub-section evaluates different fiscal policies and discusses which ones are most effective.

Recent Job Creation Measures in Advanced and Emerging Economies

Since the onset of the global economic crisis, most advanced and emerging economies have introduced or expanded programs to support labor demand. These have included credit to small and medium enterprises (SMEs), wage subsidies for existing and new jobs, reductions in non-wage labor costs (e.g., payroll or social insurance taxes), short-time work (work sharing) schemes, and public works programs. Advanced economies relied more on wage subsidies for new jobs and short-time works schemes, while emerging economies more often increased credit and support to SMEs, wage subsidies for existing jobs, and public works. For public works programs, advanced economies implemented such programs largely in the form of temporary increases in infrastructure and related spending as part of broader stimulus packages, while in emerging economies many programs were oriented towards the direct provision of jobs.

There has also been a strong expansion of ALMPs, especially in advanced economies. The

share of advanced economies introducing or expanding ALMPs is nearly 80 percent, mostly oriented toward improving training and job search/intermediation. Most emerging economies (over 60 percent) have also expanded ALMPs, although the effectiveness of these programs may be limited by implementation capacity. In 2011, a number of advanced economies further expanded spending on ALMPs, including for training (Ireland, Italy, the Slovak Republic, Spain, and the United Kingdom) and job search/intermediation services (the Slovak Republic, Spain). Sweden is the only advanced economy that has rolled back temporary ALMPs introduced during the crisis.

uA01fig02

Shares of Advanced and Emerging Economies Introducing Labor Demand and Active Labor Market Programs During 2008-2010, By Type of Program

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Sources: IMF staff, based on data from Robalino and others (forthcoming); OECD (2009, 2010, 2011f, 2011g, 2011h, 2011i); World Bank (2011a, 2011b); EC (2009a, 2009b, 2009c); and EC databases.

Taxation

Reducing labor taxes

22. Reductions in labor taxes can help stimulate labor demand. Empirical estimates for advanced economies suggest that the price elasticity of labor demand is close to -1 (Cahuc and Zylberberg, 2004). Hence, if an average OECD country would cut employer social contribution rates (which directly reduce labor costs) by 3 percentage points—implying a direct revenue loss of approximately 1 percent of GDP—this would increase domestic labor demand by 2.5 percent.8 However, over time, increased labor demand would feed into higher wages and the beneficial effects on employment would be mitigated.

23. Reductions in non-wage labor costs are most effective if targeted to low-wage earners. Empirical evidence suggests that the demand for low-skilled labor is relatively elastic (Hammermesh, 1993) and therefore reacts more strongly to policy measures. Moreover, targeted reductions can relax minimum-wage constraints in countries where high labor costs limit job openings for low-skilled workers. For example, targeted tax relief could take the form of a threshold below which no or lower social contributions are levied.

Tax shifts

24. A revenue-neutral shift from labor to consumption taxes could boost labor demand. For instance, reductions in employer social security contributions financed by higher consumption taxes (or higher recurrent property taxes) can raise labor demand by lowering (non-wage) labor costs. The effects of such tax shifts have been subject to extensive analysis for closed economies, but recently received more attention in open economies with a fixed exchange rate where they might induce a “fiscal devaluation.” Indeed, fiscal devaluations could speed up convergence to long-run equilibrium by reducing real labor costs and improving competitiveness, thus raising employment compared to the initial situation (IMF, 2011b). Model simulations for Portugal, for example, suggest that a fiscal devaluation equivalent to 1 percent of GDP would raise employment in the short term by between 0.2 and 1 percent (ECB, 2011).

25. The long-term employment effects of tax shifts depend on the extent to which the tax burden is shifted away from labor income and onto other incomes. Price adjustments will eventually drive up wage costs for employers. Compared to the long-run equilibrium under full wage flexibility, the impact of a tax shift on employment is thus expected to gradually disappear across time. The adjustment, however, can take quite some time

(De Mooij and Keen, 2012). Moreover, there may be more subtle effects that render the long-term effects of a tax shift positive on growth and employment. This is confirmed by model simulations (Auerbach and Kotlikoff, 1987) as well as empirical studies (Daveri and Tabellini, 2000; Arnold, 2008). For instance, consumption taxes have a broader base than social contributions, bearing on all incomes that support consumption, including income from economic rents and social transfers.

26. A shift from social contributions to consumption taxes may increase inequality and require offsetting measures. Unlike general taxes, social contributions may be related to the social benefits people receive (see Box 3). In addition, consumption taxes are usually slightly regressive—although less so on a lifetime basis—while labor taxes are usually progressive. A tax shift can also reduce the real value of social transfers as price levels rise in response to higher consumption taxes. This may require offsetting measures to address equity concerns.

Social Contributions Versus Taxes: Implications for Employment

Financing social benefits through payroll contributions rather than taxes can potentially be better for employment—but only if workers perceive a strong link between the two. Social benefits, such as pensions, can be financed either by general taxes or contributions paid by employers and/or employees (by payroll deduction). From a worker’s perspective, mandatory payroll deductions that have no or only weak links to the benefits they finance are likely to have the same adverse effect on labor supply as a tax on wages. However, where workers perceive a strong relationship between the amount and number of years of contributions to the pension system and pension benefits, the adverse impact on labor supply will be mitigated. Empirical evidence suggests that strengthening the link between contributions and benefits improves labor market outcomes (Disney, 2004). Over the longer term, contributions paid by employers will have a similar effect on labor markets as those paid by employees.

where perceived links between contributions and benefits are weak, relying on broader taxes could increase employment. Most health systems and some pension systems have no or only weak contribution-benefit links. This reflects the redistribution built into many systems, with those paying relatively low contributions receiving proportionately higher benefits. In addition, even where links are strong, myopia may lead workers to view the contribution as similar to a tax. Reflecting these factors, empirical evidence suggests that increases in social contributions reduce employment (OECD, 2007). Where the contribution-benefit link is not perceived to be strong, using taxes that bear not only on labor but on capital income, transfers, and property to finance social benefits could help reduce labor costs and increase employment. However, in reforming the tax system, other considerations also must be taken into account, including equity and administrative capacity.

Business tax incentives

27. Reductions in business taxes can boost labor demand, including over the longer term, but are likely to favor more skilled workers. By lowering the cost of capital, reductions in the effective tax rate on business income have two opposing effects: substitution from labor to capital reduces labor demand, but higher investment raises output—including over the longer term—and therefore labor demand. On balance, most empirical studies suggest that labor demand expands (Chirinko, 2002). Moreover, business tax relief can ease financing constraints for firms relying on retained earnings, thus further raising investment. These effects are consistent with the finding that reductions in the cost of capital reduce unemployment (Phelps, 1994; Blanchard, 1997). 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.

28. compared with general business tax relief, targeted measures for specific firms or sectors are often less effective in generating employment. Many countries have favorable tax facilities for small businesses, even though the economic rationale for them is weak (Box 4). Moreover, emerging economies often use special business tax incentives (such as tax holidays, low-tax economic zones, or sectoral investment incentives) to attract foreign investment and create jobs.9 Such policies, however, are generally less effective in encouraging investment than policies that benefit all sectors of the economy equally, as they create distortions that reduce productive efficiency. They are also more vulnerable to abuse and corruption than are policies based on a level playing field for all firms.

Small Businesses, Employment, and Tax Policy

There is widespread belief that small firms create more jobs than large firms, but evidence is mixed.

Many countries maintain tax schemes that support small businesses, such as reduced corporate tax rates for profits under a certain threshold, special tax allowances for investments by small firms, or tax preferences for (venture) capitalists who invest in small enterprises. While Ayyagari and others (2011) find higher job growth in small firms in a panel of 99 countries, including emerging economies, other studies do not support these findings. For the United States, for example, there is little evidence that small firms create more jobs (Davis and others, 1996; Neumark and others, 2011); this is also supported by Haltiwanger and others (2010), who find that firm age, rather than size, matters for job growth.

A clear economic rationale for having special tax advantages for small firms does not exist

(International Tax Dialogue, 2007). There is no evidence that targeted tax relief for small firms is more effective in increasing aggregate employment than general tax relief for businesses. In fact, special relief may hurt economic growth by creating a small-business trap, preventing small firms from growing larger to maintain their special tax treatment. Jobs created by small firms are also generally of lower quality than jobs created by large firms, with the former paying lower wages, offering more modest health insurance and pension plans, and providing poorer working conditions (Brown and others, 1990).Furthermore, jobs in small firms feature higher turnover and typically involve less on-the-job training (OECD, 2005). Also, on a macroeconomic level, smaller firm size is associated with slower innovation and lower productivity growth (Pagano and Schivardi, 2003; Ayyagari and others, 2011).

Policies that ensure access to financing for small businesses and simplify their tax compliance procedures are more likely to be effective in leveling the playing field. Small firms may find it more difficult to access debt and equity markets to finance investments than large firms, especially during a financial crisis. The best policy response to such financing constraints is to act directly on these market imperfections, for instance by offering subsidized loans, grants, or guarantees. Specific programs that support the unemployed in starting a new business have been found to be relatively effective in addressing start-up problems (Caliendo and Kuhn, 2011). A simplified tax regime for small taxpayers may be desirable if these firms face relatively higher costs in complying with complex tax rules.

Expenditures

29. Hiring and wage subsidies can be effective in boosting employment if appropriately targeted. These subsidies may be helpful in getting firms to generate new jobs, rather than to extend the hours of existing employees, in an environment of substantial macroeconomic uncertainty (IMF, 2010). The effectiveness of these subsidies in increasing employment depends on the degree to which they reduce hiring that would have occurred also without the subsidies or lead employers to substitute one type of individual for another to take advantage of the subsidy. These subsidies are usually more effective when targeted to workers for low-wage jobs, which would not be viable without them. Such targeted subsidies are especially effective in improving youth employment (Fougère and others, 2000), and are more effective if they are targeted to workers rather than firms. For instance, hiring subsidies targeted at “new” jobs are notoriously complex to monitor and end-up in low take-up (Neumark, 2011) and small employment effects (Chirinko and Wilson, 2010).

30. Employment support schemes can reduce lay-offs, but their scope and duration should be limited to avoid adverse long-term effects. Employment support schemes allow employers to reduce hours worked without layoffs while the government compensates workers for the resulting loss of income. About 70 percent of advanced and 45 percent of emerging economies have such schemes, and there is evidence they have helped to preserve jobs during downturns, especially in Germany and Japan (Cahuc and Carcillo, 2010). Employment support schemes should be withdrawn as economic conditions improve to prevent locking workers into unproductive jobs or sectors and to reduce fiscal costs. These schemes are more effective if used to address large and temporary demand shocks. To help prevent these schemes from locking workers into declining sectors, consideration could also be given to introducing wage loss insurance (Kling, 2006; IMF, 2010). This would help facilitate the movement of workers to those firms where job prospects may be brighter over the longer term but which offer lower wages.

31. Public works programs can also be effective in increasing employment in the short run, but should be phased out as economic activity recovers. Public sector employment programs have been widely used to limit rising unemployment. The expansion of such schemes was an important component of the policy response in many emerging economies to address recent food and fuel price shocks and the global financial crisis (Box 2). The net employment impact of these programs is enhanced by offering employment at low wages, thus encouraging self-selection by the unemployed. This feature also facilitates the scaling down of activities as the economy recovers.

32. Beyond public works, temporary public-sector employment programs are not cost-effective and risk permanent increases in the size of the public sector. There is little rationale for using public sector employment programs as part of a long-term employment strategy, as participation in these programs does not have a favorable effect on future employment prospects (Card and others, 2010; Kluve, 2010). Indeed, skills acquired in the public sector are often not transferable to the private sector, and governments generally face strong political pressure to transform temporary jobs into permanent positions.

33. A large public sector could hamper private sector employment. A large public sector tends to crowd out private employment, and at the same time, generate large fiscal costs. Public-sector jobs tend to pay more for unskilled workers than the private sector and may create a pool of job applicants waiting for permanent public sector employment. The availability of such public sector jobs may result in higher private sector wage demands, with negative indirect aggregate employment effects (Cahuc and Zylberberg, 2004). This is particularly the case in the MENA region.

B. Policies to Boost Labor Supply and Improve Job Matching

34. Policies to boost labor supply are generally desirable in the medium and long term, while policies that improve job matching are needed also in the short term. In the

medium term, increasing labor supply—in the form of both higher labor-force participation and longer working hours—can spur economic growth, contribute to fiscal consolidation by expanding the tax base and reducing social spending, and offset some of the effects of population aging. Some supply-oriented reforms can also boost employment in the short run by improving the functioning of labor markets and reducing structural unemployment. For example, training programs or strengthened job search requirements for the unemployed can help reduce mismatches between labor supply and demand.

35. The effectiveness of policies that raise labor supply will depend on the flexibility of both factor and product markets. Policies to boost labor supply usually have a gradual effect, as it takes time for people to adjust their working hours or participation choices. As indicated in Box 1, policies that increase labor supply require wages to adjust in order to actually raise employment. Moreover, the degree to which increases in labor supply are absorbed by higher demand also depends on the pace of economic growth. All these adjustments depend on the functioning of labor, capital, and product markets, which differs across countries. In the United States, for example, employment tends to be more responsive to increases in labor force participation rates than in Europe (Wasmer, 2009). This suggests that complementary reforms in labor, capital, and product markets may be helpful as labor supply expands, to ensure that an increased pool of workers finds its way into employment. In the remainder of this sub-section, the implications of specific tax and expenditure policies to boost labor supply and employment are discussed.

Taxation

36. A smaller labor tax wedge can significantly raise labor supply and employment over the medium and longer term. High marginal tax wedges reflect taxes on additional earnings and are important for incentives to work longer hours (intensive margin); high average tax wedges reflect total taxes over total earnings and matter for incentives for labor market participation (extensive margin). Marginal tax wedges are generally higher than average tax wedges, reflecting the progressivity of most income tax systems (Figure 8). The overall labor supply response to the tax wedge can be measured by the wage elasticity of labor supply. On average over different income groups, micro studies suggest a typical elasticity of labor supply in the economy between 0.2 and 0.3 (Appendix 4). Macro studies generally report larger elasticities of around 0.5. Hence, a 10 percentage point higher after-tax wage—for example due to a reduction in the personal income tax rate by 6 percentage points10—would raise total labor supply by 2 to 5 percent. Elasticities for the extensive margin are generally found to be larger than those for the intensive margin (Appendix 4). Tax wedges can also affect unemployment: Bassanini and Duval (2006) conclude that a 10 percentage point higher labor tax wedge in OECD countries would raise structural unemployment—that is, unemployment not caused by weaknesses in aggregate demand—by an average of 2.8 percentage points; social contribution rates are also found to be associated with higher unemployment in Latin America (Ball and others, 2011).

Figure 8.
Figure 8.

Tax Wedges, 2010

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Source: Staff calculations based on OECD (2011a,d).Note: Data refer to 2010. In the left chart, marginal and average tax rates are calculated as the unweighted average of the tax wedges for workers with different income levels (67 percent, 100 percent and 167 percent of the average wage) and different household characteristics (single, one-earner couple, two-earner couple) and the presence of children (no children or two children). In the right chart, the tax wedge for the secondary earner is calculated as the additional tax burden borne by a two-earner couple over a one-earner couple with two children. It compares this wedge with that of a single parent with two children. The calculation assumes a primary earner at the average wage and a secondary earner / single parent earning 67 percent of the average wage. See Appendix 1 for list of country abbreviations.

37. There is often scope for revenue-neutral tax reforms that mitigate the labor supply distortions of the labor tax wedge. This is particularly salient in countries where fiscal constraints limit the scope for tax cuts. For instance, policies of tax base broadening cum rate reduction may improve labor supply incentives with only modest distributional implications if the tax deductions eliminated or reduced primarily affect higher-income groups. Moreover, progressive income tax schedules—that is, those where the tax burden rises (in percent of income) as income rises—can reduce tax wedges for low-skilled workers where distortions are largest.11 In unionized labor markets, tax progression has been found to reduce unemployment rates by making wage moderation more appealing (Sorensen, 1997). However, while high-income earners generally do not have particularly large labor supply elasticities, there are limits on what rates can be imposed on these groups without causing significant increases in evasion and underreporting.12

38. Tax relief targeted to specific groups can stimulate labor supply, even when other tax rates increase to finance such relief. Empirical studies point to significant differences in labor supply elasticities between groups (Appendix 4). Targeting tax relief for groups featuring the highest elasticities may reduce distortions in labor supply. For three groups this is particularly salient:

  • Women/secondary earners: Female labor supply is more responsive to taxes than male labor supply. Hence, tax relief for women would likely elicit a positive net supply response, even when financed by higher taxes on men. For instance, India makes a gender distinction by applying a higher tax exemption for women than for men. Where legal constraints prevent a gender distinction in the tax burden, special tax relief can be targeted to single parents (single mothers have generally the highest elasticities) or to secondary earners in couples. Another way to reduce the tax burden for secondary earners is by replacing family taxation with individual taxation. Family taxation or family-related tax elements—such as mandatory joint filing, dependent spouse allowances or credits conditional on family income—are still widespread, although many OECD countries have moved toward individual taxation over the past decades. Family tax systems result in high tax wedges for secondary earners in couples (Figure 8), especially when rates rise rapidly with family income.

  • Older workers: Older workers are indeed found to be more sensitive to financial incentives than younger workers. Lower labor tax rates for older workers can increase incentives for them to remain in the labor force—although this also raises equity issues as high-income workers generally work longer. Australia, Denmark, the Netherlands, and Sweden, for example, have introduced specific earnings tax credits for older workers, aimed at stimulating labor-market participation.

  • Low-skilled workers: Labor supply elasticities for low-skilled men are larger than for high-skilled men, providing a rationale for targeted tax credits for low-wage earners. More than half of the advanced economies have introduced such “in-work” tax credits to stimulate low-skilled employment. Evaluation studies report some success in terms of the net employment effects of these policies (Box 5).

In-Work Tax Credits and Benefits

Tax credits or benefits for low-wage earners (“in work” tax credits) are used in many advanced economies to stimulate labor force participation and provide income support. These in-work tax credits reduce the net tax liability—or turn it negative in some cases for low-wage earners—and increase the net income gain from accepting a job relative to the alternative of being out of work. In-work tax credits are usually phased out as income rises. In countries that emphasize the income support objective, credits are generally phased out with family income and are often conditional on the presence of children in the household; this is the case in Canada, France, Ireland, Korea, New Zealand, the Slovak Republic, the United Kingdom, and the United States. However, the phasing out of the credit with family income causes high marginal tax rates for both partners in a family, and creates strong adverse labor supply effects because secondary earners are relatively more responsive to these rates. In countries that emphasize labor-market participation, credits are usually phased out with individual income; this is the case in Belgium, Finland, Germany, the Netherlands, and Sweden. Sometimes credits are combined with an hours-worked criterion to avoid providing income support for high-skilled workers in part-time jobs. Increased labor supply may reduce low-skilled wages, however, and shift the incidence of the credit to employers. Indeed, U.S. evidence suggests that the net gain of the earned income tax credit for low-skilled workers is only 30 percent per dollar spent (Rothstein, 2010).

Empirical studies suggest positive net employment effects from in-work credits. For existing schemes in the United Kingdom and the United States, evaluation studies find that programs have a positive net effect on employment (Immervoll and Pearson, 2009). The effect has been found to be quite small in aggregate terms, however, as these credits usually apply to a small portion of the labor force and because people with a job might be discouraged from working longer hours as the credit is phased out with more income. Indeed, there is always a dilemma between targeting the lowest labor incomes (by rapidly phasing out the credit with income) and avoiding disincentives to work longer hours or engage in on-the-job training (see, e.g., De Mooij, 2008).

In-work credits are most appropriate for countries with a strong tax administration based on the withholding of tax obligations. If most taxpayers are already filing tax returns, an effective withholding tax system is in place, and credits are provided on the same basis as the income tax (i.e., individual or family based), the cost of administering in-work tax credits will be small. However, costs can be substantial if low-wage earners are currently not filing tax returns, there is no effective withholding system, or if schemes are extended to the self-employed. In the United States, where the earned income tax credit is based on self assessment, non-compliance is a problem, and false claims (e.g., regarding number of qualifying children) are commonly reported.

Social benefits

39. Greater emphasis on ALMPs can reduce unemployment by diminishing the labor supply disincentives inherent in “passive” unemployment benefits and improving job prospects for the unemployed. Traditionally, social insurance benefits (such as unemployment and disability benefits) are automatically provided once a person becomes unemployed. However, such “passive” benefits dilute incentives to return to employment. In OECD countries, for example, a 10 percentage point higher benefit replacement rate (defined as the unemployment benefit as a share of the worker’s wage) would result in a 1 percentage point higher structural unemployment rate (Bassanini and Duval, 2006). While lowering benefit levels could mitigate such distortions, many countries have instead strengthened the “activation conditions” attached to the receipt of these benefits. For instance, conditions have been strengthened for the unemployed regarding job-search and training; benefits to partially disabled are increasingly conditioned on participation in reintegration programs; child support has shifted in some countries from unconditional transfers toward support for working mothers; and the low-skilled increasingly receive higher benefits when “in work.” Such measures aim to combine a reasonable level of social insurance benefits to those in need, while reducing the adverse labor-market effects, and can reinforce the beneficial employment impacts of other reforms to benefit design discussed below. However, the monitoring and enforcing of these conditions makes such benefit schemes more complex and administratively demanding.

40. The large disincentive effects associated with means-tested benefits can be mitigated through greater use of in-work tax credits. Social benefits create especially strong labor supply disincentives when they are subject to a means test. Where these benefits are high relative to potential labor market earnings they can dull incentives to take up employment or to increase labor supply, both through an income effect (by increasing the demand for leisure) and a substitution effect (by decreasing the net income gain from taking up employment or from increasing earnings). By targeting benefits to those who need them most, means-testing reduces fiscal costs compared with universal benefits. However, the withdrawal of benefits, as labor market earnings rise, operates like a tax on earned income. The interaction between benefit withdrawal and the tax systems can result in very large labor supply disincentives for low-wage earners. In some countries, in fact, the disincentives are so large that work is penalized. This can be seen by observing countries’ “participation tax rates”—defined as the proportion of gross in-work income that is lost through taxes and decreased benefits on entering the labor force. It equals or exceeds 100 percent for one-earner families in nine OECD countries, with most of this “tax” coming from the withdrawal of social benefits (Figure 9).

Figure 9.
Figure 9.

Participation Tax Rates, 2009

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Source: OECD (2011a).Note: The bars show the participation tax rates—how much of the gross income earned from moving from short-term unemployment into a job is taxed away in the form of reduced out-of-work benefits, means-tested benefits and taxation of in-work income (income tax and social contributions). Tax rates apply to a one-earner family moving from short-term unemployment to full-time work at a wage equal to 50 percent of the average wage. “X” includes the impact of income taxes that must be paid on earnings. Where countries have “in-work” benefits that offset these effects, these are captured by triangles. In Ireland, for example, if such a person receives a gross pre-tax wage w, he will lose his social insurance benefit equivalent to w as well as losing benefit entitlements equivalent to about 0.35w and paying income taxes of 0.05w. However, he receives an in-work benefit of around 0.35w (the distance between “X” and the triangle). On net, then, his total household income is lower after taking up employment by 5 percent.

41. There is substantial scope to redesign social benefits rules to strengthen incentives to participate in the labor force and increase labor supply. This can be achieved through a range of reforms including tightening eligibility criteria, reducing the duration of benefits, and decreasing benefit levels. Reforms should also be designed so as to minimize the trade-off between addressing moral hazard created by social benefits (which reduces labor supply incentives) and protecting individuals and families from adverse shocks to their incomes and consumption. For instance, equity goals can be achieved by maintaining benefit levels but attaching conditions to their receipt, such as being in work (as with in-work benefits discussed above) or participation in ALMPs. In addition, since various social programs (such as unemployment benefits, disability benefits, and early retirement benefits) provide alternative routes to exiting employment, reforms need to take a comprehensive approach to avoid unintended and adverse effects on labor supply.

42. Strict eligibility criteria are important to provide incentives to remain in the labor force. Eligibility for unemployment insurance benefits should be limited to those with a sufficiently long period of contributions and employment. Continued eligibility should also be conditioned on participation in ALMPs. Eligibility for disability benefits should be conditional on stringent medical and work capacity evaluations by independent evaluators rather than family doctors. Furthermore, those with partial capacity should be integrated into unemployment benefit systems and related job-search and training activities, as in Australia and the Netherlands. Stricter enforcement of existing eligibility criteria can often substantially decrease the number of beneficiaries and increase incentives to enter the labor force. In addition, increasing the age at which older workers can qualify for full pension benefits can delay their exit from the labor force.

43. Reducing the duration and level of social benefits—where these are high—can increase work incentives. The level of these benefits varies substantially across countries (Figure 10). However, replacement rates for low-income households should be set sufficiently high to avoid pushing households into poverty.

Figure 10.
Figure 10.

Level and Duration of Unemployment Benefits, 2007

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Source: OECD database.Note: See Appendix 1 for list of country abbreviations.
  • Unemployment benefits. Summarizing a large number of studies, Krueger and Meyer ( 2002) conclude that a 10 percent increase in unemployment benefits raises the average duration of unemployment by around 5 percent—although this impact is likely to be much higher in countries with relatively weak eligibility conditions. Based on this estimate, reducing replacement rates could help shorten unemployment spells. For example, for those economies in Figure 10 with replacement rates above 50 percent, a reduction to the average of 42 percent would decrease the duration of unemployment by 8 percent.

  • Family benefits. Reforms of family benefit systems can increase female labor force participation rates. Publicly financed maternal/parental leave schemes, with a guarantee for young mothers to return to their previous job, can help keep them connected to the labor market and increase female employment rates. Still, very long paid leave provides incentives for mothers to take lengthy spells out of the labor market, which can result in a deterioration of their work skills and damage their future employment opportunities. High child allowances also reduce incentives for women to enter the labor market, especially those with low earnings capacity. Reducing benefit levels for older school-aged children, and linking benefits to labor force participation, can increase incentives to rejoin the labor market. Since childcare generally needs to be available to support labor force participation of families, child care subsidies may also be effective. Indeed, Gong and others (2010) and Kalb ( 2009) review in total 31 studies in 10 different countries and find that the elasticity of female labor supply with respect to the price of childcare is usually between -0.13 and -0.2. Hence, if subsidies reduce the price of childcare by 50 percent, labor supply of young mothers will rise by between 6.5 and 10 percent.

44. Reforms to the structure of benefits can help offset labor market disincentives.

This can be achieved in different ways in the different social benefit schemes.

  • Unemployment benefits. Structuring unemployment benefits so that they decline over time motivates workers to undertake more intensive job search. Initial replacement rates should be set below full replacement to reduce incentives to enter unemployment, but high enough to facilitate an initial period of intensive job search aimed at improving job match quality and thus worker productivity. Increased use of individual unemployment savings accounts could help to reduce the incidence and duration of unemployment (Bovenberg and others, 2008). Under this system, part of the unemployment insurance contribution is credited to an individual account on which a person receives interest. During a period of unemployment, individuals can draw money from their account. Once the account is exhausted, individuals can borrow from the government at the same interest rate. Individual accounts are used in a number of emerging economies, including Brazil and Chile (Hijzen and Venn, 2011). These could be combined with the use of layoff taxes or “experience rating,” whereby firms with higher layoffs in a previous year face higher unemployment contribution rates (Box 6). Countries could be encouraged to use experience rating instead of employment protection legislation to reduce incentives for layoffs (Blanchard and Tirole, 2004).

    Reforming Unemployment Insurance Using Experience Rating

    Unemployment insurance (UI) with uniform payroll taxes can result in excess layoffs and contribute to instability in employment. Uniform tax rates entail a cross-subsidy from low to high layoff firms and sectors since the latter firms do not take account of the negative external impact of their individual layoff decision on the insurance premiums or tax levels that other firms pay. Furthermore, firms may have an incentive to lay off workers temporarily so they can then receive UI. As a result, UI subsidizes firms engaged in seasonal activities and those responding to the business cycle by adjusting their workforce, which can make employment less stable.

    Experience rating (ER) can help address these inefficiencies. Experience rating implies that the unemployment insurance premium that an individual firm pays is linked to its historical layoffs. In a fully experience-rated system, the firm bears the entire additional insurance cost of increasing its layoffs. However, in the United States, lower and upper bounds apply to these insurance premiums, which make ER only partial. This may be optimal if layoffs are initially excessive because firms are risk-averse or credit constrained (Blanchard and Tirole, 2008). The empirical literature on ER finds support of a favorable impact of ER on employment. Studies for the United States find that temporary layoffs are inversely correlated with the degree of experience rating (Topel, 1983; Baicker, Goldin, and Katz, 1997), and that ER dampens labor turnover, stabilizes employment, and reduces UI claims (Anderson and Meyer, 1994, 2000).

    The use of experience rating varies widely across countries. The U.S. unemployment insurance system has a significant component of firm-specific ER. In addition to firm-specific ER, sector-specific ER also exists in European countries, but to a very limited extent. For instance, firm-specific ER includes penalties in the case of permanent collective dismissals (Italy) or layoffs of older workers (France and Germany). In sector-specific schemes, such as in Finland and the Netherlands, unemployment benefits are partly financed through sector-specific funds (Fath and Fuest, 2005).

  • Pension benefits. In many countries, insufficient adjustment of pension benefits, both in terms of reductions for those who retire early and increases for those who delay retirement, means that it is financially beneficial to retire as early as possible. As a result, the effective retirement age is well below the official retirement age in many countries. In addition, individuals can often only draw a pension once they stop working (or have to pass an earnings test to draw a pension) while additional years of pension contributions beyond the official retirement age do not result in higher benefits. This implicit tax on continued work is a strong determinant of the average effective retirement age (Figure 11). Therefore, adjusting pension benefits for early and late retirement to make them actuarially neutral can reduce distortions and result in a significant increase in employment rates among older age groups. Blöndal and Scarpetta ( 1997) estimate that moving to an age-neutral pension scheme in a group of 15 OECD countries would increase participation rates of older male workers by roughly 5 percentage points. The labor supply disincentive effects of pension systems can also be reduced through increased reliance on defined contributions schemes with a strong link between contributions and benefits (see Box 3).

Figure 11.
Figure 11.

Implicit Taxes and Effective Retirement Ages

Citation: Policy Papers 2012, 042; 10.5089/9781498340458.007.A001

Source: OECD (2011c, e).Note: The implicit tax rate is calculated as one minus the ratio of the increase in the net present value of pension benefits from working another year to the additional contributions made in that year. Thus, if in net present value terms a person contributes an extra $10,000 over the extra year and pension benefits increase by $8,000, the implicit tax rate is 20 percent. See Appendix 1 for list of country abbreviations.

IV. An Agenda for Reform in Advanced and Emerging Economies

45. This section identifies strategies to boost employment in advanced and emerging economies. The discussion focuses on how the various policy instruments from Section III can be used to address the employment challenges outlined in Section II. A benchmarking exercise is used to identify more detailed potential areas for reform for each country. To that end, Appendix 2 indicates where countries stand relative to their peers on policies affecting employment performance, such as tax wedges, the level of unemployment benefits, and spending on ALMPs. The most important messages from this benchmarking exercise are summarized in Tables 3 and 4, respectively, for both advanced and emerging economies. Of course, this identification of areas for reform is only a starting point for formulating country-specific strategies.

46. When designing fiscal policies to strengthen employment, individual countries should take into account several criteria and constraints. Particularly relevant are:

  • Short- and medium-term objectives. An immediate priority for countries where unemployment has risen sharply in the wake of the crisis is to restore labor demand. Countries with high cyclical unemployment should limit policy measures that depress demand. Measures to tackle high natural rates of unemployment, for example through ALMPs that help to match labor supply and demand, are also an immediate priority. Measures to foster higher labor force participation will have a lower impact on employment in the short run and may just result in higher measured unemployment. This does not mean, however, that they should necessarily be delayed, as their effect may take time to materialize.

  • Fiscal constraints. Countries with tight fiscal constraints should prioritize reform options that are budget neutral or can provide budget savings. These would include revenue-neutral reforms that mitigate the labor market distortions created by the labor tax wedge or expenditure reforms that reduce the disincentives to work by limiting benefits. Targeted programs also tend to have lower fiscal costs and be more cost effective. These countries may also need to seek financial support from external sources, such as the Structural Funds of the European Union or multilateral development banks.

  • Cost effectiveness of different policy measures. This will vary across countries in light of the differing nature of employment problems, labor market institutions, and the scale of reforms. For example, some programs (such as hiring subsidies) can lose effectiveness as they expand beyond target groups with high rates of long-term unemployment. Moreover, the effectiveness of policy measures, including ALMPs, might be more limited in countries with lower levels of social benefits or where benefits can only be received for a short duration of time. Where minimum wage constraints are absent, wage subsidies to support the creation of low-skilled jobs might also be less effective.

  • Scope for complementary labor market reforms. Labor supply measures will lead to more employment only when the extra supply gets absorbed by rising labor demand. The effectiveness of fiscal policies can therefore be enhanced by labor market reforms that increase wage flexibility and by product and capital markets reforms that encourage job growth. Similarly, reforms in program design and labor market institutions can help offset the disincentive effects of high unemployment benefits and high tax wedges. Scandinavian countries, for example, have achieved high employment ratios in spite of high social benefits by imposing strict eligibility and job search requirements, and actuarially fair pension schemes. However, the implementation of such a combination of policies requires strong administrative capacities and broad social dialogue.

  • Equity goals. Reforms should attempt to utilize approaches that help mitigate trade-offs between employment and equity, including greater use of in-work tax credits and benefits and ALMPs. The impact of policy reforms on equity is complex, reflecting their offsetting effects on benefits, wages, and employment. Many reforms that strengthen incentives to work—such as reducing the level of unemployment benefits—will tend to increase wage dispersion because of their greater effects on the wages of the low-skilled. At the same time, if these reforms are successful, they can lead to employment gains for low-income workers, offsetting the effects of greater wage dispersion on equity at the household level.

A. Reducing Unemployment

47. A variety of policies could help to reduce unemployment in the short term and help bring down high rates of natural unemployment over the medium term. Reforms should focus on:

  • Reducing non-wage labor costs. Tax shifts are particularly attractive in Eurozone countries such as Greece, Portugal, and Spain, which suffer from high unemployment combined with large trade deficits and little room for fiscal maneuver (Table 3).

    Table 3.

    Summary: Fiscal Policy Reforms to Reduce Unemployment1

    article image
    Note: Based on information from Appendix 2. In many cases, data are not available for the full set of emerging economies.

    For countries with an unemployment rate of 5 percent or higher.

    For countries with a youth unemployment rate of 20 percent or higher.

  • Expanding ALMPs. Where unemployment spells are long and rising, an expansion of ALMPs could be considered, especially where this spending is currently relatively low, such as in the Baltic States, Greece, and the Slovak Republic. Some countries could benefit from redirecting their active labor-market spending away from public sector jobs and toward more effective programs (job-search assistance, wage subsidies, and training), such as in Belgium, Denmark, and Poland. Countries with high unemployment (such as Estonia, Greece, Ireland, Portugal, the Slovak Republic, and Spain) should consider scaling up training, apprenticeship, and job search assistance programs. This would:

    (i) improve the labor market prospects of the unemployed; (ii) ensure they stay attached to the labor market and maintain or improve work skills; and (iii) avoid current high cyclical unemployment turning into higher structural unemployment.

  • Redesigning unemployment benefits. A shorter duration of unemployment benefits could be considered in Belgium and Iceland. Eligibility criteria could be tightened in the Czech Republic and Denmark, while Italy and Sweden might benefit from strengthening job-search requirements. Better use of sanctions on non-compliant recipients and compulsory participation in activation programs could also reduce unemployment levels and duration in several countries. Replacement rates are also relatively high in Denmark and the Netherlands.

48. Reducing youth unemployment calls for comprehensive policy packages that improve both training and job matching. The approach should include non-fiscal measures addressing skill mismatches, facilitating access to on-the-job training, and tackling stringent hiring and firing regulations and high minimum wages for youth. Fiscal policies can complement this approach through effective job-search assistance, targeted study-and-work programs and well-tailored wage subsidies, e.g., for apprenticeship contracts targeted at those who have difficulty entering or staying attached to the labor market. Benefits for unemployed youth should be conditional on participation in these programs.

49. Lowering the tax wedges facing low-skilled workers will be essential to boost employment rates. Steep implicit tax rates due to benefit withdrawal and high social contributions create high participation tax wedges in all countries, but particularly in Ireland, Iceland, and Hungary. Remedies include:

  • Targeted tax relief to employers. Reductions in employer social security contributions are particularly effective if targeted to low-wage earners and where the link with benefits is weak (e.g., for health expenditures).

  • Greater use of in-work tax credits. Currently, at least 14 advanced economies apply in-work tax credits, and experience has shown that low-skilled employment is relatively responsive to such financial incentives.

  • Lowering marginal tax rates for low-wage earners. Countries that combine flat income taxes and social contributions with low basic tax allowances—for example, some Central and Eastern European countries—could reduce marginal tax rates for low-wage earners, thus making the income tax more progressive.

50. In other emerging economies, the nature of reforms to address high unemployment, especially youth unemployment, differs from that of the advanced economies. High unemployment in these countries typically reflects the poor functioning of labor, product, and capital markets, resulting in weak job creation (although these weaknesses also apply to some advanced economies). The first-best response is to address these market imperfections directly, e.g., by regulatory reform, rather than the use of fiscal policies. Indeed, given the limited scope of social benefit programs in these countries, the role of fiscal reforms in promoting employment is modest. Nonetheless, improved ALMPs and reduced tax wedges can be part of the solution. A key issue in many emerging economies, for instance, is the need to transform short-term workfare programs, which are typically expanded during crises—such as the Employment Guarantee Schemes in India—into effective active labor-market programs aimed at increasing skills and job placement in the private sector.

51. Many emerging economies face capacity issues in administering ALMPs. The track record in implementing ALMPs in emerging economies is mixed, partly reflecting the administrative demands of these programs. Where public administrative capacity is weak, using private sector companies can help to scale up ALMPs. Peru and some Eastern European countries use a network of labor information centers operated through the private sector, including NGOs and religious institutions. In Argentina, Colombia, and Mexico, ALMPs focusing on young workers have found success by using a competitive bidding process in choosing training providers and appropriate financial incentives to both employers and employees (Almeida and others, 2012). Effective training programs have also been developed in Thailand. In many emerging economies in the Middle East and Latin America, ALMPs could be improved by integrating them with unemployment insurance programs. These countries can benefit from the experiences of past and ongoing reforms in countries with more established and integrated social protection systems, such as those in Brazil, Chile, and Romania.

B. Increasing Labor Force Participation

52. Policies to spur labor force participation could include more general reforms, but those targeted to women and older workers will be particularly important. Among the more general reforms, two stand out:

  • Reducing the labor tax wedge. These are highest in Europe, such as Austria, Belgium, France, Germany, Italy and Hungary, where they exceed 45 percent.

  • Strengthening actuarial links in social insurance. This link is especially relevant for pensions, where it can be strengthened with defined contribution or notional contribution schemes. Unemployment insurance could be strengthened with the use of individual savings accounts.

53. The scope for increasing female labor force participation is significant. The factors behind low female participation rates differ across countries, ranging from fiscal incentives and labor market regulations to cultural factors. The scope for fiscal policies to address these low participation rates will therefore differ as well. Higher labor supply of secondary earners (in most cases women) raises issues regarding childcare and family life, as increased labor force participation will imply a smaller at-home presence of parents. Promising directions for fiscal policy reform include:

  • Reducing the secondary earner tax wedge—that is, the tax wedge applying to the spouse with the lowest income in two-earner couples—which can be reduced significantly in countries that currently apply family taxation, such as in France, Portugal, and the United States. Elsewhere, lower marginal tax rates or targeted in-work tax credits for secondary earners may help to reduce distortions.

  • Reforming child support. Unconditional income support to families with children is especially high in European countries. This could be replaced with programs that give higher benefits to those in work, such as childcare subsidies for working mothers (which are relatively low in Austria, Ireland, Japan, Korea, and Portugal). The duration of paid parental leave benefits should also be curtailed to avoid adverse labor-market effects. Currently, it exceeds 100 weeks in Austria, the Czech Republic, Finland, France, Norway, Poland, and the Slovak Republic.

54. Policy reforms could raise labor force participation among those 55 and older.

Policies to expand elderly participation include reforms in old-age and disability pensions.

  • Increasing effective retirement ages. This could be achieved by: (i) increasing statutory retirement ages, which are especially low in some Eastern European countries (particularly for women) as well as in France, Greece, and Korea; and (ii) fully adjusting pension benefits in several countries to a level that is “actuarially fair”—the neutral benchmark under which no participation distortion occurs.

  • Tougher rules for disability benefits and greater allowance for partial disability.

    Participation in disability benefit programs exceeds 10 percent of the labor force in Hungary, Norway, and Sweden. Linking disability benefits to work capacity and integrating those with greater capacity into the labor market can also increase labor force participation. There is room for strengthening medical assessment rules in Denmark, Norway, and the United States, e.g., by requiring certification from independent medical staff. Greater emphasis on linking benefits to the work capacity of claimants could increase elderly labor force participation in Austria, Belgium, and Portugal. Strengthening the attachment of disability claimants to the labor force through integration into ALMPs could help in Greece, Ireland, and Portugal.

55. One of the most important challenges in emerging Europe and Latin America in boosting labor force participation is to reduce tax wedges, especially as social insurance is expanded to a larger share of the work force. The expansion of social insurance should be based on programs that involve lower tax wedges and fewer labor market distortions than those prevalent in many economies. Broader coverage of unemployment benefits, for example, could be in the form of individual accounts, which have been undertaken in Brazil and Chile. These schemes provide a safety net for workers with minimal adverse labor-market incentives.

56. In emerging economies, reforms to pension systems could also boost the labor supply of older workers. Reforms should focus on increasing normal pension ages to at least 65 years for both men and women. This would entail an increase in retirement ages in many emerging economies but still maintain them below that of advanced economies with longer life expectancies. Given high levels of labor market informality and low rates of coverage, countries could also consider the expansion of social pensions for low-income workers, financed from general revenues.

Table 4.

Summary: Fiscal Policy Reforms to Increase Labor Force Participation1

article image
Note: Based on information from Appendix 2. In many cases, data are not available for the full set of emerging economies.

For countries with male labor force participation rate lower than 85 percent.

For countries with female labor force participation rate lower than 70 percent.

Fiscal Policy and Employment in Advanced and Emerging Economies
Author: International Monetary Fund