HOW DOES REDUCING TAXES ON EMPLOYERS' PAYROLL AFFECT SALARY AND EMPLOYMENT LEVEL?

Responsible researcher: Bruno Benevit

Original title: The Incidence of Payroll Taxation: Evidence from Chile

Author: Jonathan Gruber

Intervention Location: Chile

Sample Size: 71,000 Companies

Sector: Job market

Variable of Main Interest: Salaries and Jobs

Type of Intervention: Tax reduction

Methodology: OLS, Triple Difference and IV

Summary

Payroll taxation is a large and growing source of public financing in the United States and around the world. However, this type of collection is linked to the firms' payroll costs, and may result in a reduction in the level of employment. The objective of this article was to evaluate how the payroll tax reduction resulting from the privatization of Chile's social insurance system in the 1980s impacted wages and employment. Using the OLS, Triple Difference and instrumental variables methodologies, the author identifies that the incidence of payroll taxation was entirely applied to salaries. No effects on the level of employment were identified. Several robustness strategies corroborate this evidence.

1. Policy Problem

The increasing tax burden around the world over the last century has been widely criticized for several reasons. According to critics, increases in payroll taxes cause increases in the cost of labor, resulting in a decrease in the competitiveness of a country's producers and potentially causing underemployment. This explanation has been supported by the persistently high level of unemployment observed in Europe following the continued rise in payroll tax rates since 1960. However, the costs of such tax increases will only affect employment if it is not possible to pass them on through of salary reductions. In other words, if there is freedom to transfer tax costs to salaries, there will be no resulting unemployment. In this sense, measuring the incidence of payroll taxes is essential to assess the impacts of this form of tax collection.

2. Implementation and Evaluation Context

Payroll collections corresponded to 12.4% of United States federal revenues in 1960, reaching a rate of 38% in 1993 (Gruber, 1997). The same pattern was observed in other Organization for Economic Co-operation and Development (OECD) nations during the period 1965-88, going from 19% to 25% of national tax revenues.

However, there was a drastic change in payroll taxation in Chile with the privatization of its Social Security and Disability Insurance programs in May 1981, until then financed by a substantial payroll tax on workers. In 1980, the average payroll tax rate for manufacturing companies was 30%, while the average rate for workers was 12%. There was a maximum income level for taxable income. In 1980, this maximum was approximately 528,000 pesos annually, corresponding to more than 5 times the average earnings of blue-collar workers in my country and more than twice the average earnings of white-collar workers observed in this study's sample.

Chile's Social Security system began in 1924, evolving in the 1970s into a standard pay-as-you-go defined benefit plan. Social Security “contributions” were paid to “Social Security Institutions” (IPSs) in Chile. The main IPSs were aimed at groups of white-collar, blue-collar and public sector workers. Although other IPSs existed for other groups of workers, only 5% of private sector workers were eligible for them in 1980. Contributions collected in IPSs financed old-age pensions. In addition, contributions also financed disability and maternity leave benefits, family allowances (annual benefits paid for each child), unemployment insurance and compensation for work accidents. These benefits were funded by payroll taxes levied on businesses and workers

3. Policy/Program Details

With the privatization of Social Security, individuals became responsible for their own retirement, instead of it being used to finance the consumption of current retirees. Individual retirement savings became invested in one of several competing private pension funds, and the savings could be converted into a lump sum payment or an annuity upon retirement. Privatization also brought with it major changes in the financing of social security. Privatized pensions and disability insurance were financed by a mandatory contribution of 13% of the earnings of both blue and white collar workers, with no contribution from employers. The system maintained a minimum benefit, financed from general revenues.

Joining this new system was optional for existing workers and mandatory for new entrants to the workforce. Among existing workers, 85% to 90% have joined the new system. After privatization, there was a drop in the average payroll tax rate for manufacturing companies to 8.5% in 1982.

4. Method

To evaluate the effects of the privatization of Chile's Social Security programs on wages and employment, this study uses data from the census of companies in Chile during the period from 1979 to 1986. All companies with more than 10 employees were considered. The data includes information on employment, wages and payroll taxes paid by the firm for the white and blue collar categories. All values ​​were deflated by specific price indices for each sector.

The analysis of this study verifies the effect of the incidence of taxation on the salaries of a given company before and after the policy change due to the change in its average tax rate. The outcome variables analyzed refer to wages and employment of groups of workers. The explanatory variable referring to the tax rate on the payroll was constructed through total tax payments and total salaries by category of worker, considering each firm and year.

Due to data limitations, two empirical strategies were employed to overcome the problem of spurious variation in the tax rate. The first considers variations in relation to the firm, the group of workers, the year and the interactions between these three variables. The second strategy involves the use of instrumental variables (IV) correlated with the real tax rate and independent of the error terms of the outcome variable. The objective of this IV is to control the possible bias caused by heterogeneity in the reduction of rates between companies and groups.

The article presented an analysis of temporal trends in contribution rates and salaries in the period from 1979 to 1986. In order to control the effects of the recession suffered by the country in the early 1980s, the analysis considers the periods from 1979 -80 and 1984-85. The analysis of the impacts on wages and employment used four models considering 3,305 firms per year. The first model estimated through OLS the first average difference between wages, jobs and taxes. The second employed the triple difference, where the change in wages is identified by the relative change in wages within a factory for white- and blue-collar workers as a function of the relative changes in their contribution rates. The third model used an IV of the contribution rate for each group of workers (white or blue collar) based on the rate of the other group. Finally, the fourth estimated model used an IV of the contribution rate created from a set of 13 regional area dummies With the exception of the triple difference model, all models present disaggregated estimates in relation to groups of workers.

• Main Results

The time trend results indicate that average real wages per worker increased by 27% for blue-collar workers and 29% for white-collar workers. This amount is considerably higher than the nominal salary increase of 18% (9% real) established for the year. From 1982 onwards, there was a salary reduction. However, the author highlights that such results may be associated with the economic recession that caused a 14.1% drop in Chile's GDP. Regarding contributions, constant declines were observed until 1985.

The results on the effect of the reduction in the contribution rate on workers' salaries demonstrate strong evidence of transmission of the amount of taxes to workers' salaries and the absence of a drop in employment. In the OLS and triple difference models, the results suggest a full transfer from taxes to wages. Observing the disaggregated analyzes of the first model, it was identified that the transfer mechanism was 50% higher for white-collar workers, indicating that white-collar workers may perceive stronger links between tax payments and social benefits.

The results of the models that used IVs presented different coefficients from the first analysis. The IV model results that simulated contribution rates through group rates maintain the same inference identified in previous results, although with greater magnitudes for white-collar workers, reinforcing the “overvaluation” interpretation of social benefits by this group. The results of the second IV model, however, indicate the full transfer of contribution rates only to the salaries of blue-collar workers.

6. Public Policy Lessons

In this article, the authors analyzed the impacts of the privatization of the Social Security and Disability Insurance programs in Chile in the early 1980s. Through various methodologies, the authors sought to mitigate the problems associated with spurious variations in error terms. The evidence found indicates that the reduction in company costs resulting from the reduction in payroll taxes were fully passed on to workers through salary increases. Furthermore, no significant effects on employment levels were identified. Analyzes based on IVs suggest that possible measurement problems at the firm level were not relevant to the estimates found.

The authors highlight, however, the limitations of such results and their interpretations more broadly, with greater attention being paid to the structural sources of wage and employment changes in countries. The perception of social benefits, elasticity of labor supply and demand, and the level of inflation in the economy are fundamental aspects for evaluating the impact of this type of policy.

References

Gruber, J. (1997), “The Incidence of Payroll Taxation: Evidence from Chile”, Journal of Labor Economics , Vol. 15 No. S3, pp. S72–S101.