Higher payroll tax rates lead to substantial employment responses
A new study on the firm-level payroll taxes by Youssef Benzarti and Jarkko Harju was recently published in the Journal of European Economic Association. The study shows that firm-level production and input factor choices are clearly affected by payroll taxes. Employment of workers with lowest education and manual tasks are hit the most by higher payroll taxes.
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Payroll taxes are increasing
The share of payroll taxes of all tax revenue has been increasing substantially in developed countries in recent decades, comprising more than 25% among OECD countries. Payroll taxes, which fund social insurance, can impose a substantial burden on the economy. In most countries both employees and employers are required to contribute with payroll tax payments.
Firm-level production and input factor choices are clearly affected by payroll taxes
Higher firm-level payroll tax rates lead to large employment responses, have no effects on employee-level earnings and slightly decrease the total output of firms. This was shown in the study “Using Payroll Tax Variation to Unpack the Black Box of Firm-Level Production” by Youssef Benzarti (University of California, Santa Barbara and NBER) and Jarkko Harju (Tampere University and VATT Institute for Economic Research) that was recently published in the Journal of European Economic Association.
As the cost of labor increases due to payroll taxes, firms substitute away from low-skilled, routine and manual workers towards more productive workers. In addition, firms decrease investments, and total revenue and profits decrease, while productivity increases.
These results have important implications for our understanding of firm-level production. First, the results imply that employees do not bear the burden of the higher payroll tax rates. Second, the results are inconsistent with large micro-level substitution between capital and labor. Third, the results highlight the importance of accounting for heterogeneity in skill level and job tasks when examining the effects of payroll taxes. Additionally, payroll taxes impose a negative fiscal externality on several other fiscal bases as they reduce capital as well as sales and profits. These effects should be considered when governments design payroll tax changes.
This paper uses quasi-experimental variation in payroll tax rates in Finland to investigate how firms use their input factors. The study uses firm-level tax record data covering the universe of Finnish firms from 1996 to 2015, provided by the Finnish Tax Administration. The study improves on previous research by using firm-level payroll tax variation, which affects all employees, and by estimating the effects of payroll taxes at the firm level.
Research Professor Jarkko Harju, VATT Institute for Economic Research, [email protected]
The study “Using Payroll Tax Variation to Unpack the Black Box of Firm-Level Production” by Youssef Benzarti (UCSB and NBER) and Jarkko Harju (Tampere University and VATT Institute for Economic Research) was published in the Journal of the European Economic Association.
Youssef Benzarti and Jarkko Harju (2021) Using Payroll Tax Variation to Unpack the Black Box of Firm-Level Production. VATT Working Papers 138.