Short- and long-term participation tax rates and their impact on labor supply

Abstract

Generous income support programs as provided by European welfare states have often been blamed to hamper employment. This paper investigates the importance of incentives inherent in the tax-benefit system for the individual decision to take up work. Using German microdata over the period 1993–2010, we find that recent reforms in Germany increased work incentives at the extensive margin measured by the participation tax rate (PTR), particularly for low-income individuals. Work incentives are even higher if the time horizon is extended to more than one year, pointing at an overestimation of the disincentives by standard measures. Regression analysis reveals that a decrease in the PTR increases the probability of taking up work significantly.

Appendices

Appendix 1: German tax-benefit system

1.1 Benefits

Statutory provisions for each of the potential transfer payments are described in the following. Individual in state U are potentially eligible for insurance payments and means-tested payments.

1.1.1 Unemployment benefits

As an insurance program, a potential receipt of unemployment benefits depends on insurance contributions carried out during employment. Contributions to unemployment insurance and thus unemployment benefits are top-coded. Unemployment benefits $b_{it}^\mathrm{ub} \left( c \right)$ in year t are obtained as a specific percentage of net earnings. Unemployment benefits $b_{it}^\mathrm{ub} \left( c \right)$ hypothetically received if out of work are based on earnings of the current year t. Formally, unemployment benefits are given by

$$\begin{aligned} b_{it}^\mathrm{ub} \left( c \right) =s^\mathrm{ub}\left( c \right) \cdot \left( {y_{it-1 }^w - t_{it-1}^w -S_{it-1} } \right) \end{aligned}$$

where $s^\mathrm{ub}\left( c \right)$ is the percentage of previous net earnings depending on the existence of children $c\in \left\{ {0,1} \right\}$. $s^\mathrm{ub}\left( c \right)$ lies at 60 % for childless individuals ($c=0)$ and at 67 % for parents ($c=1)$. Net earnings are given by gross earnings $y_{it}^w$ reduced by wage taxes $t_{it}^w$ and social security contributions $S_{it}$.

In order to be eligible for unemployment benefits, a person has to have a record of employment subject to social security contributions for at least one year within the last three years (1982–2005) or within the last two years (2006-today). Marginally employed do not contribute to unemployment insurance and are thus not eligible.

The entitlement length depends on the number of months employed subject to social security contributions during the last seven or five years, respectively. For the simulation it is assumed, that individuals eligible for unemployment benefits were employed in total for at least 24 months during the last seven years (1987–2005) or five years (2006-today), respectively, thus being eligible for 12 months unemployment benefits. The length of entitlement is increasing with age. We refrain from increasing unemployment benefit length with age since most of the age-dependent variation applies do older employees not part of our sample anyway.

1.1.2 Unemployment assistance

Until 2005, individuals may receive earnings-related unemployment assistance after the exhaustion of unemployment benefits. Unemployment assistance is an insurance payment hinging on social security contributions, but means-tested at the same time. Possible claims for unemployment assistance are reduced by net household income. Net household income is reduced again by an allowance on spouse’s earnings equal to his hypothetical unemployment assistance claim. The remaining amount decreases the claim of the individual for unemployment assistance which can be expressed as

$$\begin{aligned} b_{i\mathrm{h}t}^\mathrm{ua} \left( c \right)= & {} s^\mathrm{ua}\left( c \right) \cdot \left( {y_{it-1 }^w - t_{it-1}^w -S_{it-1} } \right) \\&-\left( {(y_{\mathrm{h}t-1 }^{U} - t_{\mathrm{h}t-1}^{U} -S_{jt-1} } \right) - s^\mathrm{ua}\left( c \right) \cdot \left( {y_{jt-1 }^w - t_{jt-1}^w -S_{jt-1} )} \right) \end{aligned}$$

where $s^\mathrm{ua}\left( c \right)$ is the percentage of previous net earnings depending on the existence of children $c\in \left\{ {0,1} \right\}$. $s^\mathrm{ua}\left( c \right)$ is at 53 % for childless individuals ($c=0)$ and at 57 % or parents ($c=1)$. $y_{jt }^w , \quad t_{jt}^w$ and $S_{jt}$ are spouse’s earnings, wage taxes and social security contributions. In sum, only singles or individuals with a partner who is a transfer recipient and/or not working receive the full amount of unemployment assistance. Families with children receive a more generous income support. This is the case for both unemployment benefits and unemployment assistance. Unemployment assistance is allowed for one year after which the individual has to renew his claim and prove his neediness again. Under the condition that the claim is admitted unemployment assistance can be granted until the individual’s retirement.

1.1.3 Social assistance

Means-tested social assistance is based on the needs of the household as a whole with household members being treated as a community (Bedarfsgemeinschaft). Households can be entitled to social assistance if the individual in state U has not contributed (sufficiently) to unemployment insurance in state E (1) or if the claim for unemployment benefits/assistance of the individual in state U is very low (2). In 2005, the Hartz IV-reform merges social assistance for those able to work and unemployment assistance to a single system so-called unemployment benefit II (Arbeitslosengeld II). Since payments of unemployment benefit II are equivalent to social assistance it is referred to social assistance in the following. Starting in 2005, households additionally can be entitled to social assistance if unemployment benefits of the individual in state U are exhausted (3) with the overall household income not covering household needs.

The household head receives the standard rate of social assistance, whereas other household members only receive a share of the standard rate depending on age. Hence, social assistance increases with the number of persons in the household. The sum of household member shares gives the household-size-specific factor $f_{\mathrm{h}t}$ which is multiplied by the annual standard rate $\hbox {sr}_{\mathrm{h}t} \left( r \right)$. The standard rate $\hbox {sr}_{\mathrm{h}t} \left( r \right)$ differs by region r the household is located (West or East Germany) and year t. Additionally, housing assistance $\hbox {hh}_{\mathrm{h}t} \left( r \right)$ is provided to compensate for rent and heating payments. Possible claims on social assistance $b_{\mathrm{h}t}^{\mathrm{sa}} \left( c \right)$ are computed as

$$\begin{aligned} b_{\mathrm{h}t}^{\mathrm{sa}} \left( c \right) = f_{\mathrm{h}t} \cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) + \hbox {hh}_{\mathrm{h}t} \left( r \right) \end{aligned}$$

Potential claims for social assistance are reduced by household income and property as well as unemployment benefits and unemployment assistance. For the simulation it is assumed that household’s property does not exceed the exemption limits. Following Bönke and Eichfelder (2010), claims for social assistance after deductions can be expressed as

$$\begin{aligned} b_{\mathrm{h}t}^{\mathrm{sa}} \left( c \right)= & {} \hbox {Max}\left( f_{\mathrm{h}t} \cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) + \hbox {hh}_{\mathrm{h}t} \left( r \right) - \hbox {ch}_{\mathrm{h}t} \left( c \right) \right. \\&-\left. \hbox {Max}\left( {y_\mathrm{h}^{U} - t_\mathrm{h}^{U} + b_{it}^\mathrm{ub} \left( c \right) + b_{i\mathrm{h}t}^\mathrm{ua} \left( c \right) - \hbox {Min}\left( {\hbox {LE}, y_\mathrm{h}^{U} } \right) - A_j , 0} \right) , 0 \right) , \end{aligned}$$

where $\hbox {ch}_{\mathrm{h}t} \left( c \right)$ are child benefits and $A_j$ denotes the earnings allowance for spouse j’s earnings $y_{jt}^w$ . LE is lump-sum income-related expenses of 20 Euro per month between 2002 and 2004 and 100 Euro per month (1200 per year) since 2005. Statutory earnings allowances are subject to reform during the time period studied. Allowances before 2005 are given as

$$\begin{aligned} A_{jt} =\left\{ {{\begin{array}{ll} {y_{jt}^w }&{} {\hbox {if}\,\,y_{jt}^w \le 0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) } \\ {0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) +0.15\cdot \left( {y_{jt}^w -0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) } \right) }&{} {\hbox {if}\,\,0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) < y_{jt}^w } \\ {0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) +0.15\cdot \left( {y_{jt}^w -0.25\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) } \right) }&{}~ {\hbox {if}\,\,y_{jt}^w \le 0.5\cdot \hbox {sr}_{\mathrm{h}t} \left( r \right) } \\ \end{array} }} \right. \end{aligned}$$

Allowances since 2005 are defined as

$$\begin{aligned} A_{jt} =\left\{ {{\begin{array}{ll} {0.2 \cdot \left( {y_{jt}^w -1200} \right) }&{}\quad { \hbox {if} ~~1200<y_{jt}^w \le 9600} \\ {0.2 \cdot 8400+0.1\cdot \left( {y_{jt}^w -9600} \right) }&{}\quad { \hbox {if} ~~9600< y_{jt}^w \le 14{,}400} \\ {0.2\cdot 8400+0.1\cdot 8400}&{}\quad {\hbox {if}~~ y_{jt}^w >14{,}400} \\ \end{array} }} \right. \end{aligned}$$

The upper limit of 14,400 Euro increases to 18,000 Euro if children live in the household.

1.1.4 Housing allowance

Households with an income below a specific threshold can apply for housing allowance instead of social assistance. The payment depends on the number of household members and on household income reduced by lump-sum deductions. Housing allowances are computed in accordance to the German Housing Benefit Act (Wohngeldgesetz) following Bönke and Eichfelder (2010) as

$$\begin{aligned} b_{\mathrm{h}t}^\mathrm{ha} = \hbox {Max}\left( {H_{\mathrm{h}t}^\mathrm{ha} - \left( {a_i + b_i \cdot H_{\mathrm{h}t}^\mathrm{ha} + c_i \cdot H_{\mathrm{h}t}^\mathrm{ha} } \right) \cdot y_{\mathrm{h}t}^\mathrm{ha} , 0} \right) , \end{aligned}$$

where $H_\mathrm{h}^\mathrm{ha}$ denotes the relevant housing costs, $y_\mathrm{h}^\mathrm{ha}$ the relevant net household income and $a_i, b_i, c_i$ the factors in Appendix 1 of the Housing Benefit Act. The relevant income for housing benefits $y_\mathrm{h}^\mathrm{ha}$ is gross household income $y_\mathrm{h}^{U}$ reduced by the lump sum for income-related expenses. The relevant housing costs $H_\mathrm{h}^\mathrm{ha}$ are based on the rent observed in the data up to the legislative maximum threshold (Höchstmiete).

1.1.5 Child benefits

Households with children receive child benefits depending on the number of children. Child benefits are paid at least until the 18th birthday regardless of the labor market state of the parents. A tax exemption instead of child benefits is granted to households with higher income. In 2005 an additional child benefit (Kinderzuschlag) is introduced to raise the household income of working families above the threshold of social assistance. The additional child benefit is conditional on being employed and is so far the only in-work benefit in Germany. Households are eligible for this benefit if household income meets the needs of the parents but not the needs of their children. The maximum benefit lies at 140 Euro per month for children under 18 years living in the same household as their parents and is granted to households where household income is equal to the hypothetical claim on social assistance of the parents only. If income lies above that level, additional child benefit is withdrawn at a rate of 70 %. The upper income level for eligibility lies at the social assistance level for the household as a whole including the children.²⁰

1.2 Taxes

Statutory provisions for the calculation of household income taxes and social security contributions are described below.

1.2.1 Social security contributions

Individual gross earnings are the assessment basis for social security contributions of the employee. Earnings below a threshold are denoted as marginal employment and were always exempted from social security contributions except for the period between 1999 and 2003 under certain conditions. The reform in 2003 increases the threshold remarkably from 325 to 400 Euro per month (or 4800 Euro annually). Up to the earnings threshold the employer pays a flat-rate contribution which does not establish an entitlement to social security payments such as unemployment benefits for the employee.

Earnings exceeding these thresholds are due to social security contributions resulting in high marginal tax rates. With the introduction of a zone with increasing social security contributions for modest incomes in 2005 marginal tax rates for low-income earners are cut down. Since then, social security contributions increase for annual earnings between $e_t^1 =4800$ and $e_t^1 =9600$ Euro (so-called Midi-Jobs) from about 4 % to about 21 %. $S_{jt}$ for earnings above earnings threshold $e_t^1 =e_t^2$ between 1995 and 1997 and above $e_t^2$ between 2005 and 2007, respectively. Above the contribution ceiling $\hbox {CC}_t$ of the respective year t contributions are fixed in absolute value. Contribution rates s and contribution ceilings $\hbox {CC}_t$ vary over social security branches such as health, unemployment and pension insurance and contribution ceilings differ between East and West Germany. Social security contributions are simulated for a working spouse j when individual i is out of work and in state U. $S_{jt}$ can be denoted by the following formula neglecting the above mentioned specificities by branch and region:

$$\begin{aligned} S_{jt}=\left\{ \begin{array}{ll} 0&{}\hbox {if} \quad e_{t}^{1}>y_{jt}^{w}\\ s_{t}\cdot (F\cdot e_{t}^{1}(2-F)(y_{jt}^{w}-e_{t}^{1})) &{}\hbox {if}\quad e_{t}^{1}< y_{jt}^{w}\le e_{t}^{2}\\ s_{t}\cdot y_{jt}^{w} &{} \hbox {if} \quad y_{jt}^{w}>e_{t}^{2}\\ s_{t}\cdot CC_{t}&{}\hbox {if} \quad y_{jt}^{w}>CC_{t}\\ \end{array}\right. \end{aligned}$$

F is a factor that is annually fixed and lies between 0.5 and 0.8 in the period of study.

1.2.2 Income tax

Gross household income is subject to taxes on income if exceeding the exemption limits. Income tax reforms undertaken by the red-green government between 1998 and 2005 reduce average tax rates substantially. The tax burden for low-income groups is reduced by decreasing the basic allowance and the minimal marginal tax rate. In the German tax schedule, marginal tax rates increase linearly with income up to a threshold. The top marginal tax rate stays constant for income exceeding that threshold. Both threshold and top marginal tax rate are decreased throughout the reforms reducing the tax burden of high-income groups, too. Since 2005, capital income from interest and dividends is taxed separately at a flat rate of 25 %. In 2007, taxable incomes exceeding 250,731 Euro are subject to a marginal tax rate of 45 %. Calculating the taxable income, a lump sum for income-related expenses LE and a lump sum for special private expenses (Sonderausgaben) LS are deducted. It is assumed that expenses do not exceed these lump-sum deductions. Furthermore, the saver’s allowance SA is deducted from asset income which is twice as high for married couples.

Moreover, social security contributions can be partially deducted from taxable income. A time-varying amount $\hbox {SE}_{jt}^{m2}$ reflecting social security contributions is deducted from taxable income. Since 2005 tax authorities apply the more favorable of two different calculations of deductions $\hbox {SE}_{jt}^{m1}$ and $\hbox {SE}_{jt}^{m2}$ (${\S }$10 Income Tax Code). Furthermore, until 2004 the so-called profit share (Ertragsanteil) of social security pensions and after 2004 their taxable share are added to taxable income. Following Bönke and Eichfelder (2010) the taxable base can be described as

$$\begin{aligned} y_{\mathrm{h}t}^T = y_{\mathrm{h}t}^{U} - \hbox {LE} -\hbox {LS} - \hbox {Min}\left( {\hbox {Max}\left( {\hbox {SE}_{jt}^{m1} , \hbox {SE}_{jt}^{m2} } \right) , S_{jt} } \right) \end{aligned}$$

The income tax $T_{\mathrm{h}t}^\mathrm{inc}$ is then computed according to ${\S }$32a income tax code. Married couples are taxed jointly. Couple’s joint taxable income is halved to assess the income tax rate. Then, the resulting income tax is doubled.

1.2.3 Solidarity surcharge

A solidarity surcharge $T^{\mathrm{S}}$ is levied if the income tax surpasses the exemption limit $\hbox {EL}^{\mathrm{S}}$. On the first pay level the surcharge is imposed at a higher marginal rate $t^{S*}= 20\,\%$. Hence, $T_{\mathrm{h}t}^S$ is given by

$$\begin{aligned} T_{\mathrm{h}t}^S =\left\{ {{\begin{array}{ll} 0&{} {\hbox {if}~~ T_{\mathrm{h}t}^\mathrm{inc} \le \hbox {EL}_t^S } \\ {\hbox {Min}\left( {T_{\mathrm{h}t}^\mathrm{inc} \cdot \left( {1+t^{s}} \right) ,T_{\mathrm{h}t}^\mathrm{inc} +\left( {T_{\mathrm{h}t}^\mathrm{inc} -\hbox {EL}_t^S } \right) \cdot t^{s*}} \right) }&{} {\hbox {if}~~ T_{\mathrm{h}t}^\mathrm{inc} >\hbox {EL}_t^S } \\ \end{array} }} \right. \end{aligned}$$

Appendix 2: Additional figures

See Figs. 14, 15 and 16.

Fig. 14

Earnings decile intervals. Source: SOEPv29 & IZA$\Psi$MOD, own calculations

Fig. 15

Employment in Germany, 1991–2012 Source: German Microcensus. Note: Vertical line indicates year of major labor market reform (Hartz IV) in 2005

Fig. 16

PTR (long): distribution by earner type. Source: SOEPv29 & IZA$\Psi$MOD, own calculations

Appendix 3: Additional tables

See Tables 5, 6, 7, 8 and 9.

Table 5 Effect of short-term PTR on participation (evaluated at 20 h)

Table 6 Effect of short-term PTR on participation (evaluated at 40 h)

Table 7 Effect of long-term PTR on participation (evaluated at 20 h)

Table 8 Effect of long-term PTR on participation (evaluated at 40 h)

Table 9 Composition of PTR (short) evaluated at observed hours