Striking a Balance: Optimal Tax Policy at the EPCS 2017 Meeting

We were honored to present our results at the recently concluded European Public Choice Society Annual Meeting 2017, where our work received positive feedback. Furthermore, we were lucky to have as our discussant the venerable Prof. Friedrich Schenider, whose results we have used as a benchmark and to whom our research also owes inspiration.  Our paper looks at the seldom discussed part of the labor tax wedge that is paid by firms: employers' social security contributions. Across countries, this variable ranges from 0% in Denmark to highs of 50% in most Southern European countries. Since taxation is an obvious driver to informality, could the cross country variation in irregular/atypical/secondary employment be explained by the tax burden on employers?

Our paper answers this question in a general equilibrium model of an economy where firms can use both primary employees (for whom social security contributions must be made) and secondary employees (no social security contributions through evasion that is subject to some risk). We overcome two major difficulties frequently faced by researchers developing models of tax evasion and/or irregular employment: plausible estimates of the probability of audit and the substitutability the two types of labor. We achieve this by exploiting the data equivalents of a set of model implied relationships that arise from our theoretical framework and show that our results agree with outcomes obtained from surveys such as reported by Schneider (2014). 

However, our piece de resistance is showing that shifting part of the worker/employee contribution burden to the firm increases hours worked, consumption and aggregate welfare. A tax policy shift from the current 0% share of firm social security contributions in the labor income tax burden in Denmark to 50% (like France) would increase welfare in equivalent lifetime consumption units by up to 16%!