LABOUR MARKET TAXES: New evidence that it matters whether it”s employers or employees who pay

Psychological mechanisms can lead to different economic outcomes when labour market taxes such as national insurance contributions are levied on employees rather than on employers. That is the central finding of research by Matthias Weber and Arthur Schram, published in the September 2017 issue of the Economic Journal.

Noting that in many countries, contributions to social security or labour taxes are paid partly by employees and partly by employers, their study shows that it makes a difference who pays:

• First, people prefer more public spending and a smaller private sector when the taxes are paid by employers.

• Second, employees are less happy when they have to pay the taxes rather than their employer, even when they are fully compensated by a higher gross wage.

• Third, people are more likely to take up jobs when gross wages increase even if net wages remain unchanged – that is, when the taxes are paid by the employees.

Traditional economic reasoning suggests that it does not matter whether taxes are paid by employees or employers because the former should only care about their net wage while the latter should only care about their total labour costs. The gross wage itself should be of interest to neither of them.

But if people do not perfectly understand taxation, it might matter who pays the taxes. This research shows that there are psychological mechanisms at work that can lead to different outcomes when taxes are levied on employees than when they are levied on employers. The mechanisms can be summarised as follows:

• First, people do not fully take into account the duties that are paid by their employers when making decisions.

• Second, people dislike paying taxes so much so that the loss they feel from a tax is more than just the pure effect of receiving a lower salary for their work due to the taxes.

• Third, if tax revenues are spent in a way that people consider useful, they will be less opposed to taxation than if they have the feeling that tax revenues are wasted.

The researchers provide empirical evidence for their analysis by means of a controlled laboratory experiment. In the experiment, the institutional environment of a tax on the employees'' side and a tax on the employer''s side can be perfectly implemented (without changes in net wages, total contributions or total labour costs).

Participants in the experiment face actual monetary incentives for the labour that they supply and their decisions have consequences for their payments. The experimental control over the institutional set-up is ideal to investigate the existence of the psychological mechanisms and to provide evidence for the differential reactions to the taxes.

''The Non-Equivalence of Labour Market Taxes: A Real-Effort Experiment'' by Matthias Weber and Arthur Schram is published in the September 2017 issue of the Economic Journal. Matthias Weber is at the Bank of Lithuania and Vilnius University. Arthur Schram is at the European University Institute and the University of Amsterdam.