Monday 16 May 2011

Some economics of payroll taxes

The cut in employer payroll taxes (TSU) is perhaps one of the few memorandum items that can be seen as expansionary. However, this policy created great controversy in Portugal, in part because it will have to be funded from higher VAT rates, in part because the party supporting the current government appears to be unsure about its original pledge on this matter.

In any case, the motivation for this "fiscal devaluation" is clear - wages are high, compared to productivity, and this contributed to the huge imbalances of the Portuguese economy. According to some authors, wages need to fall by around 20% before the country can restore its lost competitiveness. Without any action, the economy would correct this imbalances only over a slow and painful adjustment process involving very high unemployment rates: Extrapolating from studies that find that real entry wages tend to be about two percent higher when the unemployment rate is one percentage point lower, the unemployment rate would have to increase by at least ten percentage points, to a Spanish-sounding level of 21%.

Cutting payroll taxes could make the adjustment process less hurtful, as it would reduce the wages paid by employers without damaging the incomes of workers. According to the estimates above, cutting TSU by four percentage points (from their current level of 23.75%) would reduce the increase in the unemployment rate by two percentage points. The remaining competitiveness gap could then be closed by the other items in the memorandum - public sector cuts and higher productivity stemming from structural reforms -, without further increases in the unemployment rate beyond the already unprecedented 13% predicted for 2013.

In my view, the main issue with this idea is actually whether firms would be able to ensure that the cuts in the payroll tax would not be passed on to their employees. Previous evidence from somewhat similar reforms in Chile and Finland suggests that wage moderation in this context can be weak. Several results also indicate that "rent sharing" is an important phenomenon in Portugal (as in many other countries): Employees - in particular those with more tenure - tend to be able to extract a considerable share of any windfalls in profits in the form of higher wages.

For the TSU cuts to be successful, they should be directed towards industries where labour demand is more sensitive to the wage rate. Many of them will be industries which are exposed to international trade but not necessarily low-wage industries. A national agreement about wage moderation involving the main unions would also be important, as well as cuts in labour adjustment costs (some of which are also in the memorandum even if perhaps somewhat timid).


  1. Very well observed.

  2. @Pedro

    very correct. If interested you can find my thought on this here

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  4. Economics 101:

    Let's do a very simplistic exercise to see impact of this policy, shall we?
    The total cost of goods/services sold by a company can be split in two major components: labor + capital.

    So for a product that costs let's say 100 EUR to produce a share of it are capital costs and the other share represent labor.

    Let's see two different scenarios: a labor intensive active and a capital intensive one.

    For instance embroidery industry producing Arraiolos carpets. This type of industry per se is quite labor intensive and in a labor/(labor+capital) cost ration should not come to a surprise for it to be of over 80%.

    Now a capital intensive one. Steel Mill. This type of industry is quite capital intensive and shouldn't come as a surprise for capital to take the higher chunk of total costs surpassing 70% ...

    Looking at the portuguese economy on a broader view the costs of labor in our major exports most likely do not surpass 50-55% of total costs. It is my believe that capital on average represents a share of 60% of total costs (though I am missing the exact figures). However let's have a simplistic assumption of a 50-50 share on capital/labor costs.

    If we reduce TSU by 1% the total costs would lower 0.5%.

    Politicians are proposing a 4% decrease in TSU. The overall impact of this on very simplistic terms ceteris paribus with our fairly simplistic model would be a reduction of costs in 2% .

    Now tell me if with this reduction of 2% in costs we will see a big increase of exports? I doubt it. Our exports do not have such a high price elasticity of demand that will present a big demand boost.

    To increase total competitiveness measures should be done where costs are higher which in the vast majority of our exports are capital.

    Policies sponsoring tax decreases for exporting companies, lower fuel prices complemented by higher taxes on petrol for end consumers would provide a increased amount of competitiveness.

    Would be appreciated if someone could develop further my simplistic exercise to help evaluate impact of the proposed reductions on TSU and at same time elaborate more efficient policies than the current ones part of our politicians agenda.

  5. I agree that wages may not be a very large component of total costs for many firms. But even in those cases, payroll tax cuts can make a big difference - provided, of course, the cuts are not too small.

    For instance, capital-intensive firms may grow, at least in a first stage, by hiring more workers. In this case, wages will feature much more prominently in terms of firms' additional costs than in terms of their average costs.

    Take the case of Autoeuropa (a capital intensive business) when they added their third shift - if wage costs were lower, they would have expanded even earlier. Similarly, unions in the car manufacturing sector in Germany accepted wage moderation over the last ten years or so to keep those firms competitive internationally, apparently with great success.

    New and small businesses in Portugal could also benefit greatly from the tax cuts.

    These are also some of the reasons why I suggested that the cuts are directed towards industries were labour demand is more elastic. Cutting wages in sectors that face little competition would simply increase wages and make the adjustment of the Portuguese economy even more difficult.

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  7. I would like to add that such policy (or should I say subsidy) if doomed to be approved due to the Troika deal, then it should include restrictions (do not ask me how) to ensure that the decrease in TSU is not merely translated into an increase of retained earnings by the firms, which then are most likely distributed as profits or bonuses (as previously mentioned). Namely, such restrictions should guarantee that this policy aimed at decreasing production costs has to be reflected in a lower price of the final good or service and/or used to acquire new technologies, R&D, and/or to create additional jobs.

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