3/2008 Karsten Staehr. Estimates of employment and welfare effects of labour income taxation in a flat-tax country: The case of Estonia

Working Papers of Eesti Pank. No 3/2008

This paper presents estimates of the employment and welfare effects of personal labour income taxation in Estonia. The labour supply decision of individuals is estimated based on data from the 2005 Estonian Labour Force Survey. Economic incentives are found to affect the participation decisions of individuals, but not the number of hours worked by individuals already working. The participation elasticities are higher for individuals in the middle income groups than for individuals in the low and high income groups. Increasing the proportional tax rate by 1 percentage point is found to reduce total employment by 0.35 percentage points. The baseline estimate of the marginal cost of public funds is 1.6 if the proportional tax rate is increased and 1.8 if the basic exemption is lowered. The marginal cost of public funds varies across different income groups, which may suggest possible gains in efficiency from reallocating the taxation burden of the existing system of proportional taxation. The employment and welfare estimates are subject to substantial uncertainty.
JEL Code: H21, H24, J21, J22
Key words: taxation, labour supply, welfare, excess burden

*The author would like to thank David G. Mayes, Alari Paulus and Tairi Rõõm as well as seminar participants at the Bank of Estonia, the University of Tartu, the 9th ASPE Conference in St. Petersburg and the EcoMod2008 International Policy Modelling Conference in Berlin for useful comments. Ülle Pettai from Statistics Estonia has readily answered numerous questions concerning the data used. Kairi Ani, Tanel Liiv and Andres Võrk have helped with information on data and tax legislation. The author is solely responsible for any remaining errors and omissions.

Author's e-mail address: karsten.staehr [at] epbe.ee

The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction
2. A primer on the Estonian tax system
3. Data
4. Estimation of labour supply
4.1. Modelling labour supply
4.2. Predicted hourly pay
4.3. Labour supply with selection
4.4. Labour supply for different income groups
5. Employment and welfare consequences of changes in personal income taxation
5.1. Effects on labour supply
5.2. The marginal cost of public funds
6. Final comments
References
Appendix A. Labour supply without selection

Estimates of Employment and Welfare Effects of Personal Labour Income Taxation in a Flat-Tax Country: The Case of Estonia, Working Papers of Eesti Pank No 3/2008 (PDF*)

* To read PDF file, you need Adobe® Acrobat® Reader™ freeware, it may be downloaded from Adobe homepage.