The tax wedge measures the difference between the total labour cost of employing a worker and the worker’s net earnings. A high tax wedge can exert a negative impact both on labour supply and demand, weakening incentives to look for work, to work additional hours and to hire new staff.
The tax wedge is defined as the sum of personal income taxes and employee and employer social security contributions net of family allowances, expressed as a percentage of total labour costs (the sum of the gross wage and social security contributions paid by the employer).
Marginal effective tax rate - traps
Marginal effective tax rates measure what part of an increase in earnings, due for instance to an increase in the number of hours worked or to a change in employment situation, is "taxed away" by the imposition of personal income taxes and employee social security contributions, and the possible withdrawal of earnings-related benefits.
Depending on the initial situation, such benefits can include:
- social assistance (SA)
- housing benefits (HB)
- family benefits (FB)
- unemployment benefits (UB)
- in-work benefits (IWB)
The higher the marginal effective tax rate, the lower the incentives to look for work or to work additional hours. Because high marginal effective tax rates may discourage a change in employment situation, they are often referred to as traps.
The unemployment trap measures the short-term financial incentive for an unemployed person receiving unemployment benefits to move to paid employment. It is defined as the share of additional gross income of such a transition that is taxed away.
A person received EUR 500 in unemployment benefits and does not pay taxes. Taking up work provides a gross salary of EUR 1000 while personal income taxes and employee social security contributions amount to EUR 200 and unemployment benefits are fully withdrawn. His new net income will be EUR 800. Out of his increase in the gross salary (EUR 1000), 70% will be "taxed away" and his net income increase will be EUR 300.
The inactivity trap measures the short-term financial incentive for an inactive person not entitled to unemployment benefits (but potentially receiving other benefits such as social assistance) to move from inactivity to paid employment. It is defined as the rate at which the additional gross income of such a transition is taxed.
The low-wage trap measures the financial incentive to increase a low level of earnings by working additional hours. It is defined as the rate at which the additional gross income of such a move is taxed.
Net increase in disposable income
Like the inactivity and unemployment traps, the net increase in disposable income indicator provides a measure of the financial incentives related to the transition from unemployment or inactivity into work. It is defined as the increase in disposable income when moving from unemployment or inactivity to employment, expressed as a percentage of the initial disposable income when unemployed or inactive. The higher the rate, the higher the incentive to look for work.
An inactive person receives EUR 500 in social assistance, net of taxes. Taking up work provides a gross salary of EUR 800 per month, with income taxes and employee social security contributions amounting to EUR 150, and social assistance benefits are fully withdrawn. The additional net income is of EUR 150, corresponding to an increase in disposable income of 30 %.
Net replacement rate
The net replacement rate provides a measure of the generosity of unemployment and other social benefits. It is defined as the net income of an unemployed person receiving unemployment and possibly other benefits, expressed as a share of the income earned previously in the job before becoming unemployed. The higher the rate is, the more generous the benefits system, and consequently, the lower the financial incentives to return to work. The indicator can be measured at different points in time, as the duration of unemployment benefits is generally limited, and their generosity can decline over the unemployment spell.