Does formal work pay in the Western Balkans?

1. Does formal work pay in the Western Balkans? Informality, inactivity, and the role of labor taxes and social benefits Johannes Koettl Europe and Central Asia Region – Human Development Sector The World Bank Brussels December 15, 2010

2. Motivation • Missing link between social benefits and work incentives • Tax wedge on formal work • Welfare dependency? • Working poor? • Inactivity? • Informality? • Focus on: • Informal employment (and inactivity) • Measurements of disincentives (marginal effective tax rate and formalization tax rate)

3. Characteristics of informality and inactivity • Typical informal worker: • Self-employed, employee, or unpaid family worker • Aged 40 to 64 • With completed primary education • Also inactive have low educational attainment • Low earnings potential for informal and inactive

4. Labor taxation • Income taxes and social security contributions increase the difference between labor costs and take-home pay (tax wedge) • increase therefore the incentives for informality • Tax wedge: the share of taxes in total labor costs: • The higher the tax wedge, the higher incentives for informal employment

5. At low-wage levels, high tax wedge in BH-FED and Serbia Tax wedge for singles at 33 percent of average wage in OECD and Western Balkans (2008/09) Source: OECD Tax and Benefit Model

6. Two concepts to measure work disincentives • Marginal effective tax rate (METR): how much is taxed away by earning 1 additional dinar? • Takes into account • Taxes and social security contributions • But also benefit withdrawal • Formalization tax rate (FTR): how much is taxed away from informal income if compared to same worker with formal income? • Takes into account • Taxes and social security contributions • But also benefit withdrawal • Are benefits gained from formal work worth the cost?

7. Serbia: For singles, tax wedge (minimum social security contributions) drives implicit costs of formal work Single with no children, working part-time at average wage Source: OECD Tax and Benefit Model

8. In addition, 1-to-1 withdrawal of social assistance increases FTR to 80% Single with no children, working part-time at average wage Source: OECD Tax and Benefit Model

9. For families, minimum social security contributions and income tax drive high costs of formal work One-earner couple working part-time at average wage, with two children Source: OECD Tax and Benefit Model

10. In addition, withdrawal of social assistance and family benefits provide disincentives for formal work One-earner couple working part-time at average wage, with two children Source: OECD Tax and Benefit Model

11. Additional disincentives for formal work • Unemployment insurance: complete loss of benefits, even because of limited part-time work • Allow for part-time work (or in-work benefits) • Municipal benefits • Health insurance for the unemployed • Should not be based on formal income, but on (proxy) means testing

12. Conclusions • High informal employment in private sector • Among agricultural workers • Among low-wage earners • Low labor force participation • Does formal work pay for low-wage earners? • Relative high taxation on lower-wages (minimum social security contributions in Serbia) • Sudden loss of social benefits (social assistance, family benefits, municipal benefits) from formal income • Some benefits (health insurance) available for free to informal workers • Formal “mini-jobs” and ”midi-jobs” don’t pay

13. Policy implications • Consider lowering tax wedge on lower wages • Abolish minimum social security contributions, allow adjustment for part-time work • Balance with fiscal concerns • More progressive labor taxation? • Streamline social benefit design • Means testing instead of formal income testing • No sudden withdrawal of benefits, but phased-in withdrawal (make work pay) • Reform health insurance for unemployed