Employment and Social Developments in Europe (ESDE) 2023

2. Supporting labour market participation

Labour market participation can be increased by encouraging people to participate more in the labour market, or by removing barriers to entry into paid work. This section presents two key policy areas that can be used to improve people’s financial incentives to work and to facilitate their (re-)entry into the labour market. It presents the impacts of a set of hypothetical reforms of direct taxation of labour income and shows how such reforms could be used effectively to increase labour market activity rates of some selected population groups. This is followed by a detailed analysis of the affordability and accessibility of childcare facilities in the EU and their effects on mothers’ labour supply.

2.1. Tax-benefit systems supporting activation ⁽²⁹⁴⁾

Targeted decreases in tax on labour can be effective in fostering labour market participation and helping to address labour shortages. In a simple model framework, individuals choose between working (or actively seeking employment) or staying out of the labour force on the basis of their (potential) net income from work, i.e. the amount that they keep (or would keep if they worked) after deductions of income tax, social security contributions, and other deductions, the (means-tested) benefits they would lose when accepting a job, and their preference for labour or leisure. Consequently, if the net income that an individual can earn increases, their willingness to work (and therefore to give up part of their leisure time) may also increase.

The impact of a labour tax cut on people’s labour force participation varies considerably across population groups. Typically, the population groups whose employment is most responsive to financial incentives of the tax and benefit system are those with lower levels of education, low-wage earners, secondary earners in the household (mainly women), mothers of young children, and older people. As these groups typically have relatively low labour market participation rates (see Chapter 2), the tax system is a key policy tool to activate those with fewer incentives to work.

The impact of a labour tax cut largely depends on the details of the reform. Table 3.1 and Table 3.2 present the effects of various hypothetical PIT reforms on individuals’ labour force participation decisions for five Member States: Austria, Hungary, Italy, Belgium and Spain. Five tax reforms are considered. In the first across-the-board PIT cut scenario, the tax rates of all individuals with positive tax liabilities are reduced by the same pp. In the second scenario, the PIT cut is concentrated on low-income earners: a new lower PIT bracket is introduced to reduce the marginal tax rate for individuals earning below 80% of the median wage. ⁽²⁹⁵⁾ The average tax paid by higher-income earners is also affected, as all taxpayers see part of their income falling within the first bracket. ⁽²⁹⁶⁾ In the third scenario, a monthly lump sum Earning Income Tax Credit is introduced, up to 80% of the median monthly wage, adjusted for hours worked per week. The Earning Income Tax Credit corresponds to a specific amount by which the total tax liability is reduced. It is refundable, i.e. it leads to negative tax liabilities if the original tax paid is lower than the amount of the tax credit itself. In this scenario, the Earning Income Tax Credit is phased out by a rate of 5%, i.e. the tax credit for which the taxpayer is eligible is gradually reduced as their income increases above the threshold of 80% of the median income. After a certain income level, individuals do not benefit from this reform at all. In the fourth scenario, the joint taxation system in Belgium and Spain ‒ whereby pooled earnings of couples are considered when determining married individuals’ tax rates and tax liability ‒ is completely abolished. The fifth and final scenario combines the previous reform with the across-the-board PIT cut scenario. With the exception of the fourth (abolition of joint taxation) scenario, all reforms are calibrated such that the static (i.e. short-term, without possible behavioural changes in individuals’ labour choices) budgetary cost of the reform is 0.2% of GDP.

Targeted tax reforms have a significantly larger positive impact on labour supply (and thus on the economy in general) than across-the-board PIT cuts. The PIT cut for low-income earners targets a population group that is more responsive to the increase in net revenue than the general reduction in tax burden for all individuals. As a consequence, the aggregate labour market participation increases significantly more in this scenario than in the across-the-board PIT cut scenario. On average, across countries and considering all people, the PIT cut for low-income earners increases the aggregate participation rate 4 pp more than the across-the-board PIT cut scenario (Table 3.1, Table 3.2). The smallest difference is observed for Spain, where the income tax paid by low-income earners is already very small. The additional labour force primarily comes from lower income earners (first two income quintiles and people with (at most) primary education; see the corresponding lines in the two tables), but the distributional impact of the reform also depends on the pre-reform tax system. In terms of the increase in participation rates, the overall impact of the introduction/extension of an Earning Income Tax Credit is up to eight times higher than an across-the-board PIT cut, and up to four times higher than the PIT cut for low-income earners. The advantage of the Earning Income Tax Credit compared to the second scenario is that the reform does not affect the average tax rate of high-income earners. It is therefore less costly for the government to reduce the tax paid by low-income earners by the same amount as in the second scenario, i.e. a larger reduction in the average tax rate for low-income earners can be achieved for the same budgetary cost. Overall, this analysis highlights the potential to improve labour market participation of low-income earners by targeted tax reforms, as outlined in the 2023 Council Recommendation on adequate minimum income ensuring active inclusion. ⁽²⁹⁷⁾

Joint taxation of couples creates a significant disincentive for secondary income earners to work. ⁽²⁹⁸⁾ Under such a system, as in Belgium and Spain, a married secondary earner typically faces an income tax schedule with significantly higher rates than they would face as an unmarried individual and is therefore discouraged from working. ⁽²⁹⁹⁾ Consequently, a move away from the joint system could lead to an increase in secondary earners’ ‒ typically women’s ‒ labour supply. ⁽³⁰⁰⁾ In Belgium, this tax change would see women’s participation rate increase by 0.21 pp, while men’s labour market participation would increase by only 0.05 pp. A similar pattern emerges in Spain, with the participation rate for women increasing by 0.64 pp, compared to 0.09 pp for men. The positive impact is even higher for wealthier households (3rd quintile of the income distribution and above in Belgium; 3rd and 4th quintiles in Spain; see the bottom lines of Table 3.2) because in a progressive tax system the tax rate applied on the secondary earners’ first euro earned is higher if the income of the primary earner is higher. These reforms would also generate additional revenue for the government, even in the first year of implementation, with a budgetary impact of 0.15% of GDP for Belgium and 0.24% for Spain. That additional revenue could be used to fund PIT cuts to create additional incentives for work. As an illustration, the last columns in Table 3.2 show the effects of the move from joint taxation coupled with an across-the-board PIT cut. The static budgetary cost of the reform matches the cost of the reforms presented in the first three scenarios. These two reforms combined generate the highest positive impact on the labour market and therefore on the economy.