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Posts Tagged ‘Payroll Taxation’

When I write about Social Security, I normally focus on two serious deficiencies.

  1. The program was never properly designed to deal with demographic change, which means there’s a gargantuan long-run budgetary shortfall of $44 trillion.
  2. The program is a very bad deal for workers (especially minorities), offering a paltry retirement benefit compared to what could be obtained with private savings.

I’ve neglected to explain, though, that there’s also an economic cost. All government spending is a burden since resources get diverted from the productive sector of the economy. Moreover, the associated payroll taxes have an adverse impact on incentives for employment.

Those taxes also have a negative effect on entrepreneurship, according to new research from three economists. Here are some excerpts from their study, which has been published by the National Bureau of Economic Research. We’ll start with a look at the methodology.

Entrepreneurship plays a central role in modern economies. In the US, for example, new businesses account for 20% of total gross job creation. While entrepreneurs can be very successful…, entrepreneurship remains one of the most economically risky lines of activity and can result in large wealth losses. …the marginal value of resources for entrepreneurs can be substantial, given how cash-constrained they often are. Therefore, mandating social insurance, while reducing risks,could significantly affect entrepreneurial activity. …In this paper, we…exploit quasi-experimental variation in the amount of social insurance contributions and…administrative data on the full population of Finnish entrepreneurs to address this question. …We use a standard differences-in-differences strategy and exploit a reform in 2011 that changed the ownership share rule from 50% to 30% to assess how relaxing the social insurance mandate affects entrepreneurial activity. …Overall, we find that social insurance contributions are reduced by an aver-age of 19% for the treatment group, which has more discretion over insurance contributions after the reform. This reduction represents a large cash windfall, equivalent to, on average, a 5 percentage-point reduction in corporate taxes.

Here are the key results, which show that payroll taxes have a decidedly negative effect on new firms.

…we observe a larger than average decrease in social insurance contributions by the owners of younger firms. The cash saved from the lower contributions is channeled into their firms, as we observe an increase in both employee compensations and other input costs, and an increase in turnover after the reform. …entrepreneurs in younger firms are more liquidity-constrained and have access to better growth opportunities than more mature firms. …Figure 2 shows the effect of the 2011 reform on business activity for young firms that are equal to or younger than five years old. …we estimate a 9.9% increase in turnover and a 6% increase in employee wage costs. Overall, these results imply that firms use the saved cash to pay for additional intermediate inputs and labor in order to increase turnover, and suggests that these firms might be facing liquidity constraints.

Here’s the aforementioned Figure 2, showing the both sales and wages are higher when social insurance taxes are lower.

The bottom line is clear.

…our findings imply that the social insurance mandate…crowds out business activity for young firms… the social insurance mandate for entrepreneurs has heterogeneous efficiency costs. Efficiency gains could be achieved by…lower social insurance contributions.

What is meant by efficiency gains?

That’s simply economic jargon for faster growth and higher living standards. And those results occur because entrepreneurs play a key role in driving innovation.

P.S. This issue is timely and important since politicians such as Bernie Sanders and Alexandria Ocasio-Cortez are pushing “Medicare for All” and other schemes that would require huge increases in payroll taxes.

P.P.S. Other Democrats, such as Barack Obama and Hillary Clinton, have urged higher payroll taxes that would deliberately target entrepreneurs, investors and business owners.

P.P.P.S. You can enjoy some Social Security cartoons here, here, and here. And we also have a Social Security joke if you appreciate grim humor.

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I argued last year that leftists should be nice to rich people because upper-income taxpayers finance the vast majority of the American welfare state according to government data.

Needless to say, my comment about being “nice” was somewhat sarcastic. But I was making a serious point about the United States having a very “progressive” fiscal system. The top-20 percent basically pay for government and those in the bottom half are net recipients of that involuntary largesse.

I also pointed out a huge difference between the United States and Europe. Governments on the other side of the Atlantic impose much higher burdens on lower-income and middle-class taxpayers.

Here’s some of what I wrote.

…the big difference between the United States and Europe is not taxes on the rich. We both impose similar tax burden on high-income taxpayers, though Europeans are more likely to collect revenue from the rich with higher income tax rates and the U.S. gets a greater share of revenue from upper-income taxpayers with double taxation on interest, dividends, and capital gains (we also have a very punitive corporate tax system, though it doesn’t collect that much revenue). The real difference between America and Europe is that America has a far lower tax burden on lower- and middle-income taxpayers. Tax rates in Europe, particularly the top rate, tend to take effect at much lower levels of income. European governments all levy onerous value-added taxes that raise costs for all consumers. Payroll tax burdens in many European nations are significantly higher than in the United States.

So do this mean European politician don’t like ordinary people?

I could make a snarky comment about the attitudes of the political elite, but I’ll resist that temptation and instead point out that taxes in Europe are much higher for the simple reason that government is much bigger and that means some segment of the population has to surrender more of its income.

But here’s the $64,000 question that we want to investigate today: Why are European governments pillaging lower-income and middle-class taxpayers instead of going after the “evil rich” and “greedy corporations”?

Part of the answer is that there aren’t enough rich people to finance big government. But the most important factor is the Laffer Curve. Politicians can impose higher tax rates on upper-income taxpayers and companies, but that doesn’t necessarily translate into higher revenue. Simply stated, well-to-do taxpayers have considerable ability to earn less income and/or report less income when tax burdens increase, and they do the opposite when tax burdens decrease.

That’s true in the United States, and it’s true in European countries such as Sweden, France, Russia, Denmark, and the United Kingdom.

So even if politicians want to fleece upper-income taxpayers, that’s not a successful method of generating a lot of revenue.

Which is why a shift from a medium-sized welfare state (such as what exists in the United States) to a large-sized welfare state (common in Europe) means huge tax increases on ordinary taxpayers.

I’ve made this point before, but now I have some additional evidence thanks to a new report from the Organization for Economic Cooperation and Development. The Paris-based bureaucracy is probably my least-favorite international organization because of its advocacy for statism, but it collects and publishes lots of useful statistics about fiscal policy in the industrialized world.

And here are three charts from the new study that tell a very persuasive story (and a depressing story for ordinary taxpayers).

First, we can see how the average tax burden has increased substantially over the past 50 years.

And who is paying all that additional money to politicians?

As you can see from this second chart, income tax revenues have become a less-important source of revenue over time while social insurance taxes (mostly paid by lower-income and middle-class taxpayers) have become a more-important source of revenue.

The third chart shows the evolution of the value-added tax burden. This levy takes a big bite out of the paychecks of ordinary people and the rate keeps climbing over time (and if we looked just at European governments that are part of the OECD, the numbers are even more depressing).

Now let’s put this data in context.

The United States now has a medium-sized welfare state financed mostly by upper-income taxpayers.

But because of dramatic demographic changes, we are doomed to have a large-sized welfare state. At least that’s what will happen if we don’t reform entitlement programs.

And if we leave policy on auto-pilot and there’s a substantial increase in the burden of government spending, it’s simply a matter of time before politicians figure out new ways of taking more money from lower-income and middle-class taxpayers.

Yes, they may also impose higher rates on “rich” taxpayers, but that will be mostly for symbolic purposes since those levies won’t generate substantial revenue.

Last but not least, don’t forget that European fiscal burdens will mean anemic European economic performance.

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