Table of contents
- 1. Taxes on employment in the UK and in other major economies skip to link
- 2. Potential channels between taxes and employment skip to link
- 3. Research on the effect of tax on labour supply and employment skip to link
- 4. Research on the effect of tax on unemployment skip to link
- 5. Read more skip to link
Approximate read time: 10 minutes
On 31 October 2024 the House of Lords is scheduled to consider the following question for short debate in Grand Committee:
Lord Leigh of Hurley (Conservative) to ask His Majesty’s Government what assessment they have made of the impact of tax policy on employment.
1. Taxes on employment in the UK and in other major economies
Taxes on employment in the UK include income tax and employee and employers national insurance contributions (NICs). In the fiscal year 2023/24, these taxes raised £454.8bn, or 45% of total public sector receipts of £1,102bn.[1]
In 2023/24, revenues derived from taxes on employment were the equivalent of 16.6% of nominal UK gross domestic product (GDP). This was lower than the 16.9% of GDP in 2022/23, but above the 15.4% of GDP averaged since 2000/01. It was also the fifth highest ratio of any fiscal year since 1960/61.[2]
Figure 1. Income tax and national insurance contributions as a percentage of GDP
A comparison of tax on labour income across countries is provided by the Organisation for Economic Cooperation and Development (OECD). The OECD measures tax on labour income using what it terms the ‘tax wedge’. This is the sum of personal income tax plus employer and employee social security contributions minus family benefits as a share of total labour costs (the sum of gross wages and employer social security costs).[3] The higher the tax wedge, the higher the share of taxes in labour costs.
In 2023, and for a single worker earning an average salary, the UK had the 28th lowest tax wedge among the 38 OECD member countries. The UK tax wedge was 31.3% that year, while the OECD average was 34.8%. For a married worker earning an average salary with two children, the UK had the 18th lowest tax wedge in the OECD at 27.0%. This was above the OECD average of 25.7%.[4]
Figure 2. The ‘tax wedge’ across OECD countries in 2023
2. Potential channels between taxes and employment
At a macroeconomic level, taxes on employment are an important source of revenue for the government. Some of this revenue is spent on employing workers in the public sector, which directly supports employment. Revenues from taxes on employment are spent also on public services, such as health care, and infrastructure, such as roads and railways. This public spending supports employment indirectly via, for example, a healthier workforce and the provision of transport networks firms use to sell goods and services.
On the other hand, taxes on employment mean firms have less money to spend employing workers and workers have less money to spend on goods and services than otherwise. This could theoretically reduce employment.
At a microeconomic level, economic theory suggests several potential channels between taxation and the employment decisions of workers and firms:[5]
- Tax policies affect individuals’ decisions to enter the workforce, work more hours, or pursue higher-paying jobs.
- High tax burdens on labour can reduce work incentives, particularly for lower-income earners.
- Income taxes and social security contributions can affect employers’ hiring decisions and wage-setting practices.
- High employer taxes may discourage job creation or lead to a preference for part-time over full-time employees.
- Labour taxes may interact with other labour market institutions—such as unionised bargaining and minimum wage laws—to push wages above market clearing levels, thereby increasing long-run ‘equilibrium’ unemployment.[6]
- Employment growth is linked to overall economic performance; therefore, tax policies that enhance employment can have positive spillover effects on the economy.
While taxes on labour income have the clearest and most direct impact on employment, almost all taxes can have some effect on employment. For example, since corporate taxes reduce net profits, they might lead to fewer business start-ups, lower domestic investment by incumbent firms, a relocation of jobs abroad and lower foreign direct investment inflows than otherwise, all of which could reduce demand for labour. On the other hand, because they lower the return on capital, corporate taxes may result in a substitution of labour for capital, which could lower unemployment.[7]
Consumption taxes, such as value added tax, can also affect employment. This is because taxpayers generally work, not for the income they receive, but for the consumption they can obtain (either now or in the future) from that income. As such, a consumption tax acts equivalently to a direct tax on labour earnings in that it creates a wedge between the total labour costs faced by the employer and the return—in the form of the real consumption wage—received by the employee. This can affect both labour demand and labour supply decisions.[8]
3. Research on the effect of tax on labour supply and employment
Studies by economists tend to suggest that levels of taxation affect the supply of workers and consequently the level of employment.
Studies tend to find negative relationships between average hours worked and average tax rates. For example, a study of 18 OECD countries from 1960 to 1995 estimated an elasticity of average hours worked with respect to the tax rate of -0.5. In other words, a 1 percentage point rise in the tax rate on workers was associated with a 0.5 percentage fall in hours worked.[9]
In the 2023 autumn statement, the then chancellor cut the main rate of NICs paid by employees by 2 percentage points and the self-employed by 1 percentage point. This was followed in the March 2024 budget by a further 2 percentage point cut in the main rate of both employee and self-employed NICs. The Office for Budget Responsibility (OBR) examined the impact of these decisions in March 2024 and estimated that the reductions in NICs would increase labour supply by the equivalent of 199,000 full-time extra workers by 2028/29.[10] Conversely, the OBR estimated that the current freeze in key income tax thresholds would decrease labour supply by the equivalent of 130,000 full time workers by 2028/29, relative to a counterfactual in which thresholds rose in line with inflation from 2022/23.[11]
Empirical evidence suggests that labour supply responses to taxes on labour income of low-income workers, single parents, second earners and older workers are likely to be stronger than in the case of single individuals and men of prime working age.[12]
4. Research on the effect of tax on unemployment
In the case of unemployment, of 17 empirical studies surveyed by the OECD only five found that taxes did not have a significant adverse effect on unemployment (and one of the five still found an impact on the long-term unemployed).[13]
In addition, using data for 21 OECD countries over the period 1982 to 2003, other OECD research has found that higher labour taxes appeared to raise unemployment levels.[14] The findings of this research implied that a 10-percentage point reduction in the tax wedge in an average OECD country would reduce equilibrium unemployment by 2.8 percentage points and increase the employment rate by 3.7 percentage points (thanks to an increase in labour supply).
The economic literature also suggests that the extent to which a tax increase leads to higher unemployment may be affected by wage-setting institutions, particularly unionisation and minimum wages.[15] This appears consistent with the theoretical view that it is the interaction of a tax increase with labour market institutions that raises unemployment, rather than the tax increase alone.[16]
That said, a smaller number of studies fail to find any empirical link between labour taxes and unemployment.[17] Since high unemployment rates may lead to higher government spending and taxes, establishing the causality from taxes to unemployment, or vice versa, is subject to a degree of uncertainty.
5. Read more
- Office for Budget Responsibility, ‘The labour supply impacts of personal tax policies’, Economic and Fiscal Outlook, March 2024
- Office for Budget Responsibility, ‘The labour supply effects of the autumn 2023 national insurance contributions cut’, 8 February 2024
- OECD, ‘Taxation and employment’, OECD Tax Policy Studies, 2011, no 21
- Costas Meghir and David Phillips, ‘Labour supply and taxes, in Sir James Mirlees et al (eds) ‘Dimensions of tax design: the Mirlees Review’, 2010
- Richard Disney, ‘The impact of tax and welfare policies on employment and unemployment in OECD countries’, International Monetary Fund, October 2000
Cover image by Greg Montani from Pixabay
References
- Office for Budget Responsibility, ‘Economic and fiscal outlook’, March 2024, CP 1027. Return to text
- Calculations using data from: Office for Budget Responsibility, ‘Historical public finances database’, accessed 24 October 2024; and ‘Public finances databank’, accessed 24 October 2024. Return to text
- OECD, ‘Taxing wages 2024: Tax and gender through the lens of the second earner’, 25 April 2024. Return to text
- OECD, ‘Taxing wages 2024: The United Kingdom’, April 2024. Return to text
- OECD, ‘Taxation and employment’, OECD Tax Policy Studies, 2011. Return to text
- Equilibrium unemployment is the level at which unemployment is thought likely to settle in the long run, after the shocks and disturbances affecting the economy at any moment in time have dissipated. See: House of Commons Treasury Committee, ‘Letter from the governor of the Bank of England, Mark Carney, to the chair of the House of Commons Treasury Committee, the Rt Hon Andrew Tyrie MP’, 24 April 2017. Return to text
- Horst Feldmann, ‘The unemployment puzzle of corporate taxation’, Bath Economics Research Papers, 2011, no 7/11. Return to text
- Stephen Nickell, ‘Unemployment and labour market rigidities: Europe versus North America’, Journal of Economic Perspectives, 1997, 11(3), pp 55–74. Return to text
- Alberto Alesina et al, ‘Work and leisure in the US and Europe: Why so different?’, NBER Macroeconomics Annual 2005, June 2005, vol 20. Return to text
- Office for Budget Responsibility, ‘The labour supply impacts of personal tax policies’, Economic and Fiscal Outlook, March 2024. The OBR’s estimates of the responsiveness of labour supply to cuts in NICs were based primarily on a study by the Institute of Fiscal Studies, which reviewed empirical studies on elasticities of labour supply, focusing on the UK. See: Stuart Adam and David Phillips, ‘An ex-ante analysis of the effects of the UK government’s welfare reforms on labour supply in Wales’, Institute for Fiscal Studies, February 2013. Return to text
- Office for Budget Responsibility, ‘The labour supply impacts of personal tax policies’, Economic and Fiscal Outlook, March 2024. Return to text
- OECD, ‘Taxation and employment’, OECD Tax Policy Studies, 2011, no 21. Return to text
- OECD, ‘OECD employment outlook: Boosting jobs and incomes’, 16 June 2006. Return to text
- Andrea Bassanini and Romain Duval, ‘Employment patterns in OECD countries: Reassessing the role of policies and institutions’, OECD Social, Employment and Migration Working Papers, June 2006, no 35. Return to text
- OECD, ‘Employment outlook 2006: Boosting jobs and incomes', 16 June 2006. Return to text
- As above. Return to text
- For example, see: Andrew Glyn et al, ‘Labour market institutions and unemployment: A critical assessment of the cross-country evidence’, Economics Series Working Papers 168, Department of Economics, University of Oxford, August 2003. Return to text