The effects of business and payroll taxes on firms and workers: evidence from linked employer-employee data

Lead Research Organisation: University College London
Department Name: Economics

Abstract

While the average rate of corporation tax amongst OECD countries was close to 50 percent in the early 1980's, it had fallen to below 25 percent by 2015. Moreover, competition to attract inward investment through cuts in business and payroll taxes is likely to intensify in the near future. In the UK, Prime Minister Theresa May has suggested that Britain is to have the lowest corporate tax rate among the world's 20 largest economies, and in the US, President Donald Trump is seeking a dramatic reduction in the rate of corporation tax to around 15 percent.

Advocates of a reduction in business or payroll taxes argue that it will lead to an increase in firm profits and thereby affect firms' location decisions and hence employment levels. Opponents, on the other hand, claim that such taxes are shifted either onto workers' wages or consumer prices, and hence will not alter firms' location decisions. Even if tax reductions have a positive effect on employment, governments might face a trade-off between job creation and tax revenues; while business and payroll taxes may indirectly boost tax revenues through increased employment and wages, they directly reduce tax revenues. Unless the indirect positive effects dominate the direct negative effects, tax reductions will result in a decrease in tax revenues and public spending. Therefore, a thorough understanding of the overall effects on employment, wages and tax revenues of cutting taxes levied on businesses is crucial for governments to make informed policy choices.

This project aims to improve our understanding of firms' adjustments in response to changes in two types of taxes levied on firms: business taxes (levied on profits) and payroll taxes. Employing rare and detailed administrative data linking firms and workers and following them over a prolonged period of time, we will analyse the causal effects of changes in business and payroll taxes on firm adjustments, including the demand for labour (hiring and firing), wages, investments, product price setting, firm entry and exit. Furthermore, we will look at whether workers respond by migrating. Based on our thorough understanding of the responses of firms and workers, we will simulate the overall effects of business and payroll tax changes on tax revenues, taking into account both the direct and indirect effects.

A particular strength of our analysis, besides using unusually rich longitudinal administrative data on firms and workers, is the proposed research designs. We exploit policy changes induced by national-level regulations that generated tax changes of different magnitudes across local labour markets. These changes were unrelated to local economic conditions, and our research designs hence allow us to separate out the causal effects of tax changes from confounding factors.

The scientific output of the proposed research is aimed at publication in top academic journals, and we expect our contributions to significantly advance the academic debate on business and payroll taxation, firm behaviour and labour market outcomes of workers. Moreover, a thorough understanding of the overall effects on employment and tax revenues of cutting business and payroll taxes is crucial for governments to make informed policy choices. We expect the results from our proposed research to have direct policy relevance to governments, the business community as well as to central banks, and international institutions such as the EU, Organisation for Economic Co-operation and Development (OECD), the World Bank, The International Monetary Fund (IMF) and NGO's.

Planned Impact

Besides its intellectual merit, the results from our proposed research have immediate policy relevance. Knowledge on how taxes levied on firms impact on workers, firms, the productivity of local labour markets and overall tax revenues is crucial for informed policy making in the UK and elsewhere. From the onset of the project period we aim to build links and contacts with potential beneficiaries and users of the research. Potential beneficiaries include:

1) The Academic Community: The scientific output of the proposed research is aimed at publication in top academic journals, and we expect our contributions to significantly advance the academic debate on business and payroll taxation, firm behaviour and labour market outcomes of workers. Our results can further serve as an empirical basis for the development of theoretical models of the firm side of the labour market in fields of Economics such as Macroeconomics, Public Economics, Industrial Organisation and Business Economics.

2) Governments, Organisations, NGO's and the Broader Policy Community: Output from the proposed research will be beneficial for policy makers in the UK and elsewhere. The research questions addressed in this project are particularly timely, with corporate taxation high on the political agenda in the aftermath of Brexit. Moreover, central banks and international institutions such as the EU, the Organisation for Economic Co-operation and Development (OECD), the World Bank, The International Monetary Fund (IMF), and NGO's may employ our findings to make economic predictions about the economy, and to advise countries on the conduct of macroeconomic policy.

3) Businesses and Workers: The findings of the proposed research are likely to be of significant interest to the business community as well as to worker unions. Knowledge on how different types of firms (e.g., by size and industry) respond to tax changes is of importance to entrepreneurs planning to start a business, and to existing firms that need to take into account the responses of their competitors and business partners when planning their own actions.

4) The General Public: The consequences of tax changes for different types of workers and firms, as well as their overall welfare implications is of utmost interest to the general public. Our research will answer several questions of immediate policy relevance to the general public: How do the politicians' proposals of cutting corporate taxes affect workers' wages and employment? And how do the effects differ across workers with different levels of education or firms operating in different sectors?
 
Description In the first part of the project, we investigate the effects of changes in payroll taxes on local labour markets and firms. To this end, we leverage a unique policy setting in Norway where a system of geographically differentiated payroll taxes was suddenly abolished due to an EU regulation. The policy was unexpectedly reinstated four years later. Our key findings are as follows. First, place-based payroll tax incentives can be effective in stimulating employment in remote regions. Second, firms respond to a payroll tax increase, and the resulting increase in labour costs, by reducing employment and sales while investing more in R&D and cost-saving innovations. Labour productivity rises after the tax increase, but the labour share falls. And third, these effects persist even when the payroll tax increase is reversed four years after the initial increase.

In the second part of the project, we investigate the effects of changes in business tax rates-taxes levied on firms' profits-affect local labour markets, firms and workers, leveraging more than 4,500 tax changes across municipalities and over time in Germany. Our key findings are as follows. First, an increase in the local business tax rate reduces wages, employment, the capital stock, and the number of establishments operating in the municipality. Second, while smaller, lower-paying establishments drive establishment exits, within-establishment declines in employment and wages are more pronounced in larger, higher-paying establishments. And third, workers' wages in local labour markets fall for two reasons: directly, through wage reductions within affected establishments, and indirectly, through a reduction in upward job-to-job mobility caused by a reduction in hiring by larger and higher-paying establishments. This indirect effect is large and fully explains the overall wage losses for early career workers in low-paying establishments. Overall, our findings highlight that higher tax rates on firms' profits may not benefit workers.

In addition to payroll and business taxes, we have examined two related reforms that affect firms' costs of hiring workers. We find that the higher labour costs resulting from a minimum wage increase may induce workers to increase their effort and hence their productivity. In a different setting, we also show that although minimum wage workers experience a wage increase following a minimum wage increase, they are not more likely to move into inactivity or unemployment.
Exploitation Route Academic routes: Our research has pushed the research frontier in various ways. For example, our work on business taxes highlights, for the first time in the literature, that the wage and employment effects of a business tax increases are highly heterogeneous across firms. Our research findings further highlight that business tax increases have indirect effects on workers, making it less likely that they will climb the job ladder and thus limiting their wage growth, aspects that have been ignored in the literature so far. We rationalize these findings with a theoretical model with monopolistic and monopsonistic competition in the product and labor market, thus making also an important methodological contribution. We expect other researchers in the field to build on our empirical findings and theoretical framework to broaden our knowledge on the heterogenous and indirect effects of tax changes.

Our research on minimum wages highlights that minimum wage workers respond to a minimum wage hike by working harder - a finding that may help to explain why the existing literature on minimum wages (including our own work) typically fails to detect negative employment effects of minimum wages. Since the publication of this paper, other papers have established a similar link between the minimum wage and effort.

Non-academic routes: The findings from our work have implications far beyond the academic remit and directly speak to the "levelling up" debate in the UK. For example, they illustrate that geographically differentiated payroll subsidies (that make the factor labour cheaper) can be effective in promoting employment in remote regions. In contrast, geographically differentiated tax increases on firms' profits (that make the factor capital more expensive) may reduce employment and wages in affected areas, in particular in larger, more productive firms. While both payroll and business tax increases are likely to lower local employment, the employment decline is likely to be larger for a payroll tax increase, in part because it may induce firms to switch to labour-saving technologies. Our research findings further highlight that policy "experiments"-temporary tax changes that were perceived as persistent-may have long-lasting effects on firms and workers.
Sectors Financial Services

and Management Consultancy

Government

Democracy and Justice

 
Description Our results were covered by the UCL News, as they have implications far beyond the academic remit and directly speak to the "levelling up" debate in the UK. Our research findings highlight that geographically differentiated payroll subsidies (that make the factor labor cheaper) can be effective in promoting employment in remote and under-developed regions. Our research findings further cast doubt that increasing tax rates on firms' profits provide an effective way of raising tax revenues without leaving workers worse off. Rather, our findings suggest that taxing firms more will lead to lower employment and wages, in part because such tax increases disrupt movements up the job ladder.
 
Description Institute for Employment Research, Nuremberg 
Organisation IAB Nuremburg
Country Germany 
Sector Private 
PI Contribution Our research team works together with Adrian Lerche on the project on business taxation and local labor market outcomes.
Collaborator Contribution The IAB provides invaluable data support for the research on business taxation and local labour market outcomes.
Impact The Effects of Business Taxation on Local Labor Markets, Firms and Workers. Working Paper.
Start Year 2019
 
Description University of Oslo 
Organisation University of Oslo
Country Norway 
Sector Academic/University 
PI Contribution Uta Schonberg and Hyejin Ku have been working together with Ragnhild Schreiner, Assistant Professor at the Department of Economics at the University of Oslo, on the project related to payroll taxation.
Collaborator Contribution Uta Schonberg and Hyejin Ku and Ragnhild Schreiner are contributing equally to the project and are actively involved at all stages of the project.
Impact Do Place-Based Tax Incentives Create Jobs?, with Hyejin Ku and Uta Schönberg. Forthcoming in Journal of Public Economics. [NBER Working Paper No. 25115] Place-based payroll taxes and regional employment, VoxEU article. Taxing Labor: Firm R&D, Automation and the Labor Share. Working Paper.
Start Year 2019
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact This was an academic presentation given by Prof Schoenberg of the work on "The effects of changes in business taxation on firms, workers and local labor markets" at the Department of Economics of University of Connecticut that reached academic faculty and postgraduate students. Prof Schoenberg received useful feedback that helped improve the project.
Year(s) Of Engagement Activity 2020
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Postgraduate students
Results and Impact Uta Schonberg presented the "The effects of business taxation on local labor markets, firms and workers" at the University of British Columbia in front of academics and PhD students.
Year(s) Of Engagement Activity 2021
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact Uta Schonberg presented the paper "The Effects of Business Taxation on Local Labor Markets, Firms and Workers" at the University of Hong Kong in front of academics and PhD students.
Year(s) Of Engagement Activity 2022,2023
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Postgraduate students
Results and Impact Uta Schoenberg presented the paper "Taxing Labor: Firm R&D, Automation and the Labor Share" at the University of Hong Kong in front of postgraduate students and academic researchers.
Year(s) Of Engagement Activity 2023
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Postgraduate students
Results and Impact Uta Schonberg presented the paper "Taxing Labor: Firm R&D, Automation and the Labor Share" at the 6TH UNIBG INDUSTRIAL ORGANIZATION WINTER SYMPOSIUM in December 2023.
Year(s) Of Engagement Activity 2023
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact This was an academic presentation given by Prof Schoenberg of the work on "The effects of changes in business taxation on firms, workers and local labor markets" at the Department of Economics at the University of Bonn that reached academic faculty and postgraduate students. Prof Schoenberg received useful feedback that helped improve the project.
Year(s) Of Engagement Activity 2020
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach Regional
Primary Audience Other audiences
Results and Impact This was an academic presentation given by Prof Schoenberg, of the work on "The effects of changes in business taxation on firms, workers and local labor markets" at the Department of Economics of University of Oxford that reached academic faculty and postgraduate students. Prof Schoenberg received useful feedback that helped improve the project.
Year(s) Of Engagement Activity 2020
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Other audiences
Results and Impact This was an academic presentation given by Ragnhild Schreiner of the work on "Do Place-Based Policies Create Jobs" at the Department of Economics of University of Oslo that reached academic faculty and postgraduate students. Ragnhild received useful feedback from the audience that helped improve our paper.
Year(s) Of Engagement Activity 2020
 
Description Academic Presentation 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact This was an academic presentation of the work on "The effects of changes in business taxation on firms, workers and local labor markets" at the Department of Economics of University of Maryland, given by Prof Schoenberg, that reached academic faculty and postgraduate students.
Year(s) Of Engagement Activity 2020
 
Description Current debates on German labor market policies 
Form Of Engagement Activity A formal working group, expert panel or dialogue
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Policymakers/politicians
Results and Impact Uta Schoenberg participated in the policy panel on "Current debates on German labor market policies", which was part of the 25th Anniversary IZA Conference in Labor Economics held in Berlin in June 2023. Uta Schoenberg talked, among other things, about her research on payroll and business taxation.
Year(s) Of Engagement Activity 2023
URL https://conference.iza.org/conference_files/25years_research_conference_2023/call_for_papers/render_...
 
Description EALE conference 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Public/other audiences
Results and Impact Ragnhild Schreiner presented the results of this project to a large audience at the annual conference of the European Association of Labour Economists, sparking a lively debate.
Year(s) Of Engagement Activity 2023
 
Description Presentation in front of policy makers 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Ragnhild Schreiner presented the paper "Do place-based policies create jobs" at the Ministry of Finance in Oslo in front of policy makers and professional practitioners, who showed great interest in the paper and expressed interest in future co-operations and meetings.
Year(s) Of Engagement Activity 2020
 
Description Press Release Place-Based Policies 
Form Of Engagement Activity A press release, press conference or response to a media enquiry/interview
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Media (as a channel to the public)
Results and Impact We press released our article "Do Place-Based Tax Incentives Create Jobs?", published in the Journal of Public Economics, through the UCL press office.
Year(s) Of Engagement Activity 2020
 
Description School visit - Eton College 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach Regional
Primary Audience Other audiences
Results and Impact Hyejin Ku gave a public lecture to an audience of students at Eton College, sparking the students' interest in the subject area.
Year(s) Of Engagement Activity 2023
 
Description UCL News 
Form Of Engagement Activity A press release, press conference or response to a media enquiry/interview
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Media (as a channel to the public)
Results and Impact UCL reported on our paper "Do Place-Based Tax Incentives Create Jobs".
Year(s) Of Engagement Activity 2020
URL https://www.ucl.ac.uk/news/2020/feb/place-based-tax-incentives-stimulate-employment-remote-regions
 
Description VoxEU article 
Form Of Engagement Activity Engagement focused website, blog or social media channel
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Public/other audiences
Results and Impact The VoxEU article summarized the key findings from our research in a way accessible to the general audience.
Year(s) Of Engagement Activity 2020
URL https://voxeu.org/article/place-based-payroll-taxes-and-regional-employment
 
Description Workshop on regional inequality 
Form Of Engagement Activity Participation in an activity, workshop or similar
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Postgraduate students
Results and Impact 45 delegates including academics, postgraduate students and professional practitioners attended a one-day workshop on regional inequality, which our research team organized.
Year(s) Of Engagement Activity 2023
 
Description Workshop on topics in labor economics 
Form Of Engagement Activity Participation in an activity, workshop or similar
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Postgraduate students
Results and Impact 200 delegates from around the world, including academics, postgraduate students and professional practitioners, attended a three-day workshop that generated questions and discussions on business and payroll taxes and regional inequality, and the network formed continues to share research.
Year(s) Of Engagement Activity 2023