World Bank EU-8 Quarterly Economic Report April 2005 World bank Vilnius office Jekaterina Rojaka

Lithuania will remain among the leaders by growth in 2005

Consumption and investment remain strong drivers

CPI starts to be a key constraint Brent Crude Oil, US/BBL

While significantly dropped, structural unemployment remains high

Do the Baltics run pro ‑ cyclical expansionary policies? Electoral budget cycles in the Baltic countries Source: AMECO

Special Topic Labor taxes and employment in the EU-8

Labor taxes and employment in the EU-8 - contents current statutory and effective tax rates theoretical foundations of the tax wedge-employment findings from empirical studies situation in the EU: determinants panel regression analysis conclusions: there exists a strongly negative relationship between employment growth and the size of the tax wedge in EU8

Current tax rates in EU8

Effective and statutory tax rates

The relative tax burden for low wage earners is much higher in EU8 than in EU15 The average tax wedge for a 50% APW earner in EU8 countries is 38.6%, whereas in EU15 it is on average 4.7 percentage points lower WHY? Because of the flat or regressive character of social security contributions.

The more elastic is the L supply curve, the more harmful is the tax wedge for employment Important factors: skills minimum wage non-employment benefits other taxes taxed party

Empirical results Problem 1: Lagging Problem 2: Measurement issues – which taxes to include: payroll vs income taxes – average or marginal tax rates: participation vs working hours – representative worker or a macroeconomic ratio – no clear guidelines, but: measures are correlated Results: there is a negative relationship, however magnitude fluctuates, because of different elasticities ( from to -0.55)

Determinants of the tax wedge- employment relationship in EU8 structure of the labor force – skilled versus unskilled labor national minimum wage non-employment income – unemployment and other social benefits wage bargaining structure This relationship could be stronger in the EU8

Lithuania is highly abundant in low- skill working force Thus the negative effect is STRONGER compared to the rest of EU

Estimation EMPG j,t =  0 +  1 WEDGE j,t +  2 GDPG j,t +e j,t where: EMPG – employment growth, WEDGE – tax wedge for low wage (50% and 67% of APW) earners, GDPG – real GDP growth, j – country, t – year, e – error term.

Strongly negative relationship between employment and the tax wedge in EU8 Increase in tax wedge by 1 p.p. is associated with a decrease in employment growth by p.p.

Key conclusions and policy implications Significant and negative relationship between the size of the tax wedge and employment exists – it is stronger that in EU15 Lowering labor taxes (particularly payroll taxes) may raise employment and output in the EU8 Gap financing: – Self- financing; – Shift to general taxation – Broadening the tax base or raising consumption and/or wealth taxes – Better targeting of social transfers and reduction in subsidies

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