Most countries exhibit large and persistent geographical differences in income and employment (Kline and Moretti 2014). Place-based policies attempt to reduce these differences by targeting underdeveloped or economically distressed regions.
Research has given relatively little attention to payroll tax incentives, a place-based policy commonly used in Finland, Norway, and Sweden (Korkeamäki and Uusitalo 2009, Johansen and Klette 1997, Bennmarker et al. 2009). This tax finances the social insurance system in these countries. Payroll taxes levied on firms also constitute about 15% of the total tax revenue in OECD countries.
As payroll taxes are proportional to worker earnings, they are an additional labour cost for firms, beyond the wages they pay. To stimulate employment in remote areas, and reduce regional disparities in labour market opportunities as a result, the governments of Finland, Sweden and Norway have a long history of applying geographically differentiated payroll tax rates. In Norway, for instance, tax rates in five different tax zones ranged from 0% in the northernmost regions to 14.1% in central areas (Figure 1).
Figure 1 Tax zones and regional labour market regions in Norway, 2003
Source: Ku et al. (2020).
The case of Norway
In a recent paper (Ku et al. 2020), we look at Norway's experience to investigate whether place-based payroll tax incentives boost employment in these remote, low-tax areas. The key challenge when evaluating geographically differentiated payroll taxes is that the prevailing tax rates in different regions likely reflect regional economic conditions or developments. This makes it difficult to separate the impacts of different payroll tax rates on local employment and wages from the effects of local labour market conditions or business cycles. To overcome this challenge we exploit an unusual policy setting in Norway in the mid-2000s: at this time, the system of geographically differentiated payroll taxes was suddenly abolished.
Prior to the reform, the government of Norway allowed lower payroll tax rates in remote areas to stimulate employment and business activity, and to avoid depopulation of sparsely populated areas of the country. In 1999, however, the European Free Trade Association Surveillance Authority (ESA) ruled that the Norwegian system of geographically differentiated payroll tax rates did not comply with EU trade regulations.
The result was a tax-rate harmonisation reform between 2004 and 2006. The reform was adopted and implemented independently of the local labour market developments, and so created (arguably) exogenous variation in the payroll tax rates faced by firms in different regions over time.
In 2007, another ESA ruling allowed Norway to re-introduce the system of differentiated payroll taxes (after an appeal case). Tax rates were reduced to their pre-2004 levels.
Our analysis takes advantage of the EU-induced payroll tax changes at the level of the local labour market or commuting zone (there are 45 commuting zones in Norway, excluding Oslo). We compare employment and wages before (2000-2003) and after (2004-2006) the abolition of geographically differentiated payroll taxes between commuting zones that are differentially exposed to the policy.
We find a significant decrease in local employment in response to the payroll tax rise. A one percentage point increase in the payroll tax rate reduces employment in the local labour market by 1.37%. The employment decline is largely driven by employed workers becoming unemployed or non-employed rather than out migrating to different commuting zones.
We also find that a one percentage point increase in the payroll rate tax leads to a decline in wages in the local labour market of 0.32%, which means that firms were able to shift some of their increased payroll costs to workers' wages. While the pass-through rate is lower than that found for the US (e.g. Anderson and Meyer 1997), it is comparable to that found by Holmlund (1983) and Johansen and Klette (1997) for earlier periods in Sweden and Norway.
The effectiveness of payroll tax incentives
The effectiveness of these place-based incentives in stimulating local employment depends on how flexibly wages can adjust to a tax change. In settings in which rising labour costs for firms are easily shifted to worker wages, we would expect no changes in employment levels in response to payroll tax hikes (Anderson and Meyer 1997, 2000, Gruber 1997).
In contrast, in situations in which wages cannot fully adjust, employment levels may be responsive to payroll tax changes (Kugler and Kugler 2009, Cruces et al. 2010, Saez et al. 2019).
Higher payroll taxes were not fully shifted on to worker wages in Norway. This indicates downward wage rigidity. Our findings suggest that in settings with some degrees of wage rigidity, place-based payroll tax incentives can be effective in stimulating local employment.
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