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Databases and indicators - Tax and benefits database

Calculated indicators of financial incentives to work are needed for identifying any undesired influences of taxes and social transfers on people’s work decisions. At the same time, a central part of recent tax and benefit reform strategies has been to reduce reliance on welfare by “making work pay”, that is, to make work an economically attractive option relative to welfare. It is therefore desirable to monitor the effects of such policies as well as the potential for further reform.

Indicators of financial incentives to work

  • marginal effective tax rates (the unemployment trap, the inactivity trap and the low wage trap)
  • net replacement rates
  • net increase in disposable income and the tax wedge

All indicators are calculated for six “stylized” family types and for different income levels (ranging from 0 to 200% of average worker earnings).

In addition, the database provides information about the income tax/social security contributions-free earnings threshold (in % of average worker earnings) and information about the earnings level (in % of the average worker earnings) at which social transfers are entirely withdrawn.

Main tax and benefits indicators

1. Marginal effective tax rates (METRs)

METRs are calculated in order to show what part of a change in earnings is “taxed away” by the combined operation of taxes, social security contributions (SSCs), and any withdrawal of earnings related social transfers.

They are important policy indicators for determining how financially desirable it is for an employee to increase working hours or for an unemployed / inactive person to take up employment in the first place. Their magnitude may affect structural unemployment, labour market attachment and working hours, especially for those persons at the low end of the productivity scale whose labour market opportunities may not be sufficient to induce work given the low wages they attract.

Three different types of METRs are calculated in order to measure so-called low wage, unemployment and inactivity traps, that is situations where incentives to work are low.

The unemployment trap

The unemployment trap - or the implicit tax on retuning to work for unemployed persons - measures the part of the additional gross wage that is taxed away in the form of increased taxes and withdrawn benefits such as unemployment benefits, social assistance, housing benefits when a person returns to work from unemployment.

The 'trap' indicates that the change in disposable income is small and, conversely, the work-disincentive effect of tax and benefit systems is large.

The inactivity trap

The inactivity trap - or the implicit tax on retuning to work for inactive persons - measures the part of additional gross wage that is taxed away in the case where an inactive person (not entitled to receive unemployment benefits but eligible for income-tested social assistance) takes up a job. In other words, this indicator measures the financial incentives to move from inactivity and social assistance to employment.

The low-wage trap

The low-wage trap is defined as the rate at which taxes are increased and benefits withdrawn as earnings rise due to an increase in work productivity. This kind of trap is most likely to occur at relatively low wage levels due to the fact that the withdrawal of social transfers (mainly social assistance, in-work benefits and housing benefits), which are usually available only to persons with a low income, adds to the marginal rate of income taxes and social security contributions.

2. The net replacement rate (NRR) and net increase in disposable income (NIDI)

NRR and NIDI are frequently used to characterise the income consequences of labour market transitions.

NRR is usually defined as the ratio of net income while out of work (mainly unemployment benefits if unemployed or means-tested benefits if on social assistance) divided by net income while in work. A lower net replacement rate is associated with a greater incentive to search for and take up a job when unemployed. On the other hand, NIDI shows the percentage increase in disposable income when returning to work.

3. The tax wedge

The tax wedge is defined as the proportional difference between the costs of a worker to their employer (wage and social security contributions, i.e. the total labour cost) and the amount of net earnings that the worker receives (wages minus personal income tax and social security contributions, plus any available family benefits).

Tax wedge measures both incentives to work (labour supply side) and to hire persons (labour demand side).

Related papers and publications

For further detailed information on the methodology for the calculation of indicators of financial incentives to work and background information, you can consult: