Fiscal Devaluation Based on Net Job Creation With a System of Experience Rating

Banco de Portugal

First Review, FD Session Lisbon, August 4, 2011

Fiscal devaluation
Fiscal devaluation: Signicant reduction in labor costs through a substantial decline in employers Social Security Contributions (SSC). This measure changes the relative prices of production factors in favor of labor. Rational: Obtain an improvement in the competitiveness of the Portuguese economy. How does it work: Downward shift in the marginal costs that will induce rms to increase their supply at the prevailing prices. Firms will increase factor utilization, in particular, labor services.
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Economic mechanism
At this stage, a reduction in SSC nanced by consumption taxes amounts to a subsidy to rms paid by consumers. Is this an ecient redistribution of taxpayers money? To answer this question, it is key to understand the demography of Portuguese rms and the reasons behind the Portuguese economy low productivity (Small Firms in Portugal: A Selective Survey of Stylized Facts, Economic Analysis, and Policy Implications, Luis Cabral, 2006).

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Fat tail of low productivity rms: Low and inecient economic mobility; Weak competitive environment (product and labor market). These rms survive periods of low demand due to subsidies, tax evasion, low legal compliance and barriers to entry. A subsidy that applies equally to all rms is inecient; low productivity rms will survive again with public money. This hinders the restructuring of the Portuguese economy, limiting the Schumpeterian reallocation of resources towards more productive usages. One size doesnt t all.

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Is there a market-based mechanism that reveals which rms are reacting to the economic mechanism behind the scal devaluation? Given that the measure decreases the relative price of labor, it is quite natural to target rms that create additional employment.

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Fiscal devaluation based on net job creation

How does it work? This scal devaluation scheme would follow the same principles (scal neutrality; available to all rms), but would apply only to rms with net employment gains. The SSC reduction would take the form of an annual rebate; Apply as long as the employment gains subsist; To rms without outstanding balances with Fiscal Administration;

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Computing the rebate The rebate would be proportional to the employment gains and the total payroll of the rm: Employment gains are computed by comparing employment in the reference period and employment in the rebate year. Total payroll equals all wages and salaries subject to SSC (not only the net gains).

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Computing employment Employment: number of workers x months for which the employer made SSC. There are two important concepts in this context: employment in the rebate year: employment in the year for which the rebate is being implemented; employment in the reference period: average employment in the two (maybe three) years that precede the implementation of the measure).

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Reference period
This period remains xed while the rm qualies for the reduction in SSC, i.e., while the level of employment in the rebate year remains above the level of employment in the reference year. The reference period is updated whenever the rm employment level falls below the one in reference period. New rms will not be eligible during the rst year. The reference period for these rms will be: (i) 2nd year: 1st years employment; (ii) 3rd year: Average of 1st and 2nd years employment; (iii) 4th year onwards: general rule.

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Determining the tax schedules

Tax schedule: New employers would pay the standard SSC rate of 23.75% Qualifying employers (employment gain > 0): SSC = 23.75% rebate-year payroll reference-year employment fraction + 0% rebate-year payroll new employment fraction This means that the rm pays the basic SSC rate for the fraction of employment corresponding to the average employment in the reference period and a zero rate applies to the fraction of new employment.
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Data requirements
Information requirements are very small: matched employer-employee data; wages paid subject to SSC; number of months of contributions; All information is currently available in the Social Security data (on a monthly basis).

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Implementation issues
1. Impose a minimum eective SSC rate. The proposal considers 8%. 2. Dene the SSC rate for the fraction of new employment. The proposal considers 0%. 3. The rebate should be less or equal than a fraction of the total payroll of new hires, say 75%. 4. Limiting the employment gains to full-time equivalents has some practical diculties due to data limitations.

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An application of the system with 2009 data

An exercise with the data from Social Security records for 2009 and 2008. The exercise does not aim to estimate what would happen with the policy change, but simply to simulate the potential cost of this measure using the following information: Workers employed by rm in October of 2008 and 2009 Total wages paid by rm in October of each year Flows of jobs and workers

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Main results A large number of rms created employment (51,423). The number of net new jobs is quite large (190,598). SSC reduced by e34m/month or e480m/year. Most rms obtain a sizeable reduction in the SSC rate, in general larger than 4 p.p. (Figure 1). 67.4% of rms with an eective SSC rate 19.75%. The mode of the eective SSC is half the basic rate (Figure 1). The average eective SSC rate is 16.7% and the median 17.8%.
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Kernel density estimate

15 Density 0 .05 5 10

.1

.15 Effective SSC rate

.2

.25

kernel = epanechnikov, bandwidth = 0.0044

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Non market-based targeting

Firm-size targeting is not based on any optimality criteria. The optimal size of a rm varies by market size and sector and within sector by technology. It increases the scope to strategic behavior by rms with size around the threshold. The majority of the subsidy under the net job creation version of the proposal is concentrated in SMEs.

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 Low-wage targeting increases the ineciencies of the benchmark measures. It diverts money towards low-wage, low-tech, low-productivity jobs. It increases the scope to strategic behavior by rms with size around the threshold. It creates a kink in the wage schedule at the threshold, bunching workers just below it and penalizing their wage progression.

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