Estimating the Impact of Labor Taxes on Employment in Turkey

32 x 45 cm.

Report No 44056-TR

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

April 2009 Human Development Sector Unit Europe and Central Asia Region

Copyright @ 2009 The International Bank for Reconstruction and Development The World Bank 1818 H Street, NW Washington, DC 20433, USA All rights reserved The World Bank enjoys copyright under protocol 2 of the Universal Copyright Convention. This material may nonetheless be copied for research, educational or scholarly purposes only in the member countries of The World Bank. Material in this report is subject to revision.

Currency Equivalents Exchange rate effective as of March 31, 2009 Currency Unit: New Turkish Lira (YTL) 1.70 YTL = US$ 1 YTL 2.24 = 1 Euro Government Fiscal Year January 1 - December 31

ABBREVIATIONS AND ACRONYMS

EU GDP HLFS IMF ISKUR OECD PROST SSK TISK TURK-IS TURKSTAT UI UISIM

European Union Gross Domestic Product Household Labor Force Survey International Monetary Fund Turkish Employment Organization Organisation for Economic Co-operation and Development Pension Reform Options Simulation Toolkit Social Security Institution Union of Turkish Employer Associations Confederations of Turkish Trade Unions Turkish Statistical Institute Unemployment Insurance Unemployment Insurance Simulation Model

Vice President Country Director Sector Director Task Team Leader

: : : :

Shigeo Katsu Ulrich Zachau Tamar Manuelyan Atinc Gordon Betcherman

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Table of Contents PREFACE

............................................................................................................................................................................................................................

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EXECUTIVE SUMMARY .............................................................................................................................................................................................. vi I.

INTRODUCTION ........................................................................................................................................................................................................

1

II. A BRIEF SUMMARY OF THE LITERATURE ON THE EMPLOYMENT EFFECT OF LABOR TAXES AND SUBSIDIES...................................................................................................................................

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III. STUDY METHODOLOGY ................................................................................................................................................................................... (a) Establishment-level analysis of labor demand ................................................................................................................................ (b) Analysis of regional subsidies .................................................................................................................................................................... (c) Analysis of changes in labor costs using Household Labor Force Survey data ........................................................

5 6 7 9

IV. RESULTS ON EMPLOYMENT IMPACTS ...............................................................................................................................................

4.1 Estimates of labor demand elasticities and pass-through rates ...........................................................................................

4.2 Evidence on employment impacts from the regional subsidy programs .........................................................................

4.3 Evidence on employment impacts from household data ...........................................................................................................

10 10 12 14

V. SIMULATIONS OF POLICY REFORM OPTIONS FOR THE SOCIAL SECURITY FUNDS ............................. 16 5.1 The modeling exercise ..................................................................................................................................................................................... 16 VI. POLICY IMPLICATIONS ...................................................................................................................................................................................... 18

List of Tables TABLE A1. Real Labor Costs For Minimum Wage Workers,2003-05 (Million TL) ............................................................. 21 TABLE A2. Expenditures Under Law 5084 In The 15 Newly Subsidized Provinces And Cost Per Job Creation Under Different Assumptions, January 2004 To April 2005 .................................................................. 22 TABLE A3. Expenditures Under Law 5350 In The 13 Newly Subsidized Provinces And Cost Per Job Creation Under Different Assumptions, May 2005 To December 2005 ............................................................. 23

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

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Preface High labor tax wedges and slow formal employment growth have combined to make labor tax reform an important economic policy issue in Turkey. However, solid evidence does not exist to confidently assess the likely employment gains and fiscal implications of reduced taxes on wages or social insurance contributions.

This synthesis report presents the results of a series of empirical studies of the impact of a labor tax reform. It should be noted that the analysis was undertaken before the social contribution reforms that were introduced as part of the 2008 employment package.

Using data from firms, households, and social insurance files, the research finds that employment does respond to changes in labor costs at levels that are comparable to those found in other middle-income and OECD countries. The results show that reducing labor costs could significantly boost registered employment.

However, the actual effect of lower taxes on employment would be diluted because a significant portion of the reduced tax would be captured by workers through higher wages rather than by employers through lower labor costs. While this pass-through effect would substantially limit the job gains of a general reduction in labor taxes, it is much smaller at lower wage levels where most of the effect of a tax cut would be to lower total labor costs and, thus, increase labor demand. As a result, tax cuts targeted towards low-wage labor would be more cost-effective than across-the-board reductions. Indeed, this is confirmed by simulations of the implications of various tax reform options on the fiscal position of Turkey s social security and UI funds.

Options designed to target contribution reductions on young workers (predominantly employed at low wage levels) turn out to be considerably more cost-effective than across-the-board reductions. However, under all scenarios, the registered employment gains of a cut in social insurance contribution rates do not broaden the tax base enough to compensate for the reduced contribution rates. To achieve overall fiscal neutrality, compensating additional revenues from other sources or reduced expenditures would need to accompany lower contribution rates.

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Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey1 Executive Summary

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ob creation has been a major challenge for Turkey. The current economic crisis has caused rapid increases in unemployment. However, even before the slowdown started, employment creation had been slow despite strong economic growth in the years after the last financial crisis in 2001. The Government therefore identified increasing employment as one of the development axes in its Ninth Development Plan, covering 2007-2013. The Plan sets a target of 2.7 percent employment growth per year during this period, a rate well in excess of the 1.1 percent annual increase registered between 2002 and 2006.

Turkey s employment performance has lagged well behind European comparators, especially in the case of women. In 2006, only 46 percent of the working-age population was employed in Turkey. This rate had been relatively constant since the 2001 crisis and remained well below the employment performance in EU-member countries. In fact, employment rates for prime-age males are only slightly below EU averages. However, Turkey s employment is substantially lower for younger and older workers and especially for women: less than one in four Turkish women are employed, compared to 57 percent in the EU countries. The other dimension of Turkey s jobs deficit is the large share of employment in the informal sector close to 50 percent of the employed labor force is not registered with the social insurance institute.

The Government recognizes that a range of factors are constraining employment growth. The Ninth Development Plan raises a number of issues that are negatively affecting the functioning of the labor market and hampering job creation. These include low participation rates especially for women, a lack of responsiveness of the education system to labor demand, underdeveloped active labor market programs, insufficient

flexibility in the labor market, and high non-wage labor costs, including social insurance contributions and personal income taxes.

Employment rates are far below EU averages and the Lisbon targets*

* Employment rates for the population aged 15-64 in 2006. Lines denote Lisbon targets for overall employment and for female employment.

Even with the recent reforms, the gap between total labor costs and take-home pay for low-wage workers and workers with families in Turkey is among the highest of all European countries in the OECD. This large tax wedge stems from high social insurance contributions (by employers and employees) and income taxes levied on workers and the lack of progressivity in the labor tax system. For a single worker in Turkey paid at the average wage or above, the size of this tax wedge about 40 percent of gross wages -- is in the middle range among OECD countries elsewhere in Europe.

However, for low-wage workers and workers with dependents, Turkey s relative position worsens considerably. For example, the tax wedge for an employee with two children earning 67 percent of the average wage is higher than anywhere else in the OECD. This is because, unlike higher-income countries, Turkey s tax burden is not progressive but remains relatively constant regardless of income level or family situation. The minimum living relief introduced at the beginning of 2008 did introduce some modest improvement in this situation.

1 This synthesis paper was written by Gordon Betcherman (task team leader) and Carmen Pagés (co-task team leader). Other members of the research team included Erol

Taymaz, Meltem Daysal, and Kerry Papps. Zafer Mustafaoglu and Rodrigo Chaves contributed to the overall design and policy implications, as well as taking responsibility for liaisons with the relevant Government agencies. Ufuk Guven, Tomaz Rejec, Milan Vodopivec, and Anita Schwarz were responsible for the pension fund and unemployment insurance fund simulations. Necdet Kenar provided helpful comments and policy advice. The comments of the peer reviewers, Bill Maloney, Ana Revenga, Jan Rutkowski, and Mathew Verghis, have been very helpful. The project benefited greatly from collaboration with many Government agencies including Treasury, State Planning Organization, Ministry of Labor and Social Security (including the Social Security Institution and ISKUR), Turkstat, Ministry of Finance, SSK, and Bag Kur. The project team also benefited from discussions with TISK and TURKIS as well as academic and research experts.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

This high tax wedge is a potentially important obstacle to employment, especially in the low-wage sector that includes many women and young people. A high tax wedge can be expected to reduce employment in the formal sector. To the extent that social contributions and personal income taxes raise total labor costs, they decrease employer incentives to hire new workers. At the same time, by cutting take-home pay, a high tax wedge reduces incentives for workers to participate in the labor market.

A number of countries, including the Netherlands and Belgium, for example, have introduced measures to lessen the tax burden, especially in the case of low-wage workers and women and young people, not only for equity reasons but also to encourage their employment. Very few reforms have been systematically evaluated and, where careful studies have been undertaken, the estimated impact can vary considerably: for example, researchers found that the cuts increased employment in Belgium but not in the Netherlands.

The availability of solid evidence on the likely employment and fiscal effects is a key challenge for the consideration of labor tax reform options in Turkey.

Although lower taxes on labor would encourage job creation, the magnitude of the effect is not known. At the same time, a direct effect of reduced labor taxes would likely be to lower fiscal revenues. This is especially important because of Turkey s high social insurance deficit.

This empirical study aims to estimate quantitatively the employment and fiscal implications of reductions in labor taxes. Based on data from enterprise surveys, the Household Labor Force Survey, and social insurance administrative data, the analysis uses various methodologies to estimate how much new employment would be created if labor taxes were reduced. Then, using social insurance simulation models, the study estimates how increased registration with lower contribution rates would affect the fiscal position of the pension and unemployment insurance funds under various reform scenarios. It should be noted that this analysis was carried out before the social contribution changes introduced as part of the 2008 employment package.

Conclusion 1: Employment in Turkey is responsive to changes in labor costs. This is the common conclusion of various analytical exercises undertaken using different data and methodologies. Our estimates indicate that elasticity of labor demand how much employment changes as labor costs change -- is in the -0.4 to -0.6 range, comparable to what has been observed in other

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middle-income and developed countries. Turkey s labor market also responds relatively quickly: most of the employment adjustment to changes in labor costs occurs in less than 18 months. In addition, an evaluation of subsidies in low-income provinces concluded that reductions in total labor costs have significantly increased registered employment in eligible provinces. Finally, employment probabilities for low-wage workers especially for women and youth -- are affected by policy changes that alter the minimum wage and the social insurance contribution base. Reducing labor taxes, then, would increase registered employment in Turkey.

Conclusion 2: However, the effect of lower taxes on employment would be diluted because a significant portion of the reduced tax would be captured by workers through higher wages rather than by employers through lower labor costs. While our results show that reducing labor costs can significantly boost registered employment, the full impact of changes in labor taxes is complicated by the fact that employers and workers actually share the burden of the taxes, regardless of who they are statutorily levied on. The analysis indicates that much of the effect of a tax reduction would be passed through to workers in the form of higher wages, rather than to employers through reduced labor costs. Because of this, a one percentage point cut in social insurance contributions for an average-wage worker would reduce total labor costs by less than 0.50 percent with the result that employment would increase by under 0.25 percent. This pass-through effect would limit the overall employment gains of a general reduction in labor taxes.

Conclusion 3: Consequently, across-the-board reductions affecting all employment would not likely be cost-effective as an instrument for increasing formal jobs. Because much of the effect of an across-the-board tax cut would be absorbed through increased wages especially for higher-wage workers, it could achieve a major employment impact only if it is large. A more modest across-the-board reduction would only generate limited employment gains and at a significant cost. We simulated the effects of reducing employer pension contributions by 5 percentage points and eliminating their 2 percent contribution to the UI fund. Our estimate is that this would increase registered employment by about 1.1 percent (85,000 jobs), which would reduce the unemployment rate by about 0.35 percent (based on 2005 HLFS numbers). However, the cost of this reform to the pension fund would be considerable, initially increasing the fund s deficit by 0.75 percent of GDP and worsening somewhat over much of the simulation period.

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Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

The goal of cost-effective job creation would be better served if cuts were targeted at lower-wage labor. At lower wage levels, much more of the effect of a tax reduction decreases labor costs for the employer.

According to our estimates, about three-quarters of a tax cut targeted at minimum-wage labor would be captured by employers through lower labor costs, and only a quarter by workers through higher wages. As a result, the employment effect would be comparatively stronger than when general tax reductions are offered. In other words, tax cuts targeted towards low-wage labor would be more cost-effective in terms of stimulating employment gains.

Indeed, simulations show that reductions in contributions oriented towards low-wage workers, compared with across-the-board cuts, increase employment more at the same cost or achieve comparable employment increases at lower cost. The simulations to assess the impact of focusing tax cuts on low-wage labor assumed contribution reductions targeted at workers under the age of 30. The decision to target youth in these simulations stems from the concern that explicit targeting on low-wage workers would create incentives for employers to officially register employees at low wage levels, even if their real earnings were higher.

Youth are a good proxy because they are identifiable and are heavily represented in the low-wage sector. (In 2005, over 50 percent of workers earning less than 1.25 times the minimum wage were under 30.) The analysis suggests that the targeted reduction again reducing employer pension contributions by 5 percentage points and eliminating their 2 percent contribution to the UI fund --would increase employment (of young workers) by 70,000, not much less than the 85,000 with the general tax reduction. At the same time, the targeted option would have only a relatively small negative effect on the balance of the pension fund (about 0.2 percent of GDP).

Under all scenarios, the registered employment gains of a cut in social insurance contribution rates do not broaden the tax base enough to compensate fully for the reduced contribution rates. Even under the more cost-effective targeted options, Turkey would face some additional fiscal pressures because employment gains would not be sufficient to make up for lower contributions per worker. These pressures would be greatest with general tax reductions. In Turkey s current fiscal situation, this is an important factor if the authorities were to consider, for example, reductions in social insurance contributions. In 2005, general budget transfers equal

to 4.8 percent of GDP were needed to meet social insurance fund obligations, largely for pensions. Ceteris paribus, this transfer would need to increase under the types of scenarios evaluated in this study.

To achieve overall fiscal neutrality, policy-makers would need to find revenues from other tax sources or decrease public expenditures to compensate for the costs of labor tax reductions. The adjustments on either the revenue or expenditure side would, in turn, have implications for employment. These second-order effects have not been included in this study but would need to be considered for a complete assessment of the implications of reducing taxes on labor.

If the authorities were to consider reductions in Turkey s tax wedge, this study suggests that targeted cuts, especially for low-wage workers such as youth or women, would be the preferable option. This conclusion is based on the fact that the relative burden of employment taxes is greatest for low-wage workers and our finding that reductions targeted at this group would have the most concentrated employment impact. This study only explicitly considered cuts in social insurance contributions.

However, income tax reforms to make the taxation of personal income more progressive could also be considered. In any event, there is a strong case for reducing Unemployment Insurance contributions which would contribute modestly to employment -- because of the huge surplus in the Unemployment Insurance Fund.

Over the longer run, as the fiscal position of the other social insurance funds and the general budget becomes more favorable, there will be additional scope for further reductions.

The Turkish authorities might consider an effectively targeted reduction of social insurance contributions that increases employment as part of a comprehensive reform strategy to address the country s jobs deficit.

Although this study has focused on labor tax reductions, a comprehensive reform program is required to increase formal employment, as recognized in the Ninth Development Plan. Analytical work undertaken by the Government, the World Bank, and others suggests that this might include not only efficiently-targeted reductions in social security contributions, but also more flexible contracting arrangements, reduced severance obligations, improvements in unemployment insurance and active labor market programs, and stronger labor market institutions to administer and enforce policies and regulations.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

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Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey I. Introduction

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ob creation is a major challenge for Turkey.

Certainly, the current economic crisis has caused rapid increases in unemployment. However, even before the slowdown started, employment creation had been slow despite strong economic growth in the years after the last financial crisis in 2001. This has been a major concern for the Government. As a result, increasing employment has been identified as one of the development axes in its Ninth Development Plan, covering 2007-2013 (Government of Turkey 2006). The Plan sets a target of 2.7 percent employment growth per year during this period, a rate well in excess of the 0.4 percent annual increase registered during the 2001-2005 period covered by the Eighth Development Plan.

Turkey s employment performance lags well behind European comparators. The employment rate (15-64 years) in 2006 was only 46 percent, well below any EU member country, and far from the Lisbon targets for 2010. In fact, employment rates for men are only slightly below European averages (Table 1). However, Turkey s disadvantage is substantial for younger and older workers and especially for women: less than one in four Turkish women are employed, compared to 57 percent in the EU countries.

Table 1: Turkey s employment rates (15-64 years) relative to the Lisbon targets and EU members, 2006

Turkey EU-27 EU-15 Lisbon target 2010

Overall employment rate

Female employment rate

Male employment rate

45.9 64.3 66.0 70

23.8 57.1 58.4

68.0 71.6 73.5 67

Source: Eurostat

A second dimension of the jobs deficit is the large employment numbers in the informal sector. Although formal employment has rebounded somewhat since late

2004, the fundamental picture remains concerning.2 In 2005, one-half of the employed labor force was not registered with a social security institute; this figure is about one-third even when agriculture is excluded. Over 30 percent of regular (i.e., non-casual) wage employees in the private sector are not registered. Moreover, these figures on non-registration actually underestimate informality because of underreporting of wages for those who are registered.3 Studies undertaken for the Government (e.g., Tunali 2003; Government of Turkey 2006) and the World Bank (2006a, b) have concluded that a range of factors are constraining employment growth. The analysis underlying the World Bank reports emphasizes that many factors come into play, some outside the labor market and others directly related to labor market policies, institutions, and practices. The Ninth Development Plan raises a number of issues that are negatively affecting the functioning of the labor market and hampering job creation. These include low participation rates especially for women, a lack of responsiveness of the education system to labor demand, underdeveloped active labor market programs, insufficient flexibility in the labor market, and high nonwage labor costs, including social insurance contributions and personal income taxes levied on workers.

The high levels of labor taxes figure prominently in policy discussions on employment.4 Indeed, after the analysis reported in this report was completed, the Government in 2008 introduced changes in social contributions that were not incorporated into our calculations. Prior to these changes, combined employeremployee contributions to finance pensions and disability insurance, health insurance, unemployment benefits, and workers compensation were 36.5-42 percent of gross wages. Income tax ranges from 15-35 percent of the gross wage.5 Using contribution and tax rates prior to

2 In 2005, according to HLFS data, growth in employment registered with SSK was 12 percent.

3 For about 50 percent of employees enrolled in SSK, earnings as reported by employers are at the minimum insurable level.

4 Throughout this report, labor taxes is used as a term to include both social security contributions (levied on employers and employees) as well as personal income taxes

levied on employees.

5 Between 2000 and 2004, income tax rates ranged from 15-40 percent. In 2005, the top rate was cut to 35 percent and the number of brackets was reduced from six to five.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

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the 2008 reforms, Table 2 compares the tax wedge on labor income in Turkey with the EU-15 countries (pre2005 members) and a selection of (new accession) EU10 countries for workers at different earnings levels and with different family characteristics.6 Turkey s relative position varies, depending on family status and earning levels. In the cases of single individuals and married couples with no children at or above the average production wage, Turkey s tax burden is in the middle ranks in Europe. But for families and singles with children, Turkey s taxes on labor are among the highest.

This is especially the case for low-wage workers with children where Turkey has the highest tax wedge of all of the European OECD countries.

A high tax wedge can be expected to reduce employment in the formal sector because of its unfavorable effects on labor demand and labor supply. To the extent that social contributions and personal income taxes raise total labor costs, they decrease employer incentives to hire new workers. At the same time, by cutting take-home pay, a high tax wedge reduces incentives for workers to participate in the labor market. Many countries have introduced measures to lessen the tax burden, especially in the case of low-wage workers and women and young people, not only for equity reasons but also to encourage their employment. Indeed, studies internationally have shown that employment for these groups is particularly sensitive to the size of the tax wedge.

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Table 2: Comparing average tax wedges in Turkey with European countries by Family Type and Wage Level, 2004 Single No children

Family type Wage level 2

Single 2 children

Married 2 children

67

100

167

67

67-0

100-0

100-33

44-0

Turkey tax wedge (%), OECD methodology

41,8

42,7

44,4

41,8

42,7

42,2

42,2

41,3

Number of EU-15 countries with higher tax wedge

3

8

8

0

0

0

3

Number of EU-4 3 countries with higher tax wedge

2

3

3

0

0

0

1

Turkey tax wedge (%), with consumption tax credit

39,0

40,0

41,5

39,0

38,3

38,7

39,2

Number of EU-15 countries with higher tax wedge

5

9

9

0

1

1

3

35,3 1. Income tax plus employee and employer contributions less cash benefits; consumption tax credits added for Turkey.

Number of EU-4 3 countries with higher tax wedge

3

4

4

0

0

1

2

Turkey tax wedge (%), with minimum living relief7

31,18

40,28

43,10

37,03

37,44

39,03

39,90

32,57

Turkey tax wedge (%), 2008 (after intended reduction of social contributions)

35,50

37,71

40,66

34,33

33,60

36,42

37,32

29,67

2. Figures in this row indicate wage level as a percent of average production wage. In the married family examples, wage levels for each adult are given (e.g., 67-0 means that primary earner has wages at 67 percent of average production wage and the other adult has no earnings). The last example (44-0) represents the case of a family with one minimum wage worker and a non-earner.

3. Includes EU-10 (new accession) countries that are also OECD members -- Czech Republic, Hungary, Poland, and Slovak Republic.

Source: OECD (2004), with calculations by IMF and World Bank staff.

6 The tax wedge is defined as income taxes and combined (employer-employee) social security contributions, minus cash benefits, as a percentage of total labor compensation.

The calculations of the tax wedge are based on OECD estimates with additional calculations made by the World Bank to take into account Turkey s consumption tax credits which were not included by the OECD. Note that payroll taxes account for about 70 percent of Turkey s overall labor taxes.

7 The calculations presented in the table do not incorporate the reforms introduced in 2008. As of January 2008, the practice of Minimum Living Relief replaced the practice

of Special Expenditure Relief in the Income Tax Law, which resulted in a decrease in the tax wedge. Furthermore, additional relief in the tax wedge was introduced after the 5 percent reduction in the social security contributions of employers that took effect in October 2008. The table below shows the tax wedges after the introduction of new practices, as calculated by the Government.

Single No children

Family type Wage level

2

Single 2 children

Married 2 children

67

100

167

67

67-0

100-0

100-33

44-0

Turkey tax wedge (%), with minumum living relief

38,18

40,28

43,10

37,03

37,44

39,03

39,90

32,57

Turkey tax wedge (%)2008 (after the intended reduction of social contributions)

35,50

37,71

40,66

34,33

33,60

36,42

37,32

29,67

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

Consideration of labor tax reform options in Turkey is hampered by the fact that solid evidence does not exist on the likely employment and fiscal impacts. Although lower taxes on labor would encourage job creation, the magnitude of the effect is not known. At the same time, there would also be serious financial considerations to take into account. This is especially critical because of the social insurance deficit and the need to generate a sizeable primary surplus.

At the request of the Government, the World Bank has undertaken an empirical study of the impacts of reductions in labor taxes on employment and on the fiscal positions of the social insurance funds. Based on data from enterprise surveys, the Household Labor Force Survey, and social insurance administrative data, the analysis uses various methodologies to estimate how much new employment would be created if labor taxes were reduced.

Then, using social insurance simulation models, the study estimates how increased registration with lower

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contribution rates would affect the fiscal position of the pension and unemployment insurance funds under various reform scenarios. The results and policy implications are summarized in this synthesis report. The detailed analysis on employment impacts is presented in three technical reports (Taymaz 2006; Betcherman, Daysal, and Pagés 2007; and Papps 2007).

The rest of this paper is organized as follows. Section 2 provides a brief literature review on the employment effects of labor taxes and subsidies. The methodologies used for the different empirical studies included in this project are described in Section 3. Section 4 summarizes the results of our estimations of the employment effects of changes in labor taxes. In Section 5, we present a set of simulations to demonstrate what the effects of cuts in social security contributions rates would be on the fiscal situation of the pension and UI funds. Finally, policy implications are drawn in Section 6.

II. A Brief Summary Of The Literature On The Employment Effect Of Labor Taxes And Subsidies

A

s background, the key concepts and existing literature on the employment effects of labor taxes are summarized in this section. Labor tax reductions have been implemented in many countries at different times to encourage employment. Their effect on employment depends on the elasticities of labor supply and demand, and how the tax cut is distributed between lower labor costs for the employer and higher wages for workers. Economists have measured the impacts of taxes in various ways.

While there is no consensus, the most common finding is that tax reductions have a small but significant effect on formal employment. However, further research is needed to generate more solid conclusions.

Labor tax reductions (including social security contributions) and employment (or wage) subsidies aim to encourage employment by decreasing the cost of labor and increasing labor demand and/or by increasing takehome pay which will improve labor supply. Tax cuts and subsidies can be applied to all employees or only to new hires. They can also be general, in the sense of applying to all workers and establishments, or specific, if only certain types of workers or firms qualify. Although labor tax cuts and employment subsidies have been implemented in many countries at different times, the

quantitative evidence of their impacts on employment is limited. To the extent that these impacts have been estimated, two broad approaches have been used. The first is to make inferences based on estimates of the elasticity of labor demand. The second is to directly estimate the effects of actual tax cuts or subsidies.

Regarding the first approach, labor demand elasticity estimates provide a measure of the expected change in employment in response to a change in labor costs.

However, when the reason for a change in labor costs is a tax change (or a subsidy), this approach is confounded by the fact that, a priori, it is not clear what the tax incidence is i.e., whether the tax is actually being paid by the employer or by the employee. This depends fundamentally on the elasticity of labor demand and labor supply. When the incidence is fully on the employer, the result of a tax cut or a subsidy will be lower total labor costs and increased labor demand. On the other hand, when the incidence is fully on the employee, the result will be higher take-home pay for the worker but no effect on labor demand. However, in this case, there could also be an effect on employment depending on the elasticity of labor supply. These principles are the same whether the tax is statutorily imposed on the employer or on the employee (or the subsidy given to one or the other).

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

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In reality, tax reductions or subsidies are typically shared by the two parties and, assuming competitive labor markets, both employment and wages will increase.

Other factors can also come into play. One is whether minimum wages are binding. In that case, an excess supply of labor would imply that firms can recruit more workers without having to increase wages. This situation is similar to the case when the labor supply is fully elastic: a tax cut or an employment subsidy yields maximum employment expansion and no effect on wages. As we will see later in this report, this has potentially important implications for thinking about labor tax reforms that will maximize employment gains. Second, in noncompetitive labor markets, the tax incidence can also be determined by the relative bargaining power of employers and employees. Another key issue is how workers perceive the value of the benefits financed by their social contributions or income taxes. If they fully value these, then in the case where taxes been reduced, they will be more likely to demand higher wages as compensation for the expected lower social benefits.

The existing literature offers some guidance on the plausible range of labor demand elasticity estimates, although most of the studies are based on data from industrialized countries. The international evidence suggests that the likely range is between -0.30 and -0.50 (i.e., a 10 percent decrease in the cost of labor would cause employment to rise from between 3 percent and 5 percent).8 Recently, there have been a growing number of studies from developing and transition countries, with most of the (long run) elasticities estimates in the -0.20 to -0.40 range.9 There have been a small number of labor demand studies in Turkey, which also yield results that are roughly consistent with findings elsewhere (Taymaz 2006, Table 1). Estimates of (long-run) elasticities for Turkish manufacturing employment range from -0.09 to -0.57, while one study also calculated estimates for services (-0.20) and construction (-0.27).

As noted above, labor demand elasticities do not fully capture the employment effects of changes in labor taxes because that depends also on the tax incidence. Thus, researchers need to take into account what economists call the pass through i.e., the extent to which labor taxes are shifted on to employees. Studies in middleincome countries provide a wide range of estimates which indicate that, in some cases, the pass through can be quite large. For example, research in Latin America suggests that anywhere from 20-70 percent of the employer s 8

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social security contributions are passed on to the worker (Heckman and Pagés 2004). At the upper end of this range, most of the effect of a tax reduction would be captured by employees through higher wages, with little effect on employment. Indeed, this is what Gruber (1997) found to be the result of a major payroll tax cut (of 25 percentage points) in Chile between 1979 and 1986. In an analysis using firm-level data, he found that wages adjusted fully to the tax cut so that there was no employment effect.

However, the most reasonable assessment based on the complete literature is that labor taxes do have a modest effect on employment. This is the conclusion drawn by Nickell (2003) who assembled the results of a number of studies, albeit only from OECD countries. He concludes that a 10 percentage point change in the tax wedge can be expected to affect employment by between 1-3 percent, a relatively small but by no means insignificant effect (p. 8). On the basis of cross-country regressions for Eastern European and Central Asian countries, Rutkowski (2007) estimates that a one percentage point change in the tax wedge results in a 0.3-0.6 percent change in the employment rate. It should be noted, however, that these studies refers to tax changes affecting all workers. The limited evidence available does suggest that, because pass-through rate seems to decline around the minimum wage, the effect of tax reductions might have larger effects for low-wage workers.

The second approach directly estimating the employment effects of different tax cuts or subsidies -- has been used on a limited basis only. Bishop (1981) employed a timeseries methodology to evaluate the employment impact of the U.S. New Jobs Tax Credit and found that the program increased aggregate employment by 0.2-0.8 percent. More recently, Katz (1998) evaluated another U.S. scheme, the Targeted Jobs Tax Credit which was available to employers hiring workers defined as vulnerable and disadvantaged. Using a difference-indifferences methodology, Katz estimated that a 15 percent reduction in labor costs because of the credits yielded a net employment effect of 7.7 percent; under the assumption of an infinitely elastic labor supply, this implies an elasticity of labor demand of -0.5, a value within the range found by Hamermesh (1993). In the context of middle-income countries, Galasso, Ravaillon, and Salvia (2001) evaluate Proempleo, a wage subsidy scheme targeted to workers in temporary employment in Argentina, and find that the program provided assistance

This range is based on the literature review in Vroman and Brusentsev (2005), who rely heavily on Hamermesh (1993). They present these estimates with some caution, because of the lack of empirical evidence from middle-income countries. A more recent study of EU-8 countries (World Bank 2005) finds a higher elasticity of employment of between 0.5-0.8. There is, however, some possibility of bias in these estimates relying on macro data, although it is not clear in which direction any bias might go.

For a list of these studies, see Taymaz (2006).

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

to low-wage workers in finding regular wage employment, although effects were only statistically significant among women and youth. On the other hand, Muhlau and Salverda (2000), using time-series analysis, found no employment effects of SPAK, a Dutch program to reduce taxes and social security contributions paid by employers for workers with wages around the minimum wage.10 Not only are there few studies directly estimating the employment effects of tax cuts and subsidies, but the literature has some important gaps. There appear to be no attempts to assess whether employment growth that does occur is due to the creation of new jobs or the formalization of existing jobs. Another issue that has not been analyzed is whether job gains are the result of the expansion of existing firms (i.e., in the intensive

5

margin) or because of an increase in the number of firms (extensive margin). Another parameter of key importance and about which little is known is the deadweight loss i.e., what share of subsidized employment would have been created in the absence of the incentives. Most estimates are obtained from interviews with employers rather than from quantitative estimates. Even though employers may not have the right incentives to report on the actual numbers they would have employed in the absence of subsidies, such estimates still suggest large deadweight losses. Estimates range from around 53-70 percent for marginal subsidization under targeted programs up to 93 percent for non-targeted, across the board measures (Marx, 2005). Another important gap in the literature is the effect of tax cuts and subsidies on wages.

III. Study Methodology

T

his section describes the methodology and data used in the different lines of analysis that comprise the complete study. The approach involves two stages (Figure 1).

The first analyzes how employment in Turkey responds to changes in labor taxes. Three methods are used: (i) calculating labor demand elasticities and pass-through rates based on establishment data; (ii) evaluating the number of jobs created due to subsidies offered under regional development programs using social insurance administrative files; and (iii) estimating how employment probabilities for low-wage workers respond to changes in the cost of their labor because of changes in the minimum wage and social insurance contribution base.

The rationale for this multi-pronged approach is to increase the robustness of the findings. In the second stage, with our estimates of the employment effects of changes in labor taxes, the financial impacts of the new employment levels and the reduced tax rates on the pension fund and the UI Fund are projected using social insurance simulation models.

Methodology and data for estimating employment impacts The estimates of employment impacts of tax reductions are based on three different methodologies and data sources.

10

Figure 1: Summary of study methodology Reduction in labor taxes

Employment impacts

Establishment data, SSK data, Household Labor Force Survey

PROST, UISIM models

(a) Establishment-level analysis of labor demand This part of the study analyzes how employment in enterprises responds to changes in the cost of labor. The methodology and results are reported in detail in Taymaz (2006). The empirical work is based on Turkstat datasets for the manufacturing industry and construction. These sectors were selected because of the availability of panel data at the establishment level. Information on the data sources is provided in Box 1. Unfortunately, appropriate data were not available for the service sector. The enterprises included in these datasets can be assumed to operate in the formal sector; as a result, the analysis cannot provide insights into how informal employment responds to labor cost changes, nor how employment shifts between the informal and formal sectors.

It should be noted, however, that studies using a time-series approach may not provide a good identification of the effects of the scheme relative to the effects of other factors that also influence employment.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

6

Box 1: Establishment data used for labor demand and pass through analysis The econometric modeling of labor demand elasticities and labor tax pass-through is based on three Turkstat datasets.

For more details, including variable definitions see Taymaz (2006).

The Annual Survey of Manufacturing Industries (ASM) covers all private establishments employing 10 or more people and all public establishments, and primarily includes information on production-related aspects (number of employees, wage payments, costs of inputs, sales, investment, etc.). The dataset used in the study covers the period from 1992 to 2001. The empirical analysis reported in this paper is based on all private establishments only. Establishments are classified into three sub-sectors: i) capital goods and consumer durables, ii) consumer goods, and iii) intermediate products, in accordance with the European Commission definition.

The Short Term Production Surveys were conducted quarterly (large sample) and monthly (small sample) until 2005, and are now being conducted on a monthly basis for the large sample. The larger sample covers about 3,000 establishments that produce 90 percent of output at the 4-digit industry level. The content of the quarterly survey is more limited than that of the Annual Survey, but does include data on production, sales, employment, and wages. Data from the first quarter of 1988 to the last quarter of 2005 are included in the analysis. While establishments in the sample change over time, our panel analysis is restricted only to those establishments included for at least 68 quarters.

The construction survey is conducted annually, and our analysis of establishments in this sector covers the period 1992-2001. The basic structure of the construction survey is similar to that of the manufacturing survey, and includes questions on the number of employees, wage payments, costs of inputs, construction services provided, investment, etc.

The analysis involves calculations of labor demand elasticities and pass-through rates of employer social security contributions. As we will see in the next section when we discuss results, the pass-through is a major factor in determining the magnitude of the employment gain from a labor tax reduction. In this study, we measure the pass-through as the percentage change in labor costs for a 1 percent change in employer social security contributions.11 11 12

Taymaz (2006) formally develops and specifies the econometric models used for calculating the elasticity and pass-through estimates.12 Briefly, labor demand elasticities are estimated using the various panels described in Box 1 according to a dynamic fixed effects model that follows the common practice in the literature. This model estimates the number of employees (or hours worked) in an establishment at a point in time as a function of its average real cost of labor, real cost of capital, and real

This is actually the inverse of the pass through. For example, if three-quarters of a 1 percent reduction in employer contributions is passed on to employees through higher wages, we calculate the pass-through measure as 0.25 (i.e., labor costs are reduced by 0.25 percent).

To handle various econometric issues related to endogeneity of some variables and the use of lagged dependent variables, Taymaz (2006) uses the GMM-System estimator.

The models are estimated using first differences (fourth differences in the quarterly models) to eliminate unobserved firm-specific effects.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

output, as well as unobservable firm-specific effects.

The labor demand elasticity is calculated on the basis of the estimated coefficient for the labor cost variable. The preferred specification of that variable is total labor costs.

This is available in the annual data but gross wages are used in the quarterly model because total labor costs are not reported in the quarterly surveys.13 The lag value of employment is included in the labor demand model to estimate the speed of employment adjustment.

To calculate the pass-through rate, Taymaz estimates a separate wage equation using the annual data which include employer social security contributions. The model estimates the real gross wage in an establishment at a point in time as a function of the social security contribution rate (the ratio between the employerÂ’s contribution and gross wages), and various control variables including the real minimum wage rate, the market share of the firm, the proportion of female employees in labor force, the capital/labor ratio, and a leading indicators index. The pass-through calculation is based on the coefficient for the social security contribution rate. This model also accounts for unobservable firm-specific effects. The lagged depended variable is included into the model to allow for a partial adjustment process. (b) Analysis of regional subsidies This study attempts to directly measure the employment impacts of subsidies offered by the Government of Turkey to encourage investment and employment in low-income provinces. The program details, and the methodology and results are reported in full in Betcherman, Daysal, and PagĂŠs (2007). The research covers three different incentive regimes, legislated through Law 4325 (1998) which covered 22 provinces, Law 5084 (2004) which expanded coverage to an additional 15 provinces, and Law 5350 (2005) which added 13 more provinces.14 Given that our data do not cover the period before Law 4325 was enacted, the econometric analysis of the net employment impacts focuses on the subsidies offered under Laws 5084 and 5350. Although there have been some differences in qualification requirements and the actual subsidies, these two laws have included four subsidy components: (i) reductions in employer social security contributions; (ii) credits on income taxes on wages; (iii) subsidies for electricity consumption; and (iv) land

7

subsidies. Employers in eligible provinces have qualified for the various subsidies on the basis of meeting new job creation thresholds, either by opening new establishments or by expanding employment in existing ones.

Since these subsidies reduce the cost of labor in some provinces but not in others, the programs can be examined to estimate how much new employment is likely to be created when taxes or social security contributions are reduced. Often the impact of programs such as these is assumed by policy-makers to be simply equal to the number of new jobs that have been subsidized. However, this does not take into account the job creation that would have occurred if the program had not been introduced.

To do this requires a control group that approximates a reasonable counterfactual, while controlling for other factors that determine employment levels.

Eligible provinces under Law 5084 had a per capita GDP of less than $1500 (in 2001) or had been designated as priority development regions. All provinces (but one) covered under the existing regional incentives law (4325) qualified for this new program and any firm that received subsidies under Law 4325 could choose to continue under the old regime or switch to the new one. Beginning in January 2004, employers could qualify for monthly subsidies under Law 5084 based on the additional registered employment they reported above a benchmark based on their October 2003 level. New start-ups were eligible for subsidies for their total registered workforce.

The first subsidies were paid in March 2004.

Law 5350 came into effect in May 2005 and modified a number of provisions in Law 5084, in addition to extending coverage to 13 more provinces with low socioeconomic development according to an index elaborated by the Turkish State Planning Organization. Again, any firm that received subsidies under the previous law could choose to continue to receive subsidies under that law or switch to the new law. One major difference between Laws 5350 and 5084 was that an employment threshold of 30 employees was set as a condition to qualify for subsidies under the new law.15 At the same time, Law 5350 provided for social insurance and income tax subsidies equal to three times the amount payable to a new hire, up to specified maximums. This implied that, for every eligible worker, the law could potentially subsidize two already-employed workers.

13

One potential issue concerns the underreporting of wages. It has often been observed that a large number of firms operating formally tend to underreport wages to avoid taxes. Underreporting can lead to downward bias in the estimated values of wage elasticity because the actual wage cost is likely to be higher. However, if the behavior of firms to underreport wages is consistent over time, the firm-specific unobservable effects in the model can capture these effects as well and lead to unbiased estimates.

14

One of the 22 provinces covered under Law 4325 (Tunceli) was not covered under Law 5084 but was covered again under Law 5350.

15 Newly-created firms were now required to have at least 30 registered employees, while existing firms also had to have at least 30 employees and to have increased

employment by at least 20 percent above a benchmark based on their January 2005 level.

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Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

The employment impacts of the regional incentives are analyzed using difference-in-difference models that estimate registered employment (levels and growth) in a province in a given month as a function of whether the regional incentives program is in force, the time period, and provincial variables that cover province-specific effects. Various alternative specifications incorporating these determinants in different ways are estimated.16 The estimation approach used is to compare the change in employment between the period before and after the introduction of subsidies in the provinces that benefit from them ( treated provinces ) with the change in employment in provinces that are not covered ( control provinces ).

To clarify the specification of control and treatment groups, the following groups of provinces are defined: (i) 4325-subsidized : the 22 provinces that were subsidized under Law 4325; (ii) 5084-subsidized : the 15 provinces added under Law 5084, but not covered by Law 4325; (iii) 5350-subsidized : the 13 provinces added under Law 5350, but not covered by Law 5084; and (iv) never-subsidized : those provinces that were never covered under any of the three programs.

To estimate the net employment effect of Law 5084, two control groups are used 5350-subsidized and neversubsidized . The former has the advantage of providing a better counterfactual in that it includes provinces that are similar in terms of income, geographic location, and other characteristics to the provinces in the 5084subsidized group, but fell above the minimum income per capita threshold to qualify for subsidies under Law 5084. On the other hand, it could be argued that substitution effects will be stronger between similar and geographically close provinces than between provinces that differ substantially in income and other attributes, which suggests that the never-subsidized group may give a better idea of the effects of the subsidies net of substitution effects. The options are more restricted for estimating the effect of Law 5350, with the neversubsidized group specified as the only control group.

In fact, it should be noted that, although the study includes estimates of the effects of both Law 5084 and Law 5350, the analysis is on stronger footing for the earlier law than the later one. The impacts of Law 5084 can be estimated

under two different control groups, while the Law 5350 analysis can only use one. Moreover, given the available data, the observation period for Law 5350 is short (only 8 months).

The models are estimated with three dependent variables.

The first, registered employment, is used to estimate the net employment impact of the subsidies, as already discussed. The second, registered workplaces, allows for an assessment of how much of the estimated employment gains have been due to the addition of new firms (extensive margin) or the expansion of existing ones (intensive margin). The third, average taxable earnings, is used to estimate what effect the subsidies have had on wages and the actual incidence of the subsidies (i.e., who benefited, employers or workers).

Estimations are based on administrative data provided by the Social Security Administration (SSK). These data are reported by provincial unit for every month and cover the number of registered workers, their insurable earnings, SSK premiums, number of workplaces registered, the number of newly registered employees and workers, as well as other variables.17 The SSK data also include files with a number of variables describing new registrations under the regional incentives laws, which we use in the cost calculations. However, the data on total registrations are used for the econometric modeling described above. The models are estimated using the monthly data for the period covering 2002-2005.

The calculation of the costs incurred under the program includes the social security, income tax, and energy subsidies. The social security costs are provided in the SSK database described above. We do not have data on the income tax subsidy costs but they have been estimated as a proportion of the social security subsidies.18 The costs for the energy subsidies by month and province have been provided by the Treasury. Land has not been included in the cost calculations because neither data nor a method for approximating these costs is available.

One additional aspect of the analysis was to assess the extent to which gains in registered employment because of the subsidies were due to real increases in economic activity or to the registration of previously unregistered activity. Data availability limited our ability to examine

16 For an example of the general methodological approach, see Autor, Donohue III, and Schwab (2006).

17 The data are actually provided on a sub-provincial basis (i.e., SSK reporting unit). The sub-provincial data were aggregated up to a provincial basis for each month.

18 During the period between January and June 2004, the income tax subsidies under the program are assumed to be 56 percent of the observed social security subsidies.

Between July 2004 and December 2005, this figure is calculated at 73 percent. These proportions are calculated on the basis of differences between the employer social security contribution rate on the minimum contribution base and the income tax rate on minimum wages. The change in the ratio between the two tax subsidies reflects the fact that the minimum contribution base was higher than the minimum wage in the first period in the first period and then the two were set at the same level from July 2004 on. Actual calculations are shown in Betcherman, Daysal, and Pagés (2007).

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

this issue.19 The approach used was to estimate a model of electricity consumption, which is a commonly used proxy for economic activity, using annual provincial data between 2002 and 2004. It should be recognized that, even here, data are a limiting factor since we are only able to use three observations per province, with only one after Law 5084 was introduced. Moreover, the effect of Law 5350 cannot be tested with the available data. (c) Analysis of changes in labor costs using Household Labor Force Survey data This study analyzes how employment probabilities change for low-wage workers in response to policy-induced shifts in the cost of their labor. The data for this research come from the quarterly Household Labor Force Survey (HLFS). In addition to providing another line of evidence on how employment is affected by changes in labor costs, the HLFS analysis can offer some insights into the interactions between the formal and informal sectors and how different types of workers (e.g., women, young) are affected by changes in labor costs. Details on the methodology and results are reported in Papps (2007).

The policy changes considered in the analysis are the social security contribution base and the minimum wage.

In recent years, there have been regular changes in these parameters that have implied non-trivial variations in the cost of employing low-wage workers. Annex Table A1 summarizes these changes and their implications for the real labor costs of workers at the minimum wage.20 The impacts of these changes can be evaluated by estimating models that relate the probability of low-wage workers continuing in employment as a function of changes in the cost of their labor. The analytical approach is based on (i) observing an individual s employment status and earnings at one point in time (a particular quarter); (ii) calculating how total labor costs in employing that individual at a second point in time (a later quarter) would have changed because of changes in minimum wages and the contribution base; and (iii) observing the

9

individual s actual employment status during the second observed point (quarter).21 The probability of being employed during the second observed quarter is estimated in a model which includes individual characteristics and a treatment variable that measures the change over the two quarters in the total labor cost required to employ the worker at his or her gross wage (as observed in the first quarter). In order to focus the analysis on workers who would potentially be affected by the minimum wage and the contribution base, the estimation sample is restricted to wage employees who earned a real wage (at 2003 prices) of a maximum of 500 million TL. The analysis requires panel data in order to observe individuals at two points in time. While the quarterly Household Labor Force Survey follows a repeated sampling approach,22 unfortunately it was not possible to obtain longitudinal household identifiers, except within 2004 and 2005. Accordingly, a longitudinal panel could not be created across these years or to include any earlier years. Given this situation, Papps (2007) takes two approaches. The first involves estimating the employment models using the panel data for 2004.23 The minimum wage and contribution base changed in July 2004 so, given the HLFS sampling procedure, some individuals can be observed before and after the policy change. Nonetheless, the observation period is short (at most 4 quarters) and the analysis can only consider one policy-induced change in labor costs. As an alternative approach, Papps creates a synthetic panel which does not follow individual workers per se but tracks demographic cells where each observation refers to a combination of (narrow) demographic characteristics that is repeated across quarters. This allows data from 2002-2005 to be included. With this synthetic panel, what is being modeled is no longer the probability of a particular worker remaining employed across two quarters, but the change in the employment rate between two quarters for a particular demographic cell.

Nevertheless, in most cases, the cells consist of a single person, meaning that the synthetic panel largely resembles an individual panel.

19 Available data from the HLFS were not disaggregated to the provincial level so comparisons of formal and informal employment between covered and uncovered provinces

were not possible. Another possible approach would be to use province-level GDP data to examine whether economic activity has increased in the treated relative to the control provinces but these data were not yet available for the period under analysis.

20 It should be noted that prior to July 2004, the contribution base was sometimes at a higher level than the minimum wage. In fact, this was the case in 2003. When this

occurred, in addition to their contributions, employers were required to pay the employee s social security contributions in the earnings zone between the employee s actual wage and the contribution base. In July 2004, the contribution base and the minimum wage were synchronized. Actually, for employers, they were effectively synchronized in the January-July 2004 period because the government paid the employee contributions in the zone between the minimum wage and the contribution base.

21 This methodology has been used by economists most commonly to assess the impacts of minimum wage changes. For example, see Currie and Fallick (1996) and Kramarz

and Philippon (2000).

22 Households are sampled for two consecutive quarters, then are out of the sample for two quarters, and then are brought back in for two final quarters. In principle, with

consistent household identifiers, this should allow for tracking household members over an 18-month period. However, Turkstat reported that the availability of identifiers was limited, as described in the text.

23 There were no policy changes affecting the minimum wage or the social security contribution base in 2005.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

10

Methodology for estimating the fiscal implications The second stage of the analysis (recall Figure 1) considers the fiscal implications of tax reductions. Although, in principle, labor taxes could be reduced by decreasing personal income taxes, we assume that any reform would focus on the social security contributions. The simulations are based on reductions in employer contributions since these are the basis of the estimates by Taymaz (2006) and since, as we argue later in this report, reductions in employer rates are likely to have a greater impact on employment than reductions in employee contributions.

The future fiscal impacts of reform options for reducing social security contributions are simulated by using two World Bank social insurance simulation models the PROST model for pension insurance and the UISIM model for unemployment insurance. These computerbased models are designed to systematically model fund revenues and expenditures over a long time, according to program parameters, population and labor force trends, and macroeconomic conditions. These simulations are based on country-specific data and assumptions about the future. The PROST and UISIM models are designed

to answer a range of policy-relevant questions including the one at the heart of the present analysis: What would be the implications of alternative scenarios regarding the number of contributors and program parameters (e.g., contribution rates) for the future expenditures, revenues, and fiscal balance of the pension and unemployment insurance funds?24 The approach for this part of the study is straightforward.

First, different reform options for reducing employer pension and UI contributions are put forward. The specified contribution rates under each reform scenario are entered into the model, replacing the current (base case) rates. The employment effects through increases in the number of contributors are calculated using the estimates of labor demand elasticities and pass-through rates, based on the establishment and regional subsidy analyses. Then the model simulates the joint effects of the reduced contribution rates and the increased number of contributors on the pension and UI fund revenues, expenditures, and fund balance, relative to the existing base case projections. The UISIM projections go out to 2022 while the PROST projections extend all the way out to 2075.

IV. Results On Employment Impacts

T

his section summarizes the results from the studies on how employment reacts to changes in labor costs. All lines of analysis are consistent in finding that employment is quite responsive. Indeed, estimates of labor demand elasticity based on establishment and social insurance data are comparable to those found in other middle-income and OECD countries. The research also shows that lowwage labor is most responsive to changes in the cost of labor. The analysis of the establishment data demonstrates that the employment effects of changes in social insurance contributions are much greater at minimum-wage levels than at or above the average wage. The responsiveness of low-wage employment to changes in labor costs is confirmed by the HLFS

analysis. These data also show that women and young people are particularly affected.

4.1 Estimates of labor demand elasticities and passthrough rates As noted in the previous section, Taymaz (2006) estimates a number of labor demand functions for manufacturing and construction based on establishment survey data.25 Table 3 reports the constant output long-run total wage elasticity estimates for manufacturing and construction for production workers, administrative employees, and all employees.26 These elasticities are calculated at the mean values of the variables. The manufacturing estimates are estimated for capital goods, consumer goods, and intermediate products. Separate labor demand functions

24 The study does not consider implications for the other major fund, for health insurance. This was done for practical reasons including the fact that a new health insurance

regime was being instituted at the time the analysis was carried out. Accordingly, our methodology assumes that any social security contribution reductions would involve and affect only pensions and unemployment insurance. However, the World Bank has a newly-developed health insurance simulation model that, in principle, could be applied to this study.

25 Although the surveys include public-sector establishments, these functions are reported only for the private sector which is the focus for the study. The results are quite

different.

26 Constant output estimates do not take into account second-order employment effects of labor cost changes associated with changes in product demand from price

changes. Estimating labor demand elasticities without an output constraint is problematic. But it is reasonable to assume that constant output elasticities are downwardly biased since they do not account for output effects. Long-term elasticities refer to the completed employment effect, after the full adjustment to new labor costs have taken place.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

for manufacturing were estimated, based on annual data and quarterly data. Although the quarterly data cover a longer period of time, the annual data are richer in terms of the variables covered, including the measure of labor cost.27 For this reason, we use the estimates based on the annual data for assessing policy implications and, as a result, we only report these in this synthesis report.

Table 3: Long-term total wage elasticities, manufacturing industries and construction, annual and quarterly data

Source: Taymaz (2006, Table A1a)

Looking first at the elasticities for all workers, the estimates for the four sectors are roughly clustered in the -0.4 to -0.6 range. This means that total employment increases (decreases) by 0.4-0.6 percent for a 1 percent decrease (increase) in labor costs. In all sectors, production employment is much more responsive than administrative employment to labor cost changes.

These results are broadly consistent with the existing estimates for Turkey and internationally that were cited in section 2. In fact, our calculations are towards the higher end of the common range for developed countries (-0.3 to -0.5) and for lower- and middle-income countries (-0.2 to -0.4). In other words, these results suggest that, by international standards, labor demand in Turkey is relatively responsive to changes in labor costs.

Taymaz (2006) also calculates adjustment speeds – i.e., how quickly it takes an establishment to adjust (halfway) to the new employment level after a change in labor costs. For the annual data, the median length of the adjustment lag is about 1.4 years (16 months). The estimates are quite similar across the three manufacturing industries and construction. These estimated adjustment speeds are relatively quick by international standards, again pointing to the relative responsiveness of the Turkish labor market.

As we explained in section 2, the employment effects of changes in labor taxes cannot be calculated on the basis

11

of labor demand elasticities alone because the actual incidence of a tax will be shared in some way by employers and employees. Accordingly, Taymaz also calculates pass-through rates which indicate how much labor costs will change as a result of a change in labor taxes. As described in the methodology section, this is based on a wage equation which estimates a coefficient for the employer social security rate (SSC rate), measured as employer social security contributions divided by gross wages.28 The interaction between the labor demand effect and the pass-through effect is illustrated in Figure 2. This figure uses the following average rates calculated on the basis of TaymazÂ’s estimates for manufacturing: (1) An average pass-through rate of 0.30 which is calculated as the average of mean-wage production and administrative workers for the three manufacturing sectors, and (2) an average labor demand elasticity rate of 0.50 which is the mean of the elasticities in the three sectors weighted by their employment levels. It should be recalled that the wage and SSC data used for this analysis are establishment means and not individual worker data. To put the chart in words, for every percentage point reduction in employer SSC contributions, employment will increase by 0.15 percent. The major reason for this modest effect on employment is that most of a tax reduction goes to higher employee wages, with only a minority (30 percent) reducing total labor costs.

It is important to emphasize that the effect illustrated in Figure 2 is calculated on the basis of the pass-through rate for workers at the mean wage (i.e., at the mean establishment wage). Figure 3 shows how different passthrough rates are for low-wage workers, defined as the establishment wage one standard deviation below the mean. For manufacturing as a whole, these wage levels are about .66 and .83 below the mean for production workers and administrative workers, respectively. These wage levels are slightly below the monthly minimum wage.29 The pass-through rate is much lower for lowwage establishments in capital and intermediate goods.

In two of the three sectors, then, the labor cost reduction due to a tax cut is much greater at low wage levels.

Accordingly, the employment gains will be much greater for low-wage labor. At higher wage levels, much of the effect of tax reductions will be increased wages.

27 The annual data provide information on both gross wages and employer social security contributions, so that total labor costs can be calculated. The quarterly survey

did not include social security contributions until 2003 so the labor cost measure used is gross wages.

28 The computed SSC coefficient in the wage equation is transformed into a pass-through rate, defined as the percentage change in total labor costs as a result of a 1

percentage point change in the employersÂ’ SSC rate, according to the following formula: dsssc + ln[1+ds/(1+s1)] ds[ssc + 1/(1+s1)] where ssc is (the absolute value of) the SSC rate elasticity of wages, s1 the initial SSC rate and ds the change in the SSC rate (Taymaz 2006).

29 This may be due to employees working less than full time (either part-time or part-month) or to employees actually being paid below minimum wages.

12

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

Figure 2: The role of the pass-through on the employment effect of a labor tax reduction in manufacturing establishments

Source: Calculations based on Taymaz (2006)

Three caveats should be reiterated with respect to the elasticity and pass-through findings from the establishment data. First, the estimates do not include the service sector so it is reasonable to question how well they approximate the complete labor market. Second, since the (constant output) elasticity estimates do not take into account any increases in employment that would result from greater production because of lower labor costs, they likely underestimate the actual employment effect. Third, the pass-through estimates are based on changes in employer social security contributions. Pass-through rates for changes in employee contributions and income tax have not been estimated. However, our best guess is that the rates would be similar.

Figure 3: Estimations of pass-through rates for mean- and low-wage manufacturing workers

5350 (see Betcherman, Daysal, and Pagés 2007). After conducting various consistency and quality checks on the (monthly provincial) data, the analysis was restricted to 79 provinces covering the period from April 2002 to December 2005.

Table 4 shows the registered employment and workplace growth rates by period and provincial coverage under each incentive regime, as defined by the legislation. The 4325-, 5084-, and 5350-subsidized groups include the provinces added under each respective law. Period 0 covers April 2002-December 2003 when 22 provinces received subsidies under Law 4325. Period 1 covers January 2004-April 2005, when 15 provinces were added under Law 5084 to those already eligible under Law 4325.

Period 2 covers May-December 2005, when 13 provinces were added under Law 5350 to those already eligible under the first two laws. In addition, the table also reports growth rates for those 32 provinces that have not been included under any of the laws ( never-subsidized ).

Table 4: Mean monthly growth rates in registered employment and workplaces by type of province and period, 2002-05

Source: Betcherman, Daysal, and Pagés (2007), based on SSK data

These descriptive data show that the growth in registered employment and the number of registered workplaces increased in provinces when they became eligible for the subsidies (indicated by bold in table). The 5084subsidized provinces experienced monthly employment and workplace growth rates of 2.0 percent and 1.3 percent, respectively during Period 1, when Law 5084 was introduced. These rates were much higher than the corresponding rates in Period 0 and the increases in this period compared to the previous one were greater than in the other province groups. A similar story describes the 5350-subsidized provinces in Period 2.

Source: Calculations based on Taymaz (2006)

4.2 Evidence on employment impacts from the regional subsidy programs As described in section 3, three laws between 1998 and 2005 provided for subsidies to firms in a progressively larger set of provinces in order to encourage investment and job creation. Administrative data provided by SSK were used to analyze the employment effects of the latter two of these subsidy programs, under Laws 5084 and

The econometric analysis of the regional subsidies focuses on the effects of Law 5084 on the 15 5084-subsidized provinces during Period 1 and the effects of Law 5350 on the 13 5350-subsidized provinces during Period 2.

To evaluate the impact of Law 5084, two control groups are used in our models the 5350-subsidized and the never-subsidized provinces. In order to estimate the effect of Law 5350, only the never-subsidized provinces are used as a control group. Unfortunately, the evaluation of that program cannot benefit from the comparison with a similar, though untreated, control group, as was the

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

case with the earlier law. This, plus the fact that we can only observe the first 8 months of subsidies under Law 5350, means that our results for that scheme are based on less evidence than is the case for Law 5084.

Various specifications of difference-in-difference econometric models were estimated in order to calculate the net (registered) employment impact of Laws 5084 and 5350. Figure 4 shows the magnitude of the calculated employment effect of Law 5084 under three different specifications that yield high-, mid-, and low-range estimates. As the chart shows, the size of the effect is sensitive to the model specification and the control group.

The estimates of the net employment impact of the subsidies in the 5084-subsidized provinces range from 4.1 percent to 7.9 percent for the specifications using the never-subsidized provinces as the control group, to 12.7 percent when the 5350-subsidized provinces are the control group. The mid-point between the high and low estimates is around 8.2 percent. These effects translate into increases in the number of jobs created in the 5084subsidized provinces ranging from close to 10,000 to 28,000, with the mid-point estimate around 19,000.30 Figure 5 shows the estimated employment effect of Law 5350 under two different specifications, with the neversubsidized provinces as the control group. The impact ranges from 9.0 percent to 14.9 percent, -- significantly higher than the comparable estimates for Law 5084 based on the never-subsidized control group. The mid-point estimate is just below 12 percent. These effects translate into a boost in the number of jobs in the 5350-subsidized provinces from just under 22,000 to over 34,000, with the mid-point estimate around 28,200.31 Figure 4: Econometric estimates of the net registered employment effect of Law 5084 in 15 added provinces, January 2004-April 2005

Source: Betcherman, Daysal, and Pagés (2007)

13

The modeling exercise also addressed the question of whether the employment gain from the subsidies was due to new economic activity or the formalization of existing jobs. As discussed in the methodology section, this could only be tested partially for Law 5084, using electricity data which were taken as a proxy for economic activity. The estimations did not show any significant impact of the subsidies on the consumption of energy.

While these results are limited by the factors discussed in the methodology section, they suggest that the subsidies increased formalization of existing firms and jobs more than creating new economic activity. This is an important issue that deserves further analysis.

Figure 5: Econometric estimates of the net registered employment effect of Law 5350 in 13 added provinces, May 2005-December 2005

Source: Betcherman, Daysal, and Pagés (2007)

The expenditure side of the regional incentives programs was analyzed in order to estimate the cost of the jobs that were created. Actual data on the amount of social security subsidies and energy subsidies were included in the cost calculations as well as estimates of the amount of income tax subsidies computed as a percentage of social security subsidies, as described in section 3. The value of free land provided under Law 5084 is not included so our estimates of total costs are downwardly biased.

Estimated expenditures under the two laws are summarized in Table 5.32 In each case, the first calculation estimates the cost per subsidized job i.e., the total subsidies are divided by the number of subsidized jobmonths reported in the SSK administrative files during the relevant period. In effect, this is the official estimate of the cost per job-month, without taking into account whether the jobs receiving subsidies would have been created anyway. The other calculations compute the cost

30 These percentage estimates were calculated as of April 2005 (at the end of Period 1). The formula used was number of new jobs created as a percentage of total employment

in 5084-subsidized provinces in April 2005 minus new jobs created (i.e., what employment would have been without the subsidy effect). The actual registered employment in the 5084-subsidized group was about 248,000 in April 2005.

31 These calculations are based on the same methodology used for Law 5084, using total employment in 5350-subsidized provinces in December 2005 (nearly 266,000)

in the formula.

32 Detailed calculations are shown in Annex Tables A2 and A3.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

14

per net job-month created, using our econometric modeling results to determine how many jobs were actually created because of the program. These calculations are based on the estimates shown in Figures 4 and 5.

Table 5: Summary of estimates of cost per job created under Laws 5084 and 5350

1. Employment is reported as number of job months because employees receiving subsidies are reported by SSK on a monthly basis. The estimates of jobs created for each law are taken from Figures 4 and 5. Details on the calculations are presented in Annex Tables A2 and A3.

Source: Betcherman, Daysal, and Pagés (2007)

Looking first at Law 5084, the cost per job-month was 152YTL, if the actual number of subsidized job-months is used.33 However, according to our econometric estimates, somewhere between 47 percent and 81 percent of the subsidized jobs under Law 5084 would have been created without the program. As a result of these substantial deadweight losses, costs per job-month range from 819YTL with our low estimate of jobs created to 286YTL for the upper-end estimate, with the mid range estimate at 441YTL, about 80 percent of the total cost of employing a minimum-wage worker. Under Law 5350, when employment created is taken as the number of subsidized job-months, the monthly cost was 252YTL. This figure is significantly higher than the corresponding cost per job subsidized under Law 5084 because the level of subsidies were higher under the rules of Law 5350.

However, once deadweight losses are taken into account, Law 5350 turns out to be more cost-effective. Our empirical results suggest that, depending on the specification, between 25 percent and 52 percent of the jobs subsidized under Law 5350 would have been created without the subsidy. Accordingly, the costs per actual job created are much lower as well. We calculate the cost per job-month created under low-end job creation estimate at 529YTL and at 337YTL for our higher job

estimate. These represent 89 percent and 57 percent of the total cost of a minimum wage worker, respectively.

The lower cost per actual job created under Law 5350 demonstrates that program design clearly matters.34 Finally, how do these findings on the employment effects of the regional subsidy programs compare with the estimates based on the establishment data? Even though the methodologies are very different, the results are consistent. Taking the case of the Law 5084 program, our best estimate although admittedly biased downwards35 -- is that the subsidies, on average, reduce the total cost of employing a minimum wage worker by about 14 percent.36 If we assume no pass-through, and apply a labor demand elasticity of 0.50 (which is the summary estimate from Taymaz (2006)), then this would suggest an employment gain of about 7 percent, which is just below the 8 percent increase which is the midrange estimate from the regional incentives analysis.

This assumption of no pass-through is plausible since the subsidies apply at the minimum wage/contribution base. Moreover, wage models estimated by Betcherman, Daysal, and Pagés (2007) find no evidence of a passthrough in the subsidized provinces in the form of higher wages. If, on the other hand, we do assume a passthough using the mean estimate from Taymaz (2006) for low-wage workers and again use a labor demand elasticity of 0.50, the employment gain expected by the subsidies would be 5.7 percent which is between the low and middle-range employment effects calculated for the regional incentives.37 4.3 Evidence on employment impacts from household data Household Labor Force Survey (HLFS) data was used to analyze how employment rates of low-wage workers respond to changes in the costs of their labor because of policy changes in the minimum wage and social security contribution base. The methodology requires panel data and, unfortunately, HLFS panel identifiers are only available within 2004 and within 2005. Faced with this constraint, Papps (2007) estimates employment models

33 Since the potential size of the subsidies for all of the different components is significantly higher than that, it seems that a significant proportion of subsidized employees

worked less than a full month and/or worked part-time.

34 The eligibility thresholds established in Law 5350 (30 employees and 20 percent increase in employment) appear to have significantly reduced deadweight losses.

35 This is because of unobserved substitution effects and the fact that we have not considered land costs or the administrative costs of implementing and supervising the

programs.

36 This calculation is made as follows: It assumes that the income tax subsidy does not affect total labor costs because it comes out of gross wages and the minimum wage

operates as a floor. During the period under analysis, the total labor cost at the average minimum wage is 548YTL. The social security subsidy at the 100 percent rate is 16.8 percent of total labor costs (92YTL) and 13.5 percent at the 80 percent rate. Overall, 89 percent of the subsidized employees during Period 1 are in the 80 percent category and when we rate the labor cost reductions by these shares, the mean reduction in total labor costs is 13.9 percent. Energy subsidies and the value of land would increase the amount of this reduction.

37 This is calculated as follows: Again it assumes that any reduction in total labor costs will be due to social security subsidies. Using the pass-through evidence from Taymaz (2006) for workers at one standard deviation below the mean, the social security subsidies (again weighted by the share calculated at 100 percent and at 80 percent) reduce total labor costs by 11.4 percent. Using the labor elasticity figure of 0.5 results in the expected employment gain of 5.7 percent referred to in the text.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

with the 2004 panel and with a “synthetic panel” covering the 2002-2005 period. Neither of these approaches is ideal, as discussed in section 3, but the analysis nonetheless provides additional insights into how employment in Turkey is likely to be affected by labor tax reductions.

Figure 6 summarizes the modeling results. The left-hand panel shows the estimated employment effect for all lowwage workers while the right-hand panel includes only employees initially employed in registered jobs. In each case, the results for the 2004 panel and for the synthetic panel are presented. It should be noted that the interpretation of the employment responses is slightly different for the two panels. The 2004 panel tracks individuals across two quarters. Accordingly, the first column in the figure indicates that a one percentage point decrease (increase) in the total labor cost ratio for a lowwage worker increases (decreases) the probability of that worker being employed in a subsequent quarter by 0.64 percentage points.38 Since the unit of observation in the synthetic panel is a demographic cell, the effect of a policy change is on the average employment rate within the cell. Thus, the second column in the figure indicates that a one percentage point decrease (increase) in the total labor cost ratio will increase (decrease) the employment rate by 1.1 percentage points.

Figure 6: Employment effects of changes in the costs of low-wage labor due to changes in minimum wages and contribution bases, 2004 panel and 2002-2005 synthetic panel

Source: Papps (2007)

Since, by definition, it is registered employees who will be directly affected by changes in the minimum wage and social insurance contribution base, we would

38

15

anticipate that the magnitude of the employment effect would be greater for this group than for all employees.

However, as the right-hand panel of Figure 6 shows, the effect is slightly smaller, either using the 2004 panel or the synthetic panel. This could reflect the fact that policy changes that influence wages in the formal sector may have spillover effects on the informal sector (see Maloney and Nunez 2004).

One clear finding from the synthetic panel analysis is that changes in labor costs have a significant impact on the share of jobs that are formal and informal. A one percentage point decrease (increase) in the labor cost ratio results in a 2.2 percentage point rise (fall) in the fraction of jobs that are registered. The results from the synthetic panel, taken together, suggest that the increases in minimum wages and contribution bases between 2002 and 2005 reduced overall employment and also shifted jobs from the formal to the informal sector.

Overall, the HLFS analysis suggests that demand for low-wage labor is very responsive to changes in total labor costs. This is consistent with the results from the establishment and SSK analyses about labor demand around the minimum wage. The HLFS data also allows Papps (2007) to look at how employment probabilities for different demographic groups are influenced by changes in labor costs. The analysis shows that women and youth are particularly affected. A change in labor costs has a bigger effect on the employment rates of women than men. In addition, women are more likely to shift to from the formal to the informal sector in response to an increase in labor costs. Similarly, workers under 30 are more likely to lose their jobs and to switch to the informal sector than workers who are over 30.

These results reinforce a common theme coming from all three studies – that employment for lower-wage workers is more strongly affected by changes in labor costs that higher-wage employment. Papps (2007) shows that, based on differences in employment responsiveness, tax cuts targeted at workers under 30 or women are likely to be more cost-effective than across-the-board cuts.

This has important implications for designing a labor tax reduction, as we will see in the next section.

This interpretation assumes symmetry in how employment responds to labor costs changes. In fact, only increases in labor costs are observed during the estimation period. In the 2004 panel, an individual worker can be observed one or three quarters after being initially observed.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

16

V. Simulations Of Policy Reform Options For The Social Security Funds

I

n this section, we specify options for reducing employer social insurance contributions and then simulate the implications for the fiscal position of the pension and UI funds. The fiscal impacts must be carefully considered because it turns out that, under all scenarios, revenue gains from additional contributors will not compensate for the loss of revenue because of lower contributions rates. However, the magnitude of the fiscal cost can vary considerably depending on the design of the reduction in contribution rates. Two types of reform options are tested using pension and unemployment insurance simulation models. The first is an acrossthe-board reduction in pension and UI contributions for all employment. The second is a targeted reduction for employees under the age of 30. In this latter simulation, youth are, in effect, a proxy for low-wage workers -- according to the employment analysis in the previous section, low-wage labor is most sensitive to labor tax changes. Indeed, the simulations find that the targeted options are a more cost-effective approach for increasing registered employment. Finally, the effects of eliminating only employer UI contributions are simulated with the result that there are modest gains in employment without jeopardizing the UI Fund s substantial reserve to any significant degree.

contributions in designing reform options for the simulations.40

There are actually three ways in which policy-makers could reduce Turkey s labor tax wedge through employer social security contributions, employee contributions, and personal income taxes. Two key considerations are important for choosing the best reform option from the point of view of increasing formal employment costeffectively. The first is to design the reform to minimize the pass-through so that the effect of the cut is focused on reducing labor costs to increase labor demand.39 Here, the different studies we have undertaken are consistent in showing that tax reductions targeted at low-wage labor will have the greatest employment impacts. Second, the interplay between the reform proposal and the minimum wage, which is defined as a gross wage, is important.

Employee social security contributions and income taxes come out of the gross wage and if that wage is downwardly rigid because of minimum wage laws, then reductions in these taxes will have no effect on labor costs (in the absence of minimum wage reforms). Accordingly, we have assumed reductions in employer social security

Various reform options have been evaluated in our research. However, it is possible to bring out the essential conclusions with just a few simulations. For the sake of clarity, then, we report and discuss simulations for three policy reforms:

5.1 The modeling exercise Our approach has involved the following steps: (i) Identifying different options for reducing employer contributions for pensions and unemployment insurance; (ii) Estimating the employment effect based on the results of our analysis reported in the previous section; (iii) Calculating the impact on the number of contributors to the fund; and (iv) Projecting future fund balances (compared to the base case), using the new contributor numbers and contribution rates. The simulations have been carried out using the PROST model for the pension fund and UISIM for the Unemployment Insurance Fund.

It should be noted that the models for both of these funds were last updated in 2004 so most model outputs are projected from that point on. This means that some assumptions (e.g., macroeconomic variables, etc.) and the underlying data are somewhat outdated. This does not affect the essential conclusions from the modeling exercise but if further simulations are required, these databases should be brought up to date to make the projections more precise.

· An across the board reduction in employer pension contributions from the current 11 percent of gross wages to 6 percent and elimination of the 2 percent employer contribution for UI. · A targeted reduction of the same amount for employees under the age of 30. This option is intended to assess the effects of a cut targeted at low-wage labor; as the analysis in the previous section found, labor demand is more sensitive to contribution rate changes at lower wage levels. Our decision to target youth in this option stems from the concern that explicit targeting on low-wage workers would create incentives for employers to officially register employees at low wage levels, even if their real

39 Tax reductions that lead to higher wages may also address a valid policy objective but here we are concerned with the specific objective of increasing employment.

40 While employer social security reductions are the preferred option from the point-of-view of creating incentives for job creation, there is the political economy issue of

whether workers will see the reform as a transfer to employers at the cost of reduced social security benefits for them.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

earnings were higher. Youth are a good proxy because they are identifiable and are heavily represented in the low-wage sector. In 2005 (fourth quarter), 54 percent of workers earning less than 1.25 times the minimum wage were under 30. · A UI across the board reduction eliminating the current 2 percent employer contribution for all workers.

The simulations for these reforms are designed so that the contribution reductions are introduced in 2007, with the full employment effect introduced in 2008.41 The employment effect is modeled as a one-time increase in the number of contributors.

Table 6 summarizes the three reform scenarios, including the estimated employment impacts. In all policy scenarios, the elasticity of labor demand is assumed to be -0.50, which is the mid-range estimate found by Taymaz (2006) and consistent with the evaluation by Betcherman, Daysal, and Pagés (2007). For the across the board scenarios, the pass-through rate is set at 0.53 which is the weighted mean of the pass-through rates computed by Taymaz for average-wage administrative and production employees in the three manufacturing sectors included in the analysis.

For the scenario targeted on young workers, the passthrough rate is assumed to be 0.25 which is the weighted mean for workers at one standard deviation below the mean.42 Table 6: Reform scenarios for social security fund simulations

17

indicate that the across the board option would initially increase the pension fund deficit by 0.74 percent of GDP, from 0.75 percent under the base case to 1.49 percent.

The fiscal disadvantage of the reduction would persist and even worsen slightly over the period of time until 2050 (peaking at an additional deficit of 0.89 percent of GDP), before leveling off. The option targeting new hires under the age of 30 has much lower fiscal costs.

The initial impact would increase the deficit of the fund by about 0.20 percent of GDP and this would increase slightly over the projection period, settling at a negative incremental effect of 0.25 percent around 2040.

The targeted cut adds almost as many new registered jobs 70,000 vs. 84,000 -- as the across the board cut (Table 6). Using the 2005 HLFS numbers, the targeted proposal would reduce the unemployment rate by about 0.30 percent compared to 0.35 percent for the across the board reduction. The targeted cut is more cost-efficient in terms of creating jobs since more of the cut results in lower labor costs than with the general reform where more of the reduction is captured by workers through higher wages. It should be noted, though, that the calculation of the employment gain due to the targeted reduction does not take into account any substitution effect whereby employers replace unsubsidized older workers with subsidized younger workers. While this effect could potentially be important, the results we are able to present suggest that, on balance, a targeted reduction in employer social security contributions would be a more favorable option than an across the board alternative.44 Figure 7: Implications of reduced pension contribution options for the SSK PAYG, PROST1 (a) Current balance as % of GDP

1

The numbers are calculated on the basis of the latest available data of covered workers under SSK.

Figure 7 shows the PROST simulations on the projected balance of the pension fund for the reform options.43 Panel

(a) presents the effects on the current balance of the fund and panel (b) shows the effects of the proposed reforms as the difference in the fund balance, relative to the base case. Note that both reform options included in these figures also have incorporated the elimination of the employer contribution to unemployment insurance which affects the number of contributors. The projections 41

The periodicity of UISIM is monthly so these changes are introduced in January of the year in question.

42 The specific calculations are available from the authors.

43 As noted in the text, the assumptions and database underlying the PROST simulations have not been updated since 2004, with the exception of including the most recent

data from SSK on the number of contributors.

44 See Nickell and Bell (1996) for a full discussion of the implications of targeting payroll tax reductions on low-wage workers.

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

18

(b) Difference in current balance as % of GDP relative to the base case

1

Reform options include effect on number of contributors of 2 percent reduction in employer contributions for unemployment insurance.

Figure 8 shows the UISIM simulations on the projected balance of the UI Fund if the 2 percent employer contribution was eliminated. Because of outdated data, the current fund balance (and, thus, future balances) is underestimated.45 Projections are carried out with a basecase and a low-interest rate scenario.46 Under either case, the fund balance continues to increase significantly, albeit more slowly under the reform. But, even in the low interest scenario, the fundÂ’s reserve, with the contribution cut, is equal to almost 30 percent of GDP at the end of 2022. The recent World Bank (2006a) Labor Market Study reviewed the situation of the UI Fund in detail through a series of UISIM policy

simulations and all simulations indicated that the fund could handily accommodate the 2 percent contribution reduction, even when combined with the other policy changes and a macroeconomic shock. That report suggested reforms to reduce contribution rates, as well as to increase benefits and ease eligibility requirements.

This remains an appropriate recommendation because the current level of taxation is simply not needed to finance liabilities, even if those liabilities increase somewhat because of reforms to improve the support provided by unemployment benefits. Moreover, the elimination of the 2 percent tax rate would increase employment by 22,700 which would have reduced the 2005 unemployment rate by 0.10 percent.

Figure 8: Implications of reduced UI contribution options for the fiscal balance (real TL) of the UI Fund, UISIM

VI. Policy Implications

E

mployment in Turkey is responsive to changes in labor costs. This is a common conclusion of three separate analytical exercises using very different data and methodologies. Estimates based on establishment data of the elasticity of labor demand and the speed of adjustment suggest that employment responses are comparable to those observed in other middle-income and developed countries. Our evaluation of subsidies in low-income provinces using social security administrative data concludes that the reductions in total labor costs had significant impacts on registered employment in eligible provinces. The magnitude of the responsiveness of employment levels

to changes in labor costs appears to be roughly consistent between these two studies. Finally, modeling based on HLFS data shows that employment probabilities for lowwage workers are clearly affected by policy changes that alter the minimum wage and the social insurance contribution base.

Reducing labor taxes, then, would increase registered jobs in Turkey. However, the employment impacts would be moderated by the fact that only part of any tax reduction will result in lower labor costs, with the rest passed through to workers in the form of higher wages.

Consequently, our research suggests that a major employment impact could only be achieved with very

45 The UISIM database was last updated in 2004, with the exception of the number of contributors which was updated to October 2006. As of October 2006, the balance

of the fund was 23.7 billion YTL while the balance used in our base case simulations (projected from the 2004 version) was 12.3 billion YTL in the low-interest scenario and 13.2 billion YTL in the high-interest scenario. In addition, the projections do not include the future effects of Law 5510 which will require the UI Fund to cover social security contributions for beneficiaries. This will increase the FundÂ’s liabilities. At the same time, the SSK pension fund will have increased revenues because of these contributions.

46 The low-interest rate assumption is that the real rate from 2006 on is 2 percent. For details on the modelÂ’s assumptions for Turkey, see World Bank (2006a, appendices

to chapter 4).

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

large reductions in labor taxes. For example, econometric modeling of the net effects of the subsidies offered under the regional incentives program (specifically under Law 5084) indicates a middle-range estimate of the increase in registered employment of about 8 percent. However, according to these estimates, the size of the subsidies per job was equal to at least 80 percent of the total costs of employing a minimum wage worker. It seems likely, based on our analysis of the more recent program under Law 5350, that these costs could be reduced to some extent by design improvements but they still would remain relatively high. Obviously, scaling up this type of tax reduction/subsidy program would involve very substantial expenditures.

One important conclusion to be drawn from our work is that the formal-sector employment gains of a cut in social contribution rates would not broaden the tax base enough to compensate for reduced revenues per worker because of the lower contribution rates. As a consequence, any reform that was fiscally neutral would need to include an increase from other tax sources to compensate for the decreased labor tax revenues.

The analysis shows that across-the-board rate reductions affecting all registered employment would be a particularly unfavorable instrument for increasing formal employment from a cost-effectiveness point of view. Much of the effect would be absorbed through increased wages, with these gains rising for workers at higher earnings levels.

We simulated the effects of reducing employer pension contributions by 5 percentage points and eliminating their 2 percent contribution to the UI fund. Our estimate is that this would increase registered employment by about 1.1 percent (85,000 jobs), which would reduce the unemployment rate by about 0.35 percent (based on 2005 HLFS numbers). However, the cost of this reform to the SSK pension fund would be considerable, initially increasing the fund s deficit by 0.75 percent of GDP and worsening somewhat over much of the simulation period.

Cost-effectiveness does improve when contribution rate reductions are targeted. This was demonstrated through simulations of the same pension and UI contribution reductions targeted at employees under the age of 30.

The rationale for this option is that young workers are concentrated at the lower end of the wage distribution where the relative employment impacts of a tax cut are greater because of lower pass-through rates. Our analysis suggests that the targeted reduction would have only a slightly smaller employment effect than the general reduction gains of 70,000 vs. 85,000 but with a relatively small effect on the balance of the pension fund (about 0.2 percent of GDP).

19

The effects of eliminating the employer UI contribution on the UI fund balance were also evaluated. Without any accompanying reduction in pension contributions, this cut would increase registered employment by about 20,000. However, in addition to this modest employment boost, the rationale for recommending this reform is that the extremely large and growing UI fund can accommodate the reduced revenues even when combined with other needed parametric changes to improve the support offered by unemployment insurance.

While the study has generated new empirical evidence on a number of key questions that are relevant for considering labor tax reform, some important knowledge gaps remain. Most importantly, the analysis has not incorporated a range of second-order effects, including those stemming from any compensatory increases in non-labor taxes to make any reforms fiscally neutral. In addition, our calculations of employment impacts do not incorporate substitution effects including young-for-older workers in the targeted reform and subsidized-forunsubsidized provinces in the regional incentives analysis.

Another potentially important substitution effect is whether the registered employment increases observed in our empirical analysis are simply the formalization of previously informal jobs or the creation of new jobs.

The results of the regional subsidy evaluation suggest that the former effect is more important; however, this conclusion is only tentative and more research is needed.

In the final analysis, a strong case can be made for the need for address Turkey s tax wedge, especially for lowwage workers and for workers with families where the size of the wedge is very large. This study suggests that cuts targeted at these groups would be the preferable option now not only because the relative tax burden is greatest for these workers but also because their employment is most responsive to changes in contribution levels. In this study, we have only explicitly considered cuts in social insurance contributions. However, income tax reforms to make the taxation of personal income more progressive could also be considered. In any event, authorities might consider reducing UI contributions which would contribute modestly to employment -because of the huge surplus in the UI fund. Over the longer run, as the fiscal position of the other social insurance funds and the general budget becomes more favorable, there will be additional scope for further reductions.

Although there would be some employment payoff from reducing social insurance contributions if effectively targeted, Turkish authorities might consider this as part of a comprehensive reform strategy to address the country s

20

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

jobs deficit. While this study has focused on labor tax reductions, a broader reform program is likely to be required to increase formal employment, as recognized in the Ninth Development Plan. Analytical work undertaken by the Government, the World Bank, and others suggests that this might include not only efficientlytargeted reductions in social security contributions, but also more flexible contracting arrangements, reduced severance obligations, improvements in unemployment insurance and active labor market programs, and stronger labor market institutions to administer and enforce policies and regulations.

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Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

21

Tables

Table A1. Real labor costs for minimum wage workers, 2003-05 (million TL)

2003 January Contribution Base Contribution Ceiling Minimum Wage (Gross) Employee SS Contributions Total Non-SS Tax (income and stamp) Minimum Wage (Net) Employer SS Contributions Total Labor Cost CPI deflator Real total cost to employer (2000 TL) % change previous period % change year earlier 1

April

2004

2005

July

January

July

January

327.583

393.100

458.016

423.0001

444.150

488.700

1,637.916

1,965.500

2,290.079

n/a

n/a

n/a

306.000

306.000

306.000

423.000

444.150

488.700

45.900

45.900

45.900

63.450

66.623

73.305

34.101

34.101

34.101

56.471

59.294

65.241

225.999

225.999

225.999

303.080

318.233

350.154

73.668

97.581

121.276

90.945

95.492

105.071

379.668

403.581

427.276

513.945

539.642

593.771

0.79

0.74

0.73

0.68

0.66

0.62

300.41

296.69

310.91

349.90

358.37

370.09

-2.7

-1.2

4.8

12.5

2.4

3.27

11.4

7.5

0.7

16.5

15.3

5.8

The actual contribution base in the first half of 2004 was 549.630.000 TL but the government paid employer social security contributions between minimum wage and contribution base. So for the employer, the “effective” contribution base was 423,000,000 TL.

Source: Treasury and World Bank calculations

22

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

Table A2. Expenditures under Law 5084 in the 15 newly-subsidized provinces and cost per job creation under different assumptions, January 2004 to April 2005

1

Employment is reported as number of job months because employees receiving subsidies are reported by SSK on a monthly basis. These monthly figures have been added up for the March 2004-April 2005 months (the months in Period 1 when subsidies were paid). To calculate job-months for our estimates of the net employment effect, we have multiplied the estimated jobs by the number of months when subsidies were received in Period 1.

Source: Betcherman, Daysal, and Pagés (2007)

Estimating the Impact of Labor Taxes on Employment and the Balances of the Social Insurance Funds in Turkey Synthesis Report

23

Table A3. Expenditures under Law 5350 in the 13 newly-subsidized provinces and cost per job creation under different assumptions, May 2005 to December 2005

1

See notes for Table A2.

Source: Betcherman, Daysal, and PagĂŠs (2007)

32 x 45 cm.