Tax benefit system acts as disincentive for low-wage earners

Although the Estonian tax benefit system is relatively straightforward, it creates few incentives for low-wage earners to enter into employment or to increase their working time. These are among the findings of a recent study published in 2006 by the PRAXIS Centre for Policy Studies. Inflexible benefit schemes may in particular discourage part-time and low-paid work.

In 2006, the PRAXIS Centre for Policy Studies published an analysis (in Estonian, 400 Kb PDF) on employment incentives in relation to Estonia’s tax benefit system, particularly for low-wage earners. The analysis applied a static tax benefit micro-simulation model that included parameters of the Estonian tax benefit system in 2000–2005. It is based on data from the Estonian Household Budget Survey 2000–2004, carried out by Statistics Estonia (Statistikaamet).

The analysis examined the effects of moving from a period of inactivity or unemployment to employment, or of changing from part-time to full-time work, on a person’s or household’s income. The study aimed to identify whether and in what instances the system created monetary traps, in other words changes in income which act as a disincentive to return to or to take on more work.

The analysis concluded that although the country’s tax benefit system is relatively straightforward, it creates several disincentives for low-wage earners to enter into employment or to increase their working time. However, the report also suggested that these groups are not very large: only about 1% of employed people and 2% of inactive or unemployed people actually face a potential loss of a proportion of their earnings due to increased labour taxes and reduced social benefits when increasing their work efforts marginally or when entering employment on the minimum wage.

Main study findings

Unemployment benefits

Estonia’s unemployment assistance and insurance system, along with its early retirement scheme, actually discourage people from seeking low-wage or part-time employment. Due to the inflexibility of these schemes, even low levels of income from paid employment can result in the total withdrawal of benefits. Thus, income levels have to be high enough to make it economically worthwhile for an unemployed person to start working. Moreover, people who earned a high wage prior to unemployment receive high unemployment insurance benefits, which create few incentives for them to return to work on a lower wage.

Compared with other EU countries, unemployment assistance benefits are relatively low in Estonia (EE0610019I); therefore, the incentive to enter into employment is much higher for those who are not covered by unemployment insurance benefit.

The study recommends the introduction of more flexible opportunities for combining work and benefits, thus enabling people to gradually enter the labour market, for example through part-time employment.

Parental leave benefits

In relation to parental leave benefits combined with income from paid employment, the current scheme discourages low-wage earners – those earning around EEK 2,200–3,000 (about €140–€192 as at 5 February 2006) a month – to work while on parental leave. About 4%–6% of people on parental leave earn an income, the majority of them below that of EEK 2,200 a month. People who, for instance, receive the highest possible parental benefit of EEK 17,472 (approximately €1,116) and who earn an income above EEK 2,200 a month are liable to a total loss of income of EEK 2,491 (around €159). Thus, more money is lost overall than earned when working and in receipt of parental leave benefit.

As a result, the Ministry of Social Affairs (Sotsiaalministeerium) has proposed to change the current system in order to remove this disincentive; the proposal is currently in the legislative process.

Subsistence benefits

While the Estonian subsistence benefit system guarantees a minimum income for households, it also creates disincentives to work among low-wage earners living in certain household types. For example, if an adult living in a household with two adults and two children enters employment on a low wage, such as EEK 2,690 (about €172) a month in 2006, the household’s final income does not increase when the other adult is inactive.

Commentary

Several earlier studies on social benefits and employment incentives – for example, Kuddo et al (2002), Rõõm (2003), Hinnosaar (2003), Leetmaa and Võrk (2004), Tiit et al (2004) – have largely confirmed the aforementioned disincentives that exist within Estonia’s tax and benefit system. Such disincentives have the significant effect of de-motivating low-wage earners to seek employment.

Reference

Võrk, A. and Paulus, A., Eesti sotsiaaltoetuste ja maksude mõju inimeste tööjõupakkumise stiimulitele (400Kb PDF) [Analysis of labour supply incentives in the Estonian tax benefit system], Research report, Tallinn, Praxis Centre for Policy Studies, 2006.

Andres Võrk and Marre Karu, Praxis Centre for Policy Studies