Earned income tax credits, unemployment benefits and wages: empirical evidence from Sweden

Helge Bennmarker,Anna Seim,Lars Calmfors

doi:10.1186/s40173-014-0026-1

Abstract

Abstract Although there is a large literature on employment effects of earned income tax credits (EITCs) and unemployment benefits, less is known about wage effects. In our model, the impact is via the net (after-tax) replacement rate. Using a panel of individuals from Sweden, we find a positive relationship between the net replacement rate and wages with semi-elasticities in the range 0.2-0.4. This implies that a one per cent reduction in the unemployment benefit level or a one per cent increase in the net-of-tax rate is associated with a fall in the before-tax wage of 0.1-0.2 per cent. EITCs and unemployment benefit reductions are thus likely to induce wage moderation. Keywords: Earned income tax credit, Unemployment benefits, Wage formation.

Highlights

Starting in the mid-1980s, labour market reforms have been implemented in many developed economies with the aim of reducing unemployment and raising employment in the longer term
The reforms have often involved reductions in the generosity of unemployment insurance and the introduction of earned income tax credits (EITCs), i.e. tax reductions on income from employment only, in order to increase the return to work
We set up a theoretical model where both unemployment benefits and EITCs influence wages through their effects on the net replacement rate for the unemployed

Summary

Introduction

Starting in the mid-1980s, labour market reforms have been implemented in many developed economies with the aim of reducing unemployment and raising employment in the longer term. A large amount of empirical research has studied the impact on unemployment and employment. The number of studies of how benefits influence individuals' reservation wages is small compared to the number of studies of the effects on unemployment duration, as noted by Shimer and Werning (2007). Some of them, such as Lynch (1983), Holzer (1986), van den Berg (1990) and Bloemen and Stancanelli (2001), find quite small elasticities of reservation wages with respect to Bennmarker et al IZA Journal of Labor Policy (2014) 3:54 benefits (0.1 or smaller), whereas a couple of others (Fishe 1982 and Feldstein and Poterba 1984) estimate substantially larger elasticities. Macroeconomic panel studies seldom examine the relation between unemployment benefits and wages but instead estimate reduced-form relationships between unemployment and other variables including unemployment benefits (see, e.g., Bassanini and Duval 2009)

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