Estimated Payroll Tax Incidence and Aggregate Demand for Labour in the United Kingdom

Abstract

The payroll tax should be of interest to empirical researchers for a number of reasons. It is a large and growing source of government revenues in many countries such as United States, Canada and the United Kingdom. It is also a major source of funds out of which important social security benefits such as unemployment insurance and public pensions are paid. However, while relatively easy to collect and administer, the payroll tax may be distributionally regressive and contradict the equal sacrifice principle based on ability to pay. It is thus of some concern for reasons of equity and public policy to be able to evaluate the actual magnitude of these distributional effects. In addition, there is considerable current interest in alternative social security schemes (see for example Okner, 1975, and Munnell, 1977) arising from the present demographic trends, which, with present financial arrangements, are likely to result in future funding deficits, so that revisions will have to be undertaken. In particular, a number of studies have examined the liability structure and distributional incidence of the payroll tax (Peckman and Okner, 1974; Peckman, 1977; and Johnston and Wixon, 1978). In order to evaluate the distributional implications of the various options available, there should be a better understanding particularly of the distributional characteristics of the payroll tax. The specific problem this paper addresses is the distributional incidence of the payroll tax and whether the employer portion of the tax is entirely shifted backwards on to labour. That is, do employees bear the full burden of the employer portion of the payroll tax in the form of wage cuts or forgone earnings? The empirical literature in the area of payroll tax shifting is so far fairly limited and is characterized by markedly differing estimates of the incidence. Works by Deran (1966, 1967), Weitenburg (1969), Brittain (1972), Vroman (1974a), Leuthold (1975), and Hamermesh (1979, 1980) employed different data bases and empirical procedures, and obtained widely differing results. In particular, the work of Brittain (1972) has become the standard reference and the basis for a good deal of empirical analysis. The present paper puts forward an alternative approach to estimating payroll tax incidence on employees that substantially improves upon the approach of Brittain. Specifically, it involves estimating an aggregate demand curve for labour in the United Kingdom and analysing how the curve shifts in response to changes in the payroll tax. The result that, in a world of competitive markets, the full incidence of a universal payroll tax is shifted on to an inelastic supply of labour is a standard result ifl microeconomics (Musgrave and Musgrave, 1976, pp. 404-406). The