January 1, 1996

Taxes and benefits in a non-linear wage equation

This paper estimates a non-linear wage equation for the Netherlands. The long-term equation is derived from a wage bargaining model in which the threat point of employees involves income earned in the untaxed informal sector.

The model implies that the various components of the tax wedge exert the same impact on wage costs. Wages depend also on the consumer price, the producer price, labour productivity, the unemployment rate and the replacement rate. The ways the latter two variables affect wages are related. In particular, the wage pressures generated by the replacement rate rise with the unemployment rate. Furthermore, the moderating influence of unemployment on wages falls with the replacement rate.

Estimation results for the Netherlands show a highly significant long-term impact of the tax wedge on wages. The implied elasticity of the average tax rate is about 0.5. The marginal tax rate exerts a small negative impact on wages of -0.15. Both elasticities are more or less stable over the estimation period (1967-1993). The elasticity of the replacement rate and unemployment rate, in contrast, show a large variation. The elasticity of the replacement ratio increases from 0.1 during the sixties to over 0.5 in the eighties. The semi-elasticity of the unemployment rate varies from -1.4 during the second half of the seventies to -2.7 during the second half of the sixties. The long-run impact on wage costs of various components of the tax wedge - i.e. the employers’ social premium rate, the employees’ tax and social premium rate and the consumer price - do not differ significantly.

Our results suggest that, compared to government assistance, social security benefits are less relevant to the threat point of employees’ in wage bargaining. Estimation of the dynamic effects shows that the employers’ social premium rate exerts a substantial impact on wages costs in the short run, which is twice as large as the short-term wage effect of the employees’ tax and social premium rate. However, the large impact is short-lived, because the estimated error correction mechanism implies that the wage rapidly converges towards its long-term level.

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