Contribution Ceilings and the Incidence of Payroll Taxes

Abstract

Social security contributions (SSCs) are typically formally split between employers and employees as payroll taxes, levied on earnings at a constant tax rate that applies only up to a ceiling, above which the marginal tax rate falls to a reduced rate, often 0. Such contribution ceilings create a concave kink point in the budget set of workers and hence should generate a dip in the distribution of earnings around the ceiling through labour supply responses (the reverse of bunching expected at convex kink points) but such a dip is not observed empirically. This paper sets out a new approach to infer the incidence of SSCs that exploits the absence of this dip and the fact that (mechanically) the distributions of labour cost (earnings inclusive of all payroll taxes), gross earnings (net of employer payroll taxes) and net earnings (net of both employer and employee payroll taxes) cannot all be smooth around a kink. The other papers in this special issue apply the method to data for Germany, France, the Netherlands and the UK and all find that distribution of gross earnings is smooth around kinks (implying that the distributions of labour costs and net-of-tax earnings are not) even though the concept of gross earnings is irrelevant in the standard static model of labour supply and demand that dominates the public economics literature. This suggests that other features of the labour market, such as wage bargaining based on the gross earnings concept, are relevant for determining the incidence of SSCs.