How Tax Progression Affects Effort and Employment

Within an efficiency wage framework, we study the effects of two revenue-neutral tax reforms that change the progressivity of the labour tax system. A revenue-neutral increase in both the wage tax and tax exemption and a revenue-neutral change in the composition of labour taxation towards the tax with the smaller tax base will lead to the same results: they moderate wages, workers’ effort, effective labour input and aggregate output. Whether employment rises or falls, however, depends in both reforms on the magnitude of the prereform total tax wedge. The larger this tax wedge is, the more negative is the impact of reforms on workers’ effort. A larger total tax wedge increases the negative effect of tax progression on labour productivity and thus thwarts the positive employment effect of wage moderation.