Reports 2016/38

Effects of in-work tax credits on labour supply among immigrants

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Immigrants and their Norwegian-born children comprise an increasing share of the population residing in Norway. Meanwhile, employment rates among certain immigrant groups are considerably lower than for the native population. Lower participation in the labor market increases the risk of economic poverty and contributes to increased welfare dependency. Based on these factors, the 2004 Governmental Report on the Long-term Perspectives for the Norwegian Economy (Report No. 8, 2004-2005) and the Brochmann Commission (NOU 2011: 7) have cited increased immigration as a key challenge for future public finances. The integration of immigrants and their children in the Norwegian society, especially through the labor market, is therefore considered an important policy objective.

The objective of this report is to analyze the effects of introducing so-called in-work tax credits, i.e. tax deductions on labor income, on the labor supply of immigrants, their Norwegian-born children, and natives. Alternative in-work tax credit reforms have been introduced in several countries, including the US, the UK, Canada, and a few other European countries. These tax reforms share the objective of encouraging low-income households to increase their work participation by providing tax reliefs that are conditional on having labor income. In the US, the Earned Income Tax Credit (EITC) was introduced in 1975, and gradually expanded through various tax reforms between 1986 and 2009. Because of its redistributive profile, the EITC is considered to be one of the largest welfare programs in the US. In the UK, a similar in-work tax credit was introduced in 2003; the Working Tax Credit (WTC). In 2007, the Reinfeldt Government in Sweden introduced the Jobbskatteavdraget (JSA), which was gradually expanded in the following years up to 2011.

Since Norway has yet to implement an in-work tax credit reform, studying the effects of tax credits by exploiting random variation in tax credit amounts in historical data is not an option. Instead, we make use of a structural empirical microeconomic labor supply model to analyze the effects of a hypothetical tax credit reform on labor supply in Norway. Using such a labor supply model, Bhuller and Aaberge (2012a) have previously analyzed the effects of various changes in the tax and transfer system on immigrant labor supply. In this current report, we analyze the effects of introducing, respectively, the US (EITC) and the Swedish (JSA) versions of in-work tax credits in Norway on labor supply of immigrants and natives using a structural labor supply model estimated on micro data from 2011. We extend the work by Bhuller and Aaberge (2012a) in several ways: (i) Norwegian-born children of immigrants are included as a separate group; (ii) a distinction is made between refugees and other immigrants; and (iii) individuals with reduced work capacity are included in the analysis. Results are presented separately for immigrants from three groups of countries: 1) Asia, Africa, and South America, 2) Eastern Europe, and 3) Western Europe, North America and Oceania, and further by sex and marital status. Overall, this provides a broad description of immigrant labor supply. In addition to predicted labor supply responses, we also present the effects of introducing in-work tax credits on income inequality and public finances.

The structural labor supply model predicts that the introduction of a version of the US Earned Income Tax Credit (EITC) in Norway would lead to a 0.3 percent increase in total labor supply, with considerable heterogeneity in labor supply responses across high and low income groups: We find an increase in labor supply for those with low incomes and reduced labor supply for those with high incomes. These findings are related to the in-work tax credit schemes targeting low and medium incomes. The tax credits are phased out at high incomes and thus imply high marginal tax rates for individuals with high incomes. People with high incomes may thus find it profitable to reduce labor supply; either to benefit from the tax deduction, or as a result of higher marginal tax rates in connection with the phasing out of the deduction. Furthermore, we find stronger labor supply responses among immigrants than among natives; the tax credits lead to a 0.75 percent increase in immigrant labor supply, a 0.55 percent increase in labor supply for Norwegian-born children of immigrants, and a 0.28 percent increase in labor supply for natives. Income inequality, as measured by the Gini coefficient, reduces by 4 percent. The total tax revenue, also incorporating changes in transfers and revenues from payroll taxes, reduces by 9.5 percent.

The labor supply model further predicts that the introduction of a version of the Swedish Jobbskatteavdraget (JSA) in Norway would increase total labor supply by 0.9 percent. The Swedish in-work tax credit is given as a constant percentage of labor income at low and medium levels of income until the labor income reaches a certain threshold, and beyond this threshold as a constant maximum tax credit amount (i.e. no phasing out). We nonetheless find the largest increases in labor supply among those in the lowest income decile. Both immigrants and natives increase their labor supply by about 1 percent. There are however significant differences in responses across immigrant groups; refugees from Asia, Africa, and South America increase their labor supply by 0.1 percent, while for the other immigrant groups, labor supply increases by more 1 percent. Overall, the JSA reduces Gini-income inequality by 1.8 percent, which is clearly less than the distributional effects of the EITC. The total tax revenue reduces by 11.3 percent, which is slightly larger than the tax revenue loss expected under the EITC reform.

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