Does Formal Work Pay?The Role of Labor Taxation and Social Benefit Designin the New EU Member States

The analysis presented in this paper defines three different synthetic measurements ofdisincentives for formal work: two standard measurements, namely the tax wedge and themarginal effective tax rate (METR); and a new, innovative measurement called formalizationtax rate (FTR). The novelty of the latter is that it measures disincentives stemming not onlyfrom labor taxation, but also from benefit withdrawal due to formalization. A descriptiveanalysis across a large number of OECD and Eastern European countries reveals that thedisincentives for formal work – when measured through the FTR – are especially high forlow-wage earners. This suggests that formal work might not pay in this segment of the labormarket, in particular for the so-called mini-jobs and midi-jobs (low paying part-time work).Another novelty of the paper is its empirical approach. Using EU-SILC 2008 data and OECDTax and Benefit data for six Eastern European countries (Bulgaria, Czech Republic, Estonia,Latvia, Poland, and Slovakia), we match disincentives for formal work to individualobservations in a large data set. Applying a probit regression, the analysis finds a significantpositive correlation between FTR or METR and the incidence of being informal. In otherwords, controlling for individual and job characteristics, the higher the FTR or the METR thatindividuals are facing is, the more likely they are to work informally. The tax wedge, on theother hand, yields a negative correlation. This indicates that the tax wedge is not sufficientlycapturing disincentives for formal work. We also conclude that in cross-country analysis, itmight be more useful to use the tax wedge that applies to low wage earners as opposed toaverage wage earners....