Employment and social protection are among the main objectives of both Estonia and the European Union. The EU employment guidelines emphasise the need to analyse the hidden incentives behind the system of taxes and benefits.
The experience of other countries has shown that tax-benefit systems can have a significant negative impact on the demand and supply of labour. Often in the Estonian tax and social support system, increasing low labour input or working part-time does not increase the total income of the household and could even lead to a decrease in the total income of the household. In many cases, unless unemployed or inactive persons start working long enough working hours or at a high enough salary, giving up social benefits may not seem worthwhile.
“The system should be more flexible in terms of combining social benefits and salary for enabling people to return to work step by step.”
The unemployment trap indicator for Estonia is among the lowest in Europe, since unemployment benefits are low. On the other hand, the marginal tax rate is high for a large household should one wish to increase labour input. The tax burden of low-wage workers as measured by the tax wedge is also high.
Microsimulation model analysis shows that the Estonian tax and support system for employed people imposes high tax rates for as few as about 6000 people or 1,2%. However, among unemployed people who wish to work for a minimum wage, there are close to 40 000 people with an actual marginal tax rate of more than 30% in 2004, and about 7000 of them have a marginal tax rate of 100% or more.
Additional simulations were run using the current situation at that time as comparison. The subsistence level was 750 Estonian kroons and housing costs were deducted from income according to actual expenses within the bounds of standard costs. The simulation shows that practically nothing changes from going over to average costs to figure the housing costs. Raising the subsistence level, however, results in a twofold increase in the number of potential subsistence benefit recipients.
Gradually decreasing the subsistence benefits as earnings increase could have a positive impact on the incentives of working. In this way, the net income while working would be higher for several months compared to the one-on-one reduction of the subsistence benefits.