## 1. Income Levels and Income Inequality ## Source details **Canonical URL:** [1. Income Levels and Income Inequality](https://www.imf.org/-/media/files/publications/cr/2020/english/1finea2020002.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2020/english/1finea2020002.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2020/english/1finea2020002.pdf.json) --- ### Executive summary and main recommendations - Finland’s tax and benefit system supports high income levels alongside low inequality but high tax rates can dampen labor supply. - Main recommendations: - Support for low-wage and part-time workers could be increased through higher and means-tested in-work benefits to substantially increase employment rates. - Better targeting of out-of-work benefits, especially for secondary earners, could increase fiscal space and improve labor supply incentives. - Marginal tax rates for upper-middle income workers could be lowered to increase labor supply and earnings; top tax cuts could even be self-financing. - Reform outcomes (revenue neutral, Finland-specific preferences): employment rates could be increased by up to 3 percentage points and average earnings could increase by up to 3.5 percent compared to current levels. ### Context, rationale, and analytical framework - Finland’s model: strong institutions, high taxes and public service provision, highly skilled labor force, generous social safety net. - Tradeoff: generous transfers and high marginal tax rates can create disincentives along both extensive and intensive labor supply margins. - Analytical framework: microsimulation calibrated to Finland and Mirrlees-style optimal tax principles. - Behavioral parameterization (baseline elasticities): - Hours (intensive) elasticity: 0.10 - Average participation (extensive) elasticity: 0.20 - Robustness checks: lower elasticities 0.05 and 0.1; higher elasticities 0.2 and 0.3. ### Key statistics on income, transfers, and poverty - Guaranteed Minimum Income (GMI) for a representative family without earnings in 2018: around 40 percent of the median disposable income in transfers. - Poverty rate: 5.8 percent (Finland) versus an average of 11.7 percent (comparison group). - Top personal income tax rate: 64 percent (including indirect taxes, excluding employers’ social contributions); applies to incomes in excess of 1.9 times the average wage. - Indirect tax ratio used for METR calculations: 26.6 percent in 2018. - Average potential income: - Non-workers: 45,400 euros - Workers: 60,000 euros - 30 percent of inactive individuals have potential income above the median level for workers (54,700 euros). - Employment rate in the sample: 89 percent (excludes retirees, students, disabled, and mothers of children aged less than one). - Representative individual with zero or very low earnings: average disposable income (net of income and sales tax) around 7,300 euros, equivalent to 36 percent of the median disposable income. ### Disposable income, in-work incentives, and childcare effects - In-work tax credit: - Phased in starting on average at around 5,000 euros. - Break-even gross income level is around 10,000 euros. - Reduces the PTR by up to 13 percent for low-wage and part-time workers. - Childcare costs: - Create a small penalty to work at the lowest earnings level for parents. - Childcare can add 40 percent to the PTR and push it above 100 percent as earnings approach zero. ### Marginal Effective Tax Rates (METRs) and Participation Tax Rates (PTRs) - METR profile for the representative individual (including consumption taxes): - 60 percent on the first euro earned. - Peak at 76 percent for gross incomes around 13,000 euros. - Decrease to 65 percent for middle income earners. - Top METR reaches 72 percent beyond the average earner. - Components raising METRs and PTRs include phasing-out of social assistance and housing benefits, income tax, social contributions, and childcare costs. - Participation Tax Rates: - Even for individuals earning 50,000 euros, social assistance and housing programs increase PTRs by 20 percent. - PTR is defined as one minus the net financial gains from work compared to not working. ### Social marginal welfare weights and implications - Welfare weights inferred from current policy: - Welfare weights generally decline with income but increase below the 5th percentile (government values marginal consumption of the lowest income workers less than those with slightly higher earnings potential). - Large contrast in weights between non-workers and low-wage/part-time workers (reflecting small financial penalty from working at the very bottom). - Social welfare weights are negative for the 15 percent highest income earners, implying top rates exceed the Laffer peak. - Isoelastic social welfare function fit: - Estimated Constant Relative Inequality Aversion (CRIA) parameter γ = 1.8. - Society values the additional consumption of someone at the 10th percentile 13.4 times more than someone at the 90th percentile. ### Reform scenarios analyzed and policy levers - Approaches considered: - i) Isoelastic: use isoelastic weights to guide redistribution. - ii) Combination: isoelastic weights at the bottom and the average of revealed and isoelastic weights at the top to ensure positive weights for all workers. - iii) Constant benefit: keep the out-of-work benefit constant (uses same marginal social welfare weights as Combination). - iv) Pareto: adjust only top rates to reflect positive social welfare weights (Pareto improvement). - Policy levers emphasized: - Increase and better target in-work benefits for low-wage and part-time workers (means-tested). - Re-target out-of-work benefits, especially for secondary earners (mothers of young children highlighted). - Reduce marginal tax rates for upper-middle income workers; consider revenue-neutral or self-financing cuts at the top. ### Reform design specifics for low-wage and part-time workers - Current system: small penalty of approximately 1.6 percent of median income from entering employment. - Comprehensive optimal reform would introduce an in-work tax credit that could reach up to 16 percent of the median income. - Out-of-work benefits would decrease by 13 percent in the Isoelastic and Combination reform scenarios. - In-work benefit should be means-tested with a steep phase-out; the METR for the bottom percentile could reach up around 81 percent. - Isoelastic implements the optimal reform using isoelastic social welfare weights with γ = 1.8. - Combination uses isoelastic weights at the bottom and the average of isoelastic and current weights at the top. - Pareto uses isoelastic weights when current weights are negative, keeping all other tax rates and transfers constant. ### Labor supply responses and margins under reforms - PTRs are reduced substantially through a larger in-work credit and by lowering out-of-work benefits; without combining both measures (the ‘push-pull’ approach), incentives along the extensive margin do not improve as much. - For the lowest wage earners under the Combination reform: - Increased participation raises total labor supply by 10 percent compared to current levels. - Higher METRs lower hours worked by 3 percent. - Net effect on labor supply is a 7 percent increase. - Beyond the median income, both the intensive and extensive margins contribute to increasing labor supply. - Robustness: optimal METR schedules have similar shapes across elasticity assumptions (baseline e = 0.1 and η = 0.2; lower e = 0.05 and η = 0.10; higher e = 0.20 and η = 0.30), with METR increases at the bottom and largest cuts on upper-middle income workers. ### Marginal tax rates and distributional placement under reforms - Marginal tax rates under optimal reform are U-shaped and highest at the bottom due to generous in-work benefits with steep phase-out. - Optimal METRs for upper-middle income earners can be reduced to promote labor supply; in the first three reform scenarios the METR for the worker at the 75th percentile would be reduced by up to 9 percentage points. - Workers at the 85th percentile: marginal rates decline from 67 to 58–63 percent under the scenarios considered. - Under the scenarios considered, the marginal tax rate at the very top would remain largely unchanged. - Pareto reform: - Displays a large cut in tax rates for earnings above the 85th percentile while leaving taxes and benefits constant at lower income levels. - METR cuts of around 11 percent shown under Pareto reform still leave total revenues unchanged because current rates are above revenue-maximizing rates and on the wrong side of the Laffer curve. ### Economic and welfare impacts (selected quantitative results) - Isoelastic reform: - Aggregate labor supply increases by 3.8 percent. - Employment rate goes from 89 percent to 91.7 percent. - Total earnings increase by 3.5 percent. - Disposable Gini index increases from 0.25 to 0.27. - Social welfare gain: 3.7 percent (expressed as a share of current output). - Combination reform: - Earnings and hours gains are somewhat smaller than Isoelastic, but inequality does not increase and social welfare gains are similar due to larger gains for lower income workers. - Employment rate: 91.8 percent. - Constant benefit reform: - Keeping the out-of-work benefit constant significantly reduces the economic effects of reform and increases inequality. - Employment rate: 89.4 percent. - Pareto reform: - Aggregate earnings increase by 1.8 percent. - Social welfare does not increase much because gains accrue to top incomes with low social welfare weights. - Employment rate: 89.2 percent. - Selected table values (current vs. reform outcomes): - Net revenues (percent of earnings): 55.3 (Current); 55.2 (Isoelastic); 55.2 (Combination); 55.2 (Constant benefit); 55.2 (Pareto). - Total earnings change (percent): -3.5 (Current baseline change); 2.5 (Isoelastic); 0.9 (Combination); 1.8 (Pareto). - Total hours change (percent): -3.8 (Current baseline change); 3.2 (Isoelastic); 0.7 (Combination); 0.6 (Pareto). - Employment rate: 89.0 (Current); 91.7 (Isoelastic); 91.8 (Combination); 89.4 (Constant benefit); 89.2 (Pareto). - Disposable Gini index: 0.25 (Current); 0.27 (Isoelastic); 0.25 (Combination); 0.27 (Constant benefit); 0.27 (Pareto). - Welfare gains (percent of earnings): -3.7 (Current baseline); 3.6 (Isoelastic); 0.3 (Combination); 0.2 (Constant benefit). ### Distributional impacts (winners and losers) - Low-wage and part-time workers: - Strong after-tax-and-benefit income gains of up to 40 percent under the Isoelastic and Combination reforms. - Median worker: 5 percent increase in net income. - Top earners: net income gains ranging from 10 to 20 percent under some reforms. - Individuals outside the labor force: - Around 8 percent of the sample after reform would see a decline of 13 percent in net benefits. - Constant benefit scenario: out-of-work benefits stay the same, but workers between the 20th and 55th percentiles would see net income losses of about 1 percent. - Pareto reform: everyone below the 85th percentile unaffected; individuals above the 85th percentile gain up to 8.8 percent on average, with the largest gains reaching 17 percent for those at the 99th percentile of the earnings distribution. ### Sensitivity and policy trade-offs - The level of out-of-work benefits has a large impact on economic and welfare gains from reform: - Allowing full optimization (out-of-work benefits reduced by 13 percent) combined with more in-work benefits generates large earnings and welfare gains and increases the employment rate by almost 3 percentage points. - Constraining adjustments to out-of-work benefits (Constant benefit scenario) substantially reduces aggregate effects and raises inequality. - Two complementary measures are needed to raise employment and preserve fiscal sustainability: - 'Pull' measures: increase reliance on in-work benefits, combined with greater means-testing to preserve fiscal sustainability and reduce PTRs. - 'Push' measures: better targeting and reduction of out-of-work benefits for groups where inactivity is more attractive (examples noted include the home care allowance and housing benefits, and tightening activity requirements for the Labor Market Subsidy). ### Explicit policy recommendations - Increase reliance on pull measures such as in-work benefits combined with greater means-testing to reduce PTRs and increase employment. - Increase push measures through better targeting of out-of-work benefits (reduce attractiveness of inactivity for highly skilled and secondary earners); examples include tighter targeting of home care allowance and housing benefits, and tightening activity requirements for the Labor Market Subsidy. - Reduce METRs for upper-middle income workers where current rates appear to be on the wrong side of the Laffer curve; rate cuts could be self-financing. *Source: IMF staff chapter “1. Income Levels and Income Inequality” (December 16, 2019) and IMF staff analysis chapter "Increasing support for low-wage and part-time workers" (Finland).* ### 1. Income Levels and Income Inequality _______________________________________________ 3 ### 1. Income Levels and Income Inequality ### Executive summary and main recommendations - Finland’s tax and benefit system supports high income levels alongside low inequality but high tax rates can dampen labor supply. - Main recommendations: - Support for low-wage and part-time workers could be increased through higher and means-tested in-work benefits to substantially increase employment rates. - Better targeting of out-of-work benefits, especially for secondary earners, could increase fiscal space and improve labor supply incentives. - Marginal tax rates for upper-middle income workers could be lowered to increase labor supply and earnings; top tax cuts could even be self-financing. - Reform outcomes (revenue neutral, Finland-specific preferences): employment rates could be increased by up to 3 percentage points and average earnings could increase by up to 3.5 percent compared to current levels. ### Context and rationale - Finland’s model: strong institutions, high taxes and public service provision, highly skilled labor force, generous social safety net. - Tradeoff: generous transfers and high marginal tax rates can create disincentives along both extensive and intensive labor supply margins. - Analytical framework: microsimulation calibrated to Finland and Mirrlees-style optimal tax principles. ### Key statistics on income, transfers, and poverty - Guaranteed Minimum Income (GMI) for a representative family without earnings in 2018: around 40 percent of the median disposable income in transfers. - Poverty rate: 5.8 percent (Finland) versus an average of 11.7 percent (comparison group). - Top personal income tax rate: 64 percent (including indirect taxes, excluding employers’ social contributions); applies to incomes in excess of 1.9 times the average wage. - Indirect tax ratio used for METR calculations: 26.6 percent in 2018. ### Potential incomes and labor market composition - Average potential income: - Non-workers: 45,400 euros - Workers: 60,000 euros - 30 percent of inactive individuals have potential income above the median level for workers (54,700 euros). - Employment rate in the sample: 89 percent (excludes retirees, students, disabled, and mothers of children aged less than one). ### Disposable income and in-work incentives - For a representative individual with zero or very low earnings, average disposable income (net of income and sales tax) is around 7,300 euros, equivalent to 36 percent of the median disposable income. - In-work tax credit: - Phased in starting on average at around 5,000 euros. - Break-even gross income level is around 10,000 euros. - Reduces the PTR by up to 13 percent for low-wage and part-time workers. - Childcare costs create a small penalty to work at the lowest earnings level for parents; childcare can add 40 percent to the PTR and push it above 100 percent as earnings approach zero. ### Marginal Effective Tax Rates (METRs) and participation tax rates (PTRs) - METR profile for the representative individual (including consumption taxes): - 60 percent on the first euro earned. - Peak at 76 percent for gross incomes around 13,000 euros. - Decrease to 65 percent for middle income earners. - Top METR reaches 72 percent beyond the average earner. - Components raising METRs and PTRs include phasing-out of social assistance and housing benefits, income tax, social contributions, and childcare costs. - Participation Tax Rates: - Even for individuals earning 50,000 euros, social assistance and housing programs increase PTRs by 20 percent. - PTR is defined as one minus the net financial gains from work compared to not working. ### Behavioral parameterization and robustness - Baseline elasticities used: - Hours (intensive) elasticity: 0.10 - Average participation (extensive) elasticity: 0.20 - Robustness checks use lower elasticities: 0.05 and 0.1; and higher elasticities: 0.2 and 0.3. ### Social marginal welfare weights and implications - Estimated social welfare structure inferred from current policy: - Welfare weights generally decline with income but increase below the 5th percentile (government values marginal consumption of the lowest income workers less than those with slightly higher earnings potential). - Large contrast in weights between non-workers and low-wage/part-time workers (reflecting small financial penalty from working at the very bottom). - Social welfare weights are negative for the 15 percent highest income earners, implying top rates exceed the Laffer peak. - Isoelastic social welfare function fit: - Estimated Constant Relative Inequality Aversion (CRIA) parameter γ = 1.8. - Society values the additional consumption of someone at the 10th percentile 13.4 times more than someone at the 90th percentile. ### Reform scenarios analyzed - Approaches considered: - i) Use isoelastic weights to guide redistribution. - ii) Use isoelastic weights at the bottom to ensure strictly decreasing weights and use the average of revealed and isoelastic weights at the top to ensure positive weights for all workers. - iii) Keep the out-of-work benefit constant. - iv) Adjust only top rates to reflect positive social welfare weights (a Pareto improvement where top earners can be made better-off without affecting the private utility of anyone else). - Policy levers emphasized: - Increase and better target in-work benefits for low-wage and part-time workers (means-tested). - Re-target out-of-work benefits, especially for secondary earners (mothers of young children highlighted). - Reduce marginal tax rates for upper-middle income workers; consider revenue-neutral or self-financing cuts at the top. *Source: IMF staff chapter “1. Income Levels and Income Inequality” (December 16, 2019).* ### 15. Increasing support for low-wage ### Increasing support for low-wage and part-time workers could improve the equity-efficiency tradeoff ### Reform design and key parameters - Current system: small penalty of approximately 1.6 percent of median income from entering employment (result mainly of having to pay for some childcare costs). - Comprehensive optimal reform would introduce an in-work tax credit that could reach up to 16 percent of the median income. - Out-of-work benefits would decrease by 13 percent in the Isoelastic and Combination reform scenarios. - The in-work benefit should be means-tested with a steep phase-out; the METR for the bottom percentile could reach up around 81 percent. - Tabled reform parameter notes: - Isoelastic implements the optimal reform using isoelastic social welfare weights with γ = 1.8. - Combination uses isoelastic weights at the bottom and the average of isoelastic and current weights at the top. - Constant benefit uses the same marginal social welfare weights as Combination, but keeps the out-of-work benefit constant. - Pareto uses isolelastic weights when current weights are negative, keeping all other tax rates and transfers constant. ### Labor supply incentives and margins - PTRs (participation tax rates) are reduced substantially through a larger in-work credit and by lowering out-of-work benefits; without combining both measures (the ‘push-pull’ approach), incentives along the extensive margin do not improve as much. - For the lowest wage earners under the Combination reform: - Increased participation raises total labor supply by 10 percent compared to current levels. - Higher METRs lower hours worked by 3 percent. - Net effect on labor supply is a 7 percent increase. - Beyond the median income, both the intensive and extensive margins contribute to increasing labor supply. ### Marginal tax rates and distributional placement - Marginal tax rates under optimal reform are U-shaped and highest at the bottom due to generous in-work benefits with steep phase-out. - Optimal METRs for upper-middle income earners can be reduced to promote labor supply; in the first three reform scenarios the METR for the worker at the 75th percentile would be reduced by up to 9 percentage points. - Workers at the 85th percentile: marginal rates decline from 67 to 58–63 percent under the scenarios considered. - Under the scenarios considered, the marginal tax rate at the very top would remain largely unchanged. - Pareto reform: - Displays a large cut in tax rates for earnings above the 85th percentile while leaving taxes and benefits constant at lower income levels. - METR cuts of around 11 percent shown under Pareto reform still leave total revenues unchanged because current rates are above revenue-maximizing rates and on the wrong side of the Laffer curve. ### Economic and welfare impacts (selected quantitative results) - Isoelastic reform: - Aggregate labor supply increases by 3.8 percent. - Employment rate goes from 89 percent to 91.7 percent. - Total earnings increase by 3.5 percent. - Disposable Gini index increases from 0.25 to 0.27. - Social welfare gain: 3.7 percent (expressed as a share of current output). - Combination reform: - Earnings and hours gains are somewhat smaller than Isoelastic, but inequality does not increase and social welfare gains are similar due to larger gains for lower income workers. - Employment rate: 91.8 percent. - Constant benefit reform: - Keeping the out-of-work benefit constant significantly reduces the economic effects of reform and increases inequality. - Pareto reform: - Aggregate earnings increase by 1.8 percent. - Social welfare does not increase much because gains accrue to top incomes with low social welfare weights. - Robustness: optimal METR schedules have similar shapes across elasticity assumptions (baseline e = 0.1 and η = 0.2; lower e = 0.05 and η = 0.10; higher e = 0.20 and η = 0.30), with METR increases at the bottom and largest cuts on upper-middle income workers. - Selected table values (current vs. reform outcomes): - Net revenues (percent of earnings): 55.3 (Current); 55.2 (Isoelastic); 55.2 (Combination); 55.2 (Constant benefit); 55.2 (Pareto). - Total earnings change (percent): -3.5 (Current baseline change); 2.5 (Isoelastic); 0.9 (Combination); 1.8 (Pareto). - Total hours change (percent): -3.8 (Current baseline change); 3.2 (Isoelastic); 0.7 (Combination); 0.6 (Pareto). - Employment rate: 89.0 (Current); 91.7 (Isoelastic); 91.8 (Combination); 89.4 (Constant benefit); 89.2 (Pareto). - Disposable Gini index: 0.25 (Current); 0.27 (Isoelastic); 0.25 (Combination); 0.27 (Constant benefit); 0.27 (Pareto). - Welfare gains (percent of earnings): -3.7 (Current baseline); 3.6 (Isoelastic); 0.3 (Combination); 0.2 (Constant benefit). ### Distributional impacts (winners and losers) - Low-wage and part-time workers: - Strong after-tax-and-benefit income gains of up to 40 percent under the Isoelastic and Combination reforms. - Median worker: 5 percent increase in net income. - Top earners: net income gains ranging from 10 to 20 percent under some reforms. - Individuals outside the labor force: - Around 8 percent of the sample after reform would see a decline of 13 percent in net benefits. - Constant benefit scenario: out-of-work benefits stay the same, but workers between the 20th and 55th percentiles would see net income losses of about 1 percent. - Pareto reform: everyone below the 85th percentile unaffected; individuals above the 85th percentile gain up to 8.8 percent on average, with the largest gains reaching 17 percent for those at the 99th percentile of the earnings distribution. ### Sensitivity and policy trade-offs - The level of out-of-work benefits has a large impact on economic and welfare gains from reform: - Allowing full optimization (out-of-work benefits reduced by 13 percent) combined with more in-work benefits generates large earnings and welfare gains and increases the employment rate by almost 3 percentage points. - Constraining adjustments to out-of-work benefits (Constant benefit scenario) substantially reduces aggregate effects and raises inequality. - Two complementary measures are needed to raise employment and preserve fiscal sustainability: - 'Pull' measures: increase reliance on in-work benefits, combined with greater means-testing to preserve fiscal sustainability and reduce PTRs. - 'Push' measures: better targeting and reduction of out-of-work benefits for groups where inactivity is more attractive (examples noted include the home care allowance and housing benefits, and tightening activity requirements for the Labor Market Subsidy). ### Policy recommendations (explicit) - Increase reliance on pull measures such as in-work benefits combined with greater means-testing to reduce PTRs and increase employment. - Increase push measures through better targeting of out-of-work benefits (reduce attractiveness of inactivity for highly skilled and secondary earners); examples include tighter targeting of home care allowance and housing benefits, and tightening activity requirements for the Labor Market Subsidy. - Reduce METRs for upper-middle income workers where current rates appear to be on the wrong side of the Laffer curve; rate cuts could be self-financing. *Source: IMF staff analysis as presented in the chapter "Increasing support for low-wage and part-time workers" (Finland).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1finea2020002.pdf_