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### I. Introduction — scope, motivation, and regional context
- Focus: taxation of labor (personal income taxes (PITs) and social security contributions (SSCs)) and their effects on revenue, redistribution, and labor market behavior.
- Regional scope: six Western Balkan countries — Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia.
- Key regional challenges:
  - High youth and female unemployment.
  - Low labor force participation.
  - High levels of informality.
  - Sizeable social security programs with legacy costs (despite not being larger than the EU average).
  - Strong spending pressures from demographic aging and high emigration.
- Objective: survey how high labor taxes affect efficiency (labor market distortions) and equity (redistributive outcomes), and distill lessons and policy choices to improve equity and reduce inefficiencies while broadly keeping tax-to-GDP ratios and social spending at current levels.

### II. Brief literature review — equity-efficiency trade-off and margins of response
- Core trade-off: redistribution (equity) versus work incentives (efficiency) in labor income taxation.
- Labor supply response margins:
  - Intensive margin: adjustments in hours/intensity for employed workers.
  - Extensive margin: participation decisions to enter or leave the labor force.
- Theoretical insights preserved:
  - Saez (2001): negative income taxes/transfers at the bottom can lower barriers to formal employment; optimal PIT marginal rates can follow a U-shape.
  - The legal instrument (PIT vs SSCs) matters less than how taxes and benefits are (dis-)joined and perceived linkages between contributions and entitlements.
- Empirical issues:
  - Optimal tax schedules depend critically on elasticities of labor supply to the tax wedge at both margins — largely empirical and heterogeneous.
  - Data limitations: survey self-reported earnings biases; administrative data affected by legal tax minimization and tax evasion.
- Practical implication: lowering barriers to employment can improve progressivity and reduce the equity-efficiency trade-off at the extensive margin.

### Box 1 — The Labor Tax Wedge: concept and empirical elasticities
- Conceptual framework:
  - Tax wedge = difference between total labor cost w1 (gross wage + employer’s SSCs) and take-home net pay w2 (gross wage − PIT − employee’s SSCs); usually expressed as a percentage of w1.
  - Variations in the tax wedge affect employment incentives for employees (labor supply) and employers (labor demand).
- Empirical elasticities:
  - Cross-sectional estimates for primary worker labor supply around 0 to -0.1 (Luksic 2020).
  - Own-wage elasticities largest for married women; smaller for men (Bargain and Peichl 2016).
  - Macro elasticities generally larger than micro elasticities.
  - Secondary worker elasticities typically higher but declining over time.
  - Natural experiments show overall weak responses, stronger at the extensive margin.
  - For the Western Balkans, extensive-margin responses stronger in European countries with lower labor market participation.

### Box 3 — Measures of Progressive and Redistributive Capacities
- Measurement frameworks:
  - Standard redistributive measure: difference between Gini coefficients of pre- and post-tax income.
  - Kakwani (1977) progressivity index: difference between Gini of pre-tax income and Gini of tax liabilities.
  - Kakwani decomposition: progressivity (distributional concentration) and size (aggregate tax rate = total tax liabilities / total pre-tax income).
- Limitations and methodology:
  - Kakwani and Reynolds-Smolensky indices depend on pre-tax distribution; may conflate intrinsic tax progressivity with initial conditions.
  - Method used: “transplants” tax regimes into a common base with identical pre-tax distribution (Dardanoni and Lambert 2002); indices computed are intrinsic progressive and redistributive capacities, corrected for pre-tax distributions.
  - Calculations use simulated microdata based on Gini coefficients of pre-tax income (Benítez and Vellutini 2021).

### D. Incentives at the Extensive Margin — minimum bases and means-tested benefits
- High tax wedge discourages formal market labor supply, human capital investment, and labor demand, contributing to involuntary unemployment and inactivity.
- Minimum contributions apply in four countries out of six and may reduce incentives for participation/formal hiring for low-income workers and secondary earners.
- Minimum/maximum SSC bases (Table 2 entries preserved):
  - Albania: Minimum base for SSCs (employee) = Minimum wage; Minimum base for SSCs (employer) = Minimum wage; Maximum base for SSCs (employee) = 4 x min. wage; Maximum base for SSCs (employer) = 4 x min. wage.
  - Bosnia and Herzegovina: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - Kosovo: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = Minimum wage; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - Montenegro: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - North Macedonia: Minimum base for SSCs (employee) = 50 % average wage; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = 16 x average wage; Maximum base for SSCs (employer) = -.
  - Serbia: Minimum base for SSCs (employee) = 35 % average wage; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = 7 x GDP per capita; Maximum base for SSCs (employer) = 7 x GDP per capita.
- Means-tested benefits (not shown in Figure 12) critically affect extensive-margin incentives:
  - Serbia and Montenegro: Koettl (2013; 2012) find an effective tax rate (including benefits, PIT, and SSC) surpassing 100 percent, implying a loss of net income for wages below 25 percent of the average wage. “By and large, this is still true today.”
- Key message: structure of average tax wedge disincentivizes formal employment for low-skill workers and women; limited redistributive capacity contributes to inequality.
- Footnote: For Albania, the spike in the tax wedge happens at low-income levels, below 67 percent of GDP per capita.

### E. Incentives at the Intensive Margin — marginal tax rates and SSCs
- Marginal tax rates on additional work for a single full-time worker show lumpy contributions and large discontinuities.
- Two scenarios illustrated:
  - Workers do not internalize SSCs as a cost (red line).
  - Employee (SSC e) and employer (SSC E) contributions considered not generating proportional benefits (green and blue lines).
- Findings:
  - SSCs substantially dominate marginal work and earnings incentives—especially if SSCs are not perceived as generating proportional benefits.
  - Albania, Montenegro, and Serbia: temporary drop in marginal tax wedge due to an upper limit on SSCs not aligned with PIT brackets.
  - If part of SSCs are perceived as net costs by employees, marginal tax rates display strong regressivity in Albania, Montenegro, and Serbia.
  - In all countries, SSCs at least double the marginal tax rate, likely providing negative incentives to work more and declare more income.

### F. SSCs and design of benefits
- Three dimensions for benefit design: eligibility/coverage, level, and financing.
- SSC payments generally contribute to buildup of associated benefit entitlements (pensions, health care, unemployment).
- Pensions: in all 6 countries, pensions are generally linked to earnings; pension payments related to individual contributions.
- Health care: close to universal across the region, weakening earnings-benefits link.
  - Bosnia and Herzegovina, Montenegro, Serbia: unemployed without right to unemployment benefits are registered with Employment Funds and benefit from health care; State pays contributions on their behalf, artificially increasing registered unemployed.
  - Kosovo: central government functions as purchaser and provider of health care services.
  - North Macedonia: all citizens and registered long-term residents eligible for free compulsory State funded healthcare.
  - Albania: universal health care system based on mandatory and voluntary contributions, supplemented by state budget; health care benefits identical for all, with sick pay and maternity benefits depending on contribution status.
- Unemployment programs: earnings-linked in all six countries; unemployment contributions are much smaller and affect incentives significantly less.
- Benefits withdrawal at the lower end of income distribution is a key design issue affecting formalization (notably Serbia and Montenegro).
- High proportion of income-linked benefits, especially pensions, complicates reforms of labor taxation.

### G. Self-employment — incidence, regimes, and distortions
- Share of labor through self-employment (men and women):
  - North Macedonia: 18 and 6 percent.
  - Albania: 42 and 26 percent.
  - Comparison: 18 and 10 percent in the EU.
- Self-employment high and increasing in high-wage sectors (IT, regulated professional services) partly due to tax regulations allowing lump-sum taxes and contributions up to high thresholds.
  - Kosovo permits simplified presumptive regimes for regulated professional services.
- Risks: informality and underreporting due to lack of third-party information and withholding.
- Thresholds and lump-sum regimes create discontinuities that disincentivize intensive labor supply.
- Albania example: individual earning above ALL 8 million annual net income (about 16 times GDP per capita) can face an effective income tax rate of 0 percent in self-employment under the Simplified Profit Tax, instead of 18.5 percent as an employee under the PIT.
- Taxation of the self-employed, 2021 (Table 3 entries preserved):
  - Albania: Profit or Turnover Regime = Turnover; Lump-Sum Regime = 16; Upper Threshold (x GDP per capita) = Turnover; Tax and SSC Base = 0 percent; Tax Rate = 23 percent*; SSCs = No.
  - Bosnia and Herz.: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent#; Tax Rate = 23 percent*; SSCs = No.
  - Kosovo: Profit or Turnover Regime = Turnover; Lump-Sum Regime = 17; Upper Threshold (x GDP per capita) = Turnover; Tax and SSC Base = 3 to 9 percent; Tax Rate = 10 percent*; SSCs = Yes.
  - Montenegro: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent##; Tax Rate = 34.3 percent*; SSCs = No.
  - North Macedonia: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = PIT rates; Tax Rate = 28 percent*; SSCs = Yes.
  - Serbia: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent; Tax Rate = 36.5 percent*; SSCs = No.
- Notes: * indicates combined employee and employer SSCs for wage earners; # is the standard CIT rate; ## is the top PIT rate.
- Footnote: Albania draft Income Tax Law currently in public consultations may have implications on the treatment of self-employed professionals under the PIT regime.

### V. Policy Implications — orientations and concrete measures
- Twin challenges: low redistributive capacity of labor taxation (equity) and efficiency losses from incentives to remain informal (especially due to SSCs).
- Equity implications:
  - PIT’s limited progressivity and high flat SSC rates yield low redistributive capacity by international standards.
- Efficiency implications:
  - High tax wedges on low incomes incentivize staying out of formal employment; SSCs play an essential role.
  - Low labor participation and high informality consistent with these tax features; contributes to gender participation gap (Serbia, North Macedonia, Albania).
- Policy recommendations:
  - Make PIT schedules more progressive.
    - Kosovo, Bosnia and Herzegovina, Montenegro: top rate (10 percent) is too low for significant redistributive capacity.
    - North Macedonia: with a higher top rate (18 percent), lowering rates on low-income workers or increasing the standard allowance would improve progressivity and alleviate low-income tax wedge.
    - Montenegro: introducing a standard allowance would enhance PIT progressivity and help the extensive-margin tax wedge.
    - Note: making PIT more redistributive is inseparable from increasing its weight in the tax revenue mix to strengthen resource mobilization.
  - Consider an In-Work Tax Credit (IWTC) to incentivize formalization and alleviate excessive effective tax rates faced by low-wage entrants to formal employment (documented in Serbia and Montenegro when benefit withdrawal is factored in).
    - IWTC net fiscal cost manageable depending on design (maximum credit, eligible income range), especially if combined with increasing PIT top rates.
  - SSC-focused actions (critical in Albania, North Macedonia, Serbia):
    - Lower or eliminate contribution minima where they drive the tax wedge (apply to self-employed as well).
    - Review contribution maxima that directly affect progressivity.
    - Reduce SSC rates on low-income earners to improve progressivity and formalization incentives, subject to benefit regime implications.
    - Choice between targeting employer or employee SSCs matters:
      - Reductions in employee SSCs likely influence labor supply.
      - Reductions in employer SSCs affect labor demand and could be prioritized as a constraint to formal employment.
  - SSC reductions and earnings-linked entitlements:
    - SSC reforms are more difficult when contributions fund earnings-linked entitlements (pensions).
    - Example: Kosovo’s mandatory capitalized pension scheme gives benefits directly proportional to contributions—SSC reductions advisable with general benefit reforms.
  - Recharacterizing contributions for universal benefits:
    - Contributions financing universal benefits (basic health care, minimum pensions) can be viewed as quasi-taxes and need not be levied from labor income.
    - Indirect taxes (VAT, environmental taxes) could in part or in whole compensate for SSC reductions.
    - Switching bases is possible though complex; several EU examples exist.
  - Historical precedents for financing SSC reductions:
    - Germany: unemployment insurance rate reduced from 6.5 to 4.2 percent in 2007 and to 3 percent in 2009; health insurance contribution rate reduced from 7.3 to 7 percent for employers and from 8.2 to 7.9 percent for employees; financed by permanent increase in standard VAT from 16 to 19 percent.
    - Hungary: employer’s SSC reduced by 5 percentage points for incomes up to 2 times the minimum wage in 2009, extended in 2010; lump-sum health contribution abolished as of January 1, 2010; financed by 5 percentage point increase in standard VAT rate plus higher excises on petrol, diesel, alcohol and cigarettes.

### Box 4 — Experience with SSC Reductions: implementation, financing, and relevance
- Context and rationale:
  - Employers’ SSC reductions used by many EU countries after the 2008 financial crisis to address unemployment.
  - Preference for SSC reductions: SSCs apply only to employed labor and reducing labor cost perceived to ease adjustment and increase employment.
- Implementation experience:
  - Since the financial crisis, 14 countries introduced temporary reductions in employers’ SSCs.
  - In 2010, eight OECD countries reduced employers’ social contribution rates.
  - Scope examples:
    - Reduction applies to all workers in Germany, Japan, Mexico.
    - France and the Czech Republic restricted reduction to low-wage workers.
    - Portugal: reduction for new employees only.
    - France: reduction applies to small firms only — up to 50 employees.
- Financing and distributional implications:
  - Financing SSC reductions through VAT increases may revive equity-efficiency trade-off because VAT is more regressive than labor taxation; progressivity in spending becomes important in such cases.
- Challenges related to the self-employed:
  - Lump-sum regimes and upper thresholds may trap workers or offer preferential treatment to high-earners in regulated professions.
  - Policy aims: ensure lump-sum regimes deliver lower compliance costs without preferential treatment; ensure smooth transitions to standard regimes.
- Relevance for the Western Balkan:
  - Lack of progressivity plus high tax wedge on low incomes poses twin equity-efficiency challenge.
  - Challenge largely results from high SSCs applying uniformly to income, while excluding some individuals and enterprises.
  - PITs not playing expected role in redistribution and revenue raising.
  - Low labor participation, particularly among low-skill workers and women, consistent with high tax wedges.
  - Albania, North Macedonia, Serbia: excessive tax wedge on low incomes a key hurdle to formalization and inclusiveness.
  - Policy implications:
    - Correcting tax wedges on low-income earners can be achieved by SSC reductions, including shifting funding of pensions and health to other bases (capital, consumption).
    - SSC reforms are complex due to benefit linkages; reforms could be perceived as benefit reductions even where link is weak.
    - Spending policy, including transfers to unemployed workers, influences progressivity and incentives to formalization.
    - Political difficulty of reforming income taxation toward more progressivity makes spending policies central to redistribution; spending alone will not resolve tax inefficiencies and informality.
    - Likely path: both tax and spending reforms needed.
- Further work:
  - National reform strategies require careful assessment of objectives, time horizon, administrative capacity, and in-depth analytical work on expected labor supply responses, redistributive capacity, and informality — typically country-specific.

*Source: wpiea2022239-print-pdf — https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022239-print-pdf.pdf*

### References .............................................................................................................

### wpiea2022239-print-pdf - References .............................................................................................................

### I. Introduction — scope, motivation, and regional context
- Taxation of labor (personal income taxes (PITs) and social security contributions (SSCs)) is important for revenue and has redistributive and behavioral effects on labor markets.
- Eurostat data (European Commission 2021): approximately half of government revenues in the European Union (EU) are raised through taxes on labor, corresponding to some 20 percent of GDP.
- The analysis focuses on six Western Balkan countries: Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia.
- Key regional challenges highlighted:
  - High youth and female unemployment.
  - Low labor force participation.
  - High levels of informality.
  - History of sizeable social security programs with non-negligible legacy costs (despite not being larger than the EU average).
  - Strong underlying spending pressures going forward due to demographic aging and high levels of emigration (Mehrez et al. 2016).
- Objective: survey how high labor taxes in the region affect efficiency (labor market distortions) and equity (redistributive outcomes), and distill lessons and policy choices to improve equity and reduce inefficiencies while broadly keeping tax-to-GDP ratios and spending on social programs at current levels.
- Paper organization (sections listed): literature review (II), labor market outcomes and informality in the Western Balkans (III), evolution of tax revenue and tax system indicators (IV), policy lessons and implications (V), conclusion (VI).

### II. Brief review of the literature — equity-efficiency trade-off and margins of response
- Core trade-off: redistribution (equity) versus work incentives (efficiency) in labor income taxation.
- Determinants of optimal tax schedules include social welfare preferences, individual heterogeneity, limits to rationality, external constraints (e.g., wage-setting), and behavioral responses (effort, tax avoidance).
- Distinction between labor supply responses:
  - Intensive margin: adjustments in work intensity for those already employed (Mirrlees 1971).
  - Extensive margin: participation decisions to enter or leave the labor force (Diamond 1980).
- Key theoretical insights preserved from source:
  - Saez (2001): negative income taxes (transfers) at the bottom of the earnings distribution can optimally lower barriers to formal employment; optimal PIT marginal rates can follow a U-shape (Saez 2001; P. A. Diamond 1998; Benedek, Benítez, and Vellutini 2022).
  - For labor supply purposes, the legal instrument creating the tax wedge (PITs or SSCs) matters less than how taxes and benefits are (dis-)joined; linkages between contributions and entitlements affect the effective tax wedge at the extensive and intensive margins.
- Empirical and measurement issues emphasized:
  - Optimal taxation depends critically on the elasticity of labor supply to the tax wedge at both margins — largely an empirical question.
  - Labor supply elasticities vary with income and are hard to estimate.
  - Data limitations complicate empirical assessment:
    - Survey self-reported earnings suffer biases, especially at earnings distribution extremes.
    - Administrative tax data are affected by legal tax minimization (e.g., reclassification of income, earnings splitting) and tax evasion (e.g., under-reporting of work and earnings).
- Practical implication signaled in the text: lowering barriers to employment can improve progressivity and reduce the equity-efficiency trade-off at the extensive margin — a dynamic particularly relevant for the Western Balkans.

*Source: wpiea2022239-print-pdf — https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022239-print-pdf.pdf*

### Box 1. The Labor Tax Wedge

### Box 1. The Labor Tax Wedge

### Conceptual framework
- The labor tax wedge is the difference between total labor cost w1 and the take-home net pay w2.
- Total labor cost w1 is the sum of the gross wage plus employer’s SSCs.
- The take-home net pay w2 is the gross wage minus PIT liabilities and employee’s SSCs.
- The tax wedge is usually expressed as a percentage of w1.
- Ceteris paribus, variations in the labor tax wedge affect employment incentives for both employees (labor supply) and employers (labor demand) and determine the new equilibrium level of employment q* (with wages w1 and w2 illustrated in the standard wage–quantity diagram).
- The slopes of the supply and demand curves represent elasticities with respect to wages (and therefore the tax wedge): a less inclined supply curve implies a higher labor supply elasticity (employees are more sensitive to w2), meaning a given labor tax wedge has a larger effect on employment.

### Empirical evidence on elasticities
- Cross-sectional empirical literature shows relatively low overall elasticities, with variations across time and estimation methods.
- Cross-sectional labor supply estimates for the primary worker in the household put the labor supply elasticity at around 0 to -0.1 in an international context (Luksic 2020).
- Consensus in the literature: own-wage elasticities are largest for married women and smaller for men (Bargain and Peichl 2016).
- Macro elasticities are generally larger than micro elasticities.
- For secondary workers, elasticities are usually somewhat higher, but with a downward trend over time as the labor market position of women has evolved (Pencavel 1986; Blau and Kahn 2007).
- Natural experiments and real work policy experiments confirm overall weak responses, with stronger extensive margin responses than intensive margin responses.
- For some subgroups (e.g., some categories of low-income workers), responses can be large (Eissa and Liebman 1996).
- For the Western Balkan region, extensive-margin responses are stronger in European countries with lower labor market participation (Bargain and Doorley 2011; Žarković Rakić, Ranđelović, and Vladisavljević 2016).

*International Monetary Fund — Box 1. The Labor Tax Wedge (from wpiea2022239-print-pdf)*

### Box 3. Measures of Progressive and Redistributive Capacities

### Box 3. Measures of Progressive and Redistributive Capacities

### Measurement frameworks and decomposition
- Standard redistributive measurement: difference between Gini coefficients of pre- and post-tax income (Musgrave and Thin 1948; Reynolds and Smolensky 1977).
- Kakwani (1977) progressivity index: difference between Gini coefficients of pre-tax income and the tax liabilities; higher concentration of tax liabilities on higher incomes implies more progressive PIT.
- Kakwani decomposition splits total redistributive effect into:
  - Progressivity (distributional concentration of the tax).
  - Size (aggregate tax rate): ratio of total tax liabilities over total pre-tax income.
- Illustration of insufficiency of progressivity alone:
  - Example: a PIT generating total revenue of 0.001 percent of GDP can be extremely progressive yet achieve little redistribution because it is too small.

### Limitations and methodology to control pre-tax distributions
- Limitation: Kakwani and Reynolds-Smolensky indices depend on the pre-tax distribution, conflating intrinsic tax progressivity with initial economic conditions.
- Methodology used in the paper:
  - “Transplants” tax regimes into a common base with an identical pre-tax distribution (Dardanoni and Lambert 2002).
  - Indices computed are intrinsic progressive and redistributive capacities of the PIT in each country, corrected for pre-tax distributions.
  - Calculations use simulated microdata based on Gini coefficients of pre-tax income (Benítez and Vellutini 2021).

### D. Incentives at the Extensive Margin
- High tax wedge on labor discourages:
  - Formal market labor supply and related human capital investment.
  - Labor demand, contributing to involuntary unemployment and inactivity.
- Minimum contributions apply in four countries out of six and may reduce incentives for labor force participation or formal hiring, especially for low-income workers and secondary earners.
- Minimum contribution effects (Table 2 entries preserved):
  - Albania: Minimum base for SSCs (employee) = Minimum wage; Minimum base for SSCs (employer) = Minimum wage; Maximum base for SSCs (employee) = 4 x min. wage; Maximum base for SSCs (employer) = 4 x min. wage.
  - Bosnia and Herzegovina: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - Kosovo: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = Minimum wage; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - Montenegro: Minimum base for SSCs (employee) = -; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = -; Maximum base for SSCs (employer) = -.
  - North Macedonia: Minimum base for SSCs (employee) = 50 % average wage; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = 16 x average wage; Maximum base for SSCs (employer) = -.
  - Serbia: Minimum base for SSCs (employee) = 35 % average wage; Minimum base for SSCs (employer) = -; Maximum base for SSCs (employee) = 7 x GDP per capita; Maximum base for SSCs (employer) = 7 x GDP per capita.
- Means-tested social benefits (not shown in Figure 12) critically affect extensive-margin incentives:
  - Serbia and Montenegro: Koettl (2013; 2012) find an effective tax rate (including benefits, PIT, and SSC) surpassing 100 percent, implying a loss of net income for wages below 25 percent of the average wage.
  - Authors note: “By and large, this is still true today.”
- Key message: Even without means-tested benefits, the structure of the average tax wedge significantly disincentivizes formal employment for low-skill workers and women; this, combined with limited redistributive capacity, contributes to inequality.
- Footnote preserved: For Albania, the spike in the tax wedge happens at low-income levels, below 67 percent of GDP per capita.

### E. Incentives at the Intensive Margin
- Marginal tax rates on additional work for a single full-time worker show:
  - Two scenarios: total perceived contribution-benefit linkages (workers do not internalize SSCs as a cost — red line); and employee (SSC e) and employer (SSC E) contributions considered as not generating proportional benefits (green and blue lines).
  - Both series show lumpy contributions at zero and large discontinuities.
  - Discontinuities indicate SSCs substantially dominate marginal work and earnings incentives—especially if SSCs are not perceived as generating proportional benefits.
  - Albania, Montenegro, and Serbia have a temporary drop in marginal tax wedge due to an upper limit on SSCs not aligned with PIT brackets.
  - If at least part of SSCs are perceived as net costs by employees, marginal tax rates display strong regressivity in Albania, Montenegro, and Serbia.
  - In all countries, SSCs at least double the marginal tax rate, likely providing negative incentives to work more and declare more income.

### F. SSCs and design of benefits
- Three important dimensions for benefit design: eligibility/coverage, level, and financing.
- Key distinguishing feature: SSC payment generally contributes to buildup of associated benefit entitlements (pensions, health care, unemployment).
- Pensions: in all 6 countries, pensions are generally linked to earnings; pension payments are related to individual contributions.
- Health care: close to universal across the region, weakening the earnings-benefits link.
  - Bosnia and Herzegovina, Montenegro, Serbia: unemployed without right to unemployment benefits are registered with Employment Funds and benefit from health care; State pays contributions on their behalf, artificially increasing registered unemployed.
  - Kosovo: central government functions as purchaser and provider of health care services.
  - North Macedonia: all citizens and registered long-term residents are eligible for free compulsory State funded healthcare.
  - Albania: universal health care system based on mandatory and voluntary contributions, supplemented by state budget; health care benefits identical for all, with sick pay and maternity benefits depending on contribution status.
- Unemployment programs: earnings-linked in all six countries; unemployment contributions are much smaller and affect incentives significantly less.
- Benefits withdrawal at the lower end of income distribution is a key design issue affecting formalization at the extensive margin (notably Serbia and Montenegro).
- High proportion of income-linked benefits, especially pensions, complicates reforms of labor taxation in the region.

### G. Self-employment
- Share of labor provided through self-employment (men and women) ranges:
  - North Macedonia: 18 and 6 percent.
  - Albania: 42 and 26 percent.
  - Comparison: 18 and 10 percent in the EU.
- Self-employment is particularly high and increasing in high-wage sectors (IT, regulated professional services) partly because of tax regulations allowing lump-sum taxes and contributions up to very high-income thresholds.
  - Example: Kosovo permits simplified presumptive regimes for regulated professional services (medical doctors, lawyers) even though these taxpayers typically do not need lower compliance costs.
- Self-employed regimes face higher risk of informality and underreporting due to lack of third-party information and withholding.
- Maximum thresholds and lump-sum regimes create discontinuities that disincentivize labor supply at the intensive margin.
- Albania example:
  - Individual earning above ALL 8 million in annual net income (about 16 times GDP per capita) can face an effective income tax rate of 0 percent in self-employment under the Simplified Profit Tax, instead of 18.5 percent as an employee under the PIT.
- Thresholds and lump-sum regimes in Kosovo and North Macedonia may trap workers in lower-than-optimal income ranges or provide inefficient tax shelters.

- Taxation of the self-employed, 2021 (Table 3 entries preserved):
  - Albania: Profit or Turnover Regime = Turnover; Lump-Sum Regime = 16; Upper Threshold (x GDP per capita) = Turnover; Tax and SSC Base = 0 percent; Tax Rate = 23 percent*; SSCs = No.
  - Bosnia and Herz.: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent#; Tax Rate = 23 percent*; SSCs = No.
  - Kosovo: Profit or Turnover Regime = Turnover; Lump-Sum Regime = 17; Upper Threshold (x GDP per capita) = Turnover; Tax and SSC Base = 3 to 9 percent; Tax Rate = 10 percent*; SSCs = Yes.
  - Montenegro: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent##; Tax Rate = 34.3 percent*; SSCs = No.
  - North Macedonia: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = PIT rates; Tax Rate = 28 percent*; SSCs = Yes.
  - Serbia: Profit or Turnover Regime = Profit; Lump-Sum Regime = No; Upper Threshold (x GDP per capita) = Profit; Tax and SSC Base = 10 percent; Tax Rate = 36.5 percent*; SSCs = No.
- Notes preserved: * indicates combined employee and employer SSCs for wage earners; # is the standard CIT rate; ## is the top PIT rate.
- Footnote preserved: Albania draft Income Tax Law currently in public consultations may have implications on the treatment of self-employed professionals under the PIT regime.

### V. Policy Implications
- Twin challenges: low redistributive capacity of labor taxation (equity) and efficiency losses from incentives to remain informal (especially due to SSCs).
- Equity implications:
  - PIT’s limited progressivity and high flat SSC rates yield low redistributive capacity by international standards.
- Efficiency implications:
  - High tax wedges on low incomes incentivize staying out of formal employment; SSCs play an essential role.
  - Low labor participation and high informality consistent with these tax features; contributes to gender participation gap (especially Serbia, North Macedonia, Albania).
- Policy orientations and recommendations:
  - Make PIT schedules more progressive.
    - Kosovo, Bosnia and Herzegovina, Montenegro: top rate (10 percent) is too low to achieve significant redistributive capacity.
    - North Macedonia: with a higher top rate (18 percent), lowering rates on low-income workers or increasing the standard allowance would improve progressivity and alleviate the low-income tax wedge.
    - Montenegro: introducing a standard allowance would enhance PIT progressivity and help the extensive-margin tax wedge.
    - Note: making PIT more redistributive is inseparable from increasing its weight in the tax revenue mix to strengthen resource mobilization.
  - Consider an In-Work Tax Credit (IWTC) to incentivize employment formalization and alleviate excessive effective tax rates faced by low-wage earners entering formal employment (documented in Serbia and Montenegro when benefit withdrawal is factored in).
    - IWTC net fiscal cost manageable depending on design (maximum credit, eligible income range), especially if combined with increasing PIT top rates.
  - SSC-focused actions (critical in Albania, North Macedonia, Serbia):
    - Lower or eliminate contribution minima where they drive the tax wedge (apply to self-employed as well).
    - Review contribution maxima that directly affect progressivity.
    - Reduce SSC rates on low-income earners to improve progressivity and formalization incentives, subject to benefit regime implications.
    - Choice between targeting employer or employee SSCs matters:
      - Reductions in employee SSCs likely influence labor supply.
      - Reductions in employer SSCs affect labor demand and could be prioritized as a constraint to formal employment.
  - SSC reductions and earnings-linked entitlements:
    - SSC reforms are more difficult when contributions fund earnings-linked entitlements (pensions).
    - Example: Kosovo’s mandatory capitalized pension scheme gives benefits directly proportional to contributions—SSC reductions advisable in conjunction with general benefit reforms.
  - Recharacterizing contributions for universal benefits:
    - Contributions that finance universal benefits (basic health care, minimum pensions) can be viewed as quasi-taxes and need not be levied from labor income.
    - Indirect taxes (VAT, environmental taxes) could in part or in whole compensate for SSC reductions.
    - Switching bases is possible though complex; several EU examples exist.
  - Historical/International precedents for financing SSC reductions:
    - Germany: unemployment insurance rate reduced from 6.5 to 4.2 percent in 2007 and to 3 percent in 2009; health insurance contribution rate reduced from 7.3 to 7 percent for employers and from 8.2 to 7.9 percent for employees; financed by permanent increase in standard VAT from 16 to 19 percent.
    - Hungary: employer’s SSC reduced by 5 percentage points for incomes up to 2 times the minimum wage in 2009, extended in 2010; lump-sum health contribution abolished as of January 1, 2010; financed by a 5 percentage point increase in standard VAT rate plus higher excises on petrol, diesel, alcohol and cigarettes (IMF 2018b).

*Italic: Source — Box 3. Measures of Progressive and Redistributive Capacities, wpiea2022239-print-pdf*

### Box 4. Experience with SSC Reductions

### Box 4. Experience with SSC Reductions

### Context and rationale
- Reduction in employers’ SSCs was the major policy instrument used by many EU countries to address immediate and severe unemployment in the aftermath of the 2008 financial crisis.
- Preference for SSC reductions stems from:
  - SSCs applying only to employed labor, while PIT often applies to a broader definition of income that includes business activities.
  - Perception that high labor costs are a key structural problem in several EU countries and that reduced labor costs can ease and accelerate adjustment to increase employment (Keen and Mooij 2013).
  - Focus on the employer’s contribution reflects a view that relevant rigidity comes from contracts specified in terms of payment net of the employer’s SSC.

### Implementation experience
- Since the financial crisis, 14 countries have introduced temporary reductions in employers’ SSCs to increase labor demand.
- In 2010 alone, eight OECD countries reduced their social contribution rates for employers, with varying scope and level.
- Examples of scope and targeting:
  - Reduction applies to all workers in Germany, Japan, and Mexico.
  - France and the Czech Republic restricted the reduction to low-wage workers.
  - In Portugal, the reduction is in respect of new only new employees only.
  - In France it applies to small firms only—up to 50 employees.
- Adapted from IMF (2018b).

### Financing and distributional implications
- Financing SSC reductions through VAT increases may revive the equity-efficiency tradeoff:
  - VAT is inherently more regressive than labor taxation, so efficiency gains (relaxing constraints at the extensive margin of the labor market) may be associated with equity losses (making the tax system less progressive) (Pestel and Sommer 2017).
  - For this reason, progressivity in spending is important in countries that fund SSC reductions through non-labor taxation.

### Challenges related to the self-employed
- Tax regimes for the self-employed pose specific policy challenges:
  - At the intensive margin, lump-sum regimes and upper thresholds may trap workers in low-income situations or offer high-earners in regulated professions undue preferential tax treatment.
  - Essential policy aims: ensure these regimes deliver the lower compliance costs they are designed for—without preferential treatment; ensure transition towards standard regimes is as smooth as possible.

### Relevance for the Western Balkan (concluding remarks)
- The lack of progressivity of labor taxation combined with a disproportionately high tax wedge on low incomes poses a twin equity-efficiency challenge in the Western Balkan.
- Key structural observations:
  - Challenge largely results from high SSCs applying uniformly to income—but excluding some individuals and enterprises.
  - Region’s PITs are not playing their expected role in income redistribution and revenue raising.
  - Low rates of labor participation, particularly among low-skill workers and women, are consistent with high tax wedges.
  - In Albania, North Macedonia and Serbia, an excessive tax wedge on low incomes is a key hurdle to employment formalization and inclusiveness, especially for women.
- Policy implications:
  - Correcting tax wedges on low-income earners can be achieved first and foremost by SSC reductions, including by partially shifting the funding of pensions and health programs to other tax bases, in particular capital and consumption.
  - SSC reforms are more complex than changes in the PIT because they affect the funding of corresponding benefits, especially when those are income-linked—so reforms could be perceived as a reduction in benefits even where the link contribution-benefit is weak.
  - Spending policy, including transfers to unemployed workers, influences the progressivity and incentives to formalization provided by the tax-transfer system.
  - Given political difficulty to reform taxation toward more progressivity in income taxation, spending policies become central to fiscal redistribution; however, spending policies alone will not resolve tax inefficiencies and informality in the labor market.
  - Likely policy path: countries in the region will need both tax and spending reforms.
- Further work:
  - Designing the right national reform strategy requires careful assessment of objectives, time horizon, and administrative capacity, and in-depth analytical work on expected labor supply responses, redistributive capacity, and informality—all typically country-specific aspects.

*International Monetary Fund — Box 4. Experience with SSC Reductions*

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_Source: https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022239-print-pdf.pdf_