The last few years has seen considerable attention given to the economic and social inequalities within nations, and particularly between cities and rural areas.  New research from UCL and the University of Oslo explores how tax incentives can provide economic stimulus for rural areas, thus boosting employment and prosperity.

The researchers explored how tax reforms that harmonized payroll taxes across Norway affected economic activity.  Historically, the government had applied different payroll taxes to different parts of the country, with 0% applied in the northernmost regions, up to 14.1% in more central areas.  The aim was to stimulate business activity and avoid any depopulation of more remote areas.

This differentiation was abolished in 2004 to comply with EU trade regulations.  The analysis revealed that in the aftermath of the tax reform, the regions that had previous enjoyed tax benefits suffered a significant decline in employment.

“Our findings suggest that in countries or states where wages cannot adjust so easily, due for instance to centralised wage bargaining, place-based payroll tax incentives can indeed be an effective tool in stimulating local employment in underdeveloped regions,” the researchers say.  “Ultimately, the effectiveness of place-based payroll tax incentives in stimulating local employment depends on how flexibly wages can adjust to a given tax change. In settings where rising labour costs for firms are easily shifted on to worker wages, we would expect no changes in employment levels in response to payroll tax hikes. However, in Norway, where trade unions have strong influence over wage bargaining, we see that it is employment levels that are most affected.”

Local employment

Payroll taxes are typically imposed on employers as a percentage of salary, and are a considerable cost for businesses.  They’re also a major component of most social insurance systems, and constitute 15% of all tax revenue across the OECD.

Differential payroll taxes are not common, but are popular across the Nordics, whose countries are also renowned for low levels of income inequality.

The researchers examined changes in both wages and employment between 2000-2003, and then in the three years after the tax changes were introduced.  The analysis discovered a 1% increase in the payroll tax corresponded with a 0.32% decline in wages in the local labor market.

There was also a noticeable decrease in employment, with a 1% increase in tax corresponding with a 1.37% fall in local employment.  This is especially noticeable as the payroll tax increase was only payable by large firms, as smaller firms were subsidized by the government.  Such firms employ around 70% of the local labor force.

The authors found that this decline in employment was typically a case of people going from employment to unemployment rather than simply because they moved to a different place.  It’s a finding that the authors believe is likely to be replicated in other regions.  In the UK, for instance, the employment rate in the south east is nearly 10% higher than in the north east.

“Most countries have large and persistent geographical differences in employment and income, and a growing number of place-based policies attempt to reduce these differences through targeting underdeveloped or economically stressed regions,” they say. “In the UK, for example, the Conservative Government has said it wants to reduce regional divisions, so this could be among the types of policies they consider for a post-Brexit Britain.”