Study: In Estonia, tax hikes make people work more

TALLINN - While elsewhere in the Western world income tax hikes typically make people rest more instead of working for less net income, in Estonia, the introduction of the "tax hump" increased the hours people worked to maintain their income, a recent study by a final year student at the Estonian Academy of Security Sciences reveals.

According to Egert Tsõmbalov, who conducted the study for his graduation paper, now that Estonia is moving back to a universal basic exemption, it is important to measure how the essentially progressive taxation that has been in force in Estonia since 2018 has affected taxpayers' behavior.

The study found a positive correlation between the applicable tax rate and hours worked -- as the tax rate increased, so did the number of hours worked. A 1 percentage point increase in the applicable tax rate brought about a 0.8 percentage point increase in hours worked.

The correlation is not extremely strong, but rather moderately strong, said Tsõmbalov.

According to him, the most noteworthy finding is that Estonia's result is essentially the opposite of what similar studies have shown in countries like Sweden and the United States.

"Generally speaking, it appears that when income tax increased and thus net wages decreased, people elsewhere became less motivated to work and chose to enjoy more free time instead. In Estonia, however, people worked more to maintain their income, because real wages didn't decline as a result of the tax rate change," Tsõmbalov explained.

The author of the study noted that the findings could have two possible explanations -- which may also be valid simultaneously: people with average or higher wages worked more hours, and due to the increase in the basic exemption for low-income earners, more people of that segment entered the labor market.

According to Tsõmbalov, the theoretical framework used in the study and the identified behavioral patterns of Estonian taxpayers allow for some assumptions about the potential effects of the pending elimination of the so-called tax hump.

"This could reduce the need for business operators to optimize their income and decrease employees' motivation to accept under-the-table wages. Working hours may decrease because net wages will increase. As a result, more people might enter the labor market. In any case, it is important to thoroughly study this upcoming change in a few years so that Estonia's tax policy and debate can be as evidence-based as possible," the author of the study added.