The Value-Added Contribution: A Flawed Strategy edit

Jan. 12, 2006

During his seasonal greetings to the press, President Chirac revealed that he had asked the cabinet to review the tax base of employers' social contributions. The reform he proposes would penalize capital intensive industries relatively to labour intensive ones; in the long term, it would backfire.

-->Currently, employers' contributions are based on gross wages. These contributions are funding various welfare funds (healthcare, pensions, family), which, taken together, absorb a larger share of GDP than the central government itself (24.6% of GDP vs. 22.9%). Mr. Chirac wants to shift the tax base from gross wages to value added, in order to boost employment and, it is hoped, to prevent companies from moving jobs offshore. Although most details of this major tax change are still unknown - apparently Mr. Chirac did not even inform the Treasury - the idea of a value-added based contribution is not new. I believe that the economics behind this proposition are deeply flawed and that, sadly, it may destroy good jobs in the future, instead of protecting French workers. To add insult to injury, this ex-ante tax neutral reform would harm public finances in the long run.

Although neutral for the overall tax burden by definition, this change would move the cursor from a purely labour based tax to a mixed one. Since total compensation takes roughly two-third of value added (67.6% was the exact number in 2004) and profits (as measured by the gross operating surplus) one third, the arithmetic for the average company is relatively straightforward. In short, a 1€ tax on payrolls would be replaced by a 67 cents tax on payrolls and 33 cents on gross operating surplus. It is difficult to be more specific, because the exact perimeter of the contributions targeted by this reform was not specified by Mr. Chirac. Based on 2004 national accounts for non financial and financial French companies, the total amount of contributions paid by employers was €149 bn, or 34.7% of gross wages. If fully transferred, these contributions would take 17.4% of value added (21.1% of value added net of tax). According to some news report, the reform would involve only the healthcare and family funds. In that case, the rate of the value added contribution would be only 9.3%, on my estimates.

The 2/3 vs. 1/3 breakdown between compensation and profits holds for the mythical average company only. In the real corporate world, companies are more or less labour intensive. For capital intensive companies and sectors, the relative shares of capital and labour are more evenly distributed. Hence, the overall tax burden may rise for these sectors while, conversely, labour intensive companies may benefit from a lighter tax burden. Not surprisingly, listed companies are more capital intensive than the average French company and, for that reason, would be penalized.

In the short term, fixed capital is less mobile than labour: although laying off workers in France is difficult and costly, it is nevertheless easier and less costly than to shut down plants and offices in order to relocate elsewhere. Accordingly, moving the tax cursor from labour to capital may be positive for employment in the short term, in theory at least. Why «in theory»? Because in labour intensive sectors such as retail trade, hotels, cafés and restaurants, the main obstacles to employment are stemming from over-regulation, entry barriers and the minimum wage, rather than from the tax wedge on labour. In the medium to long term, things could only get worse, because, in the long run, capital is highly mobile. Hence a higher tax on profits would result into capital outflows. By reducing the stock of productive capital in France, this policy would eventually harm employment. As a side effect, by reducing potential output, the reform would reduce the tax base and therefore inflate public deficits.

Because it fits with the old populist mantra "taxing capital creates jobs", this move may be aimed at luring left leaning voters. The problem is that it is unlikely to be effective even in the short run, because of regulatory impediments to job creation and, in the end, will simply result into capital outflows. Globalization is still about capital mobility above all, labour mobility coming as a very distant issue. I am afraid that penalizing capital to keep jobs at home is a hopeless strategy.