Tax-free extra hours worked: not such a bad idea, after all edit

June 14, 2007

As a candidate, Sarkozy promised to reform labour markets. His first move concerns the infamous 35 hours workweek, not really a surprise. The shorter workweek had been introduced by the socialist government of Jospin with the explicit aim of sharing work to increase employment. It followed on earlier moves under President Mitterrand in the 1980s and under President Chirac in the 1990s. That the idea was mistaken may be obvious to (non-French) economists, but it remains controversial in France because substantial subsidies, introduced when the Jospin government realized that the measure could, well, actually reduce employment, make it difficult to identify its effects.

Sarkozy’s approach may sound politically astute. Rather than simply repeal the 35 hours week legislation, he intends to keep it but to free extra-hour salaries from overhead taxes and from income taxes. He obviously hopes to avoid a direct fight with trade unions, which strongly support the reduced working time and have made it an iconic droit acquis. Problem is that, by not repealing the legislation, he gives up the argument that it was a bad measure based on mistaken reasoning. Accepting the 35 hour workweek as “normal”, he is led to amend its effect by adding a distortionary measure on top of an already bad law. This original sin may come to haunt him. Freed from taxes, overtime hours will be cheaper for employers and better paid for employees – the normal impact of eliminating a tax distortion. Yet, the measure itself is distortionary because it will only apply to overtime hours. The expected effect is to sharply raise the number of hours effectively worked. As a consequence, it should lead to a substitution of worked hours to employment. Given that low employment – and high unemployment – is the scourge of the French economy, this substitution is not particularly welcome. On the other had, as many workers will work longer and at a lower average cost – when normal and extra hours are added up – firms will have an incentive to hire more workers. Better pay should also encourage some unemployed people to seek employment more actively. More demand, more supply, this should lead to the substitution of labour for capital. That effect works in the right direction. It is impossible to assess with any degree of precision which of the two substitution effects will dominate, and whether the measure will raise employment. A good bet is that the employment effect will be negligible, in either direction. Unfortunately, we cannot stop here. Cutting taxes has the unavoidable effect of cutting tax revenues. The measure, therefore, will be costly, possibly amounting to 0.5 to 0.8% of GDP. Seen this way, the measure amounts to subsidising overtime work. Alternatively, it alleviates work disincentives created by labour and income taxes. At any rate, it is a costly measure that will make an already complex tax system more complex. Not a great idea, therefore. Worse, the measure will open a serious tax loophole. Employers and employees will see the merit of hiding taxable wage increases as tax-free extra hours. It will be very hard for the tax authorities to track down such a misuse of the measure. Not only will tax fraud be encouraged, but the loss of the tax revenue might rise very substantially. With the passage of time and of productivity-induced wage increases, the drain on public resources could become enormous. Will other taxes be raised, then? Will it all go into a higher public debt? Sarkozy’s trick looks like a pretty bad idea. This is where the original sin comes into play. The freeing of overtime labour and income taxes is being chosen in lieu of repealing a law that aims at centrally regulating working hours. Many other countries do not let government mingle in this area. They let working hours to be decided through negotiations between employers and employees. Keeping government and politics out of this issue has the distinct advantage of letting pragmatic outcomes flourish. Indeed, employers’ needs and employees’ wishes differ; why should the state impose a single solution? By letting this interventionist approach stand, Sarkozy is boxing himself in an uncomfortable position. Labour legislation, already extraordinarily complex, becomes even more complicated. This complexity is already discouraging many potential entrepreneurs and imposes heavy legal costs upon existing firms. Not only does this discourage employment and growth, it is also a source of legal ambiguities and of assorted loopholes. It would have been much better, therefore, to simply do away with the very idea of normal working time. Of course, abuses are possible but remedial solutions can be designed to protect employees from heavy-handed demands by unscrupulous employers. More crucially, the power of employers over their employees is directly proportional to the unemployment rate. The best protection of employees is full employment, and this should be the over-riding priority of Sarkozy. So, should we conclude that his first major employment policy move is an irremediably bad idea? Maybe not. Paradoxically, its effect on tax revenue may be its redeeming feature. Sarkozy has also committed himself to reducing the tax burden, which is the second highest in Europe. The question will be: which taxes to cut. Given France’s debt and lasting budget deficits, his margin for manoeuvre will be highly constrained. He is already moving to small but symbolic measures demanded by his electorate, which will favour the wealthy. Obviously, his priority should be to consider in priority taxes that weigh on unemployment. The measure on overtime work does reduce labour cost. To be sure, there are less distortionary ways of doing that, but given the pressure by all sorts of interest groups for self-serving tax cuts, pre-empting some of the margin for manoeuvre for the employment cause has much to recommend to it. Cynically, the more the measure’s loophole is exploited, the more labour costs will be reduced and the more the objective of raising employment through tax cuts will capture the priority. As for the distortionary effect in favour of a longer workweek, consider the fact that the flagship promise of Sarkozy’s campaign has been to portray himself as the “Work President”. Public opinion polls have indicated that this may have been his most successful slogan. He thinks that there are two categories of French people: those who want more pay for less work and those who work hard and deeply resent not reaping the fruits of their efforts. If he is right, sharply tilting incentives towards longer work hours is the right thing to do. Viewed this way, the distortion looks very different. Of course, there are better, possibly cheaper ways to encourage employment. Britain’s “make work pay” is one example, which has inspired some measures previously enacted – in a small way – in France. To his credit, Sarkozy has not claimed that making extra hours tax free will raise employment. He only wants people to work longer. In that sense, after all, the idea is much less bad than it looks at first glance.