TAXES AND SKILLS Bert Brys OECD Centre for Tax Policy and Administration LAC Forum Presentation, 10/06/2014

Overview 1.Introduction & Motivation 2.Methodology 3.Results 2

CTPA’s Skills Indicators: Examine the after-tax costs and returns of skills investments for workers, Examine costs and benefits for governments from skills subsidies. Big literature on tax and capital – tax rates on physical capital have fallen across the OECD. But what about human capital? Are we getting the mix right between physical and human capital? Also literature on tax expenditures – how can policymakers evaluate the equity/efficiency implications of credits, deductions, and exemptions? New indicators help analyse tax expenditures versus direct spending as a way to increase skills investment. Increasing OECD work on inclusive growth – new indicators highlight the relationship between progressivity and skills 3 Background

4 CTPAs Tax and Skills Work Tax and Skills Model Survey on Tax and Skills Education at a Glance Taxing Wages Marginal Effective Tax Rate on Skills Breakeven Earnings Increment Marginal Returns to Costs Ratio Financing of Education Work/ Education at a Glance Tax and Skills Policy Study (2015) Skills Country Reviews (ongoing) Inputs New Indicators Outputs Potential Future Uses Economic Surveys Taxing Wages & Skills, Savings Average Effective Tax Rate on Skills Average Returns to Costs Ratio

5 Full Set of New Indicators Earning Data Used Measure of the Effect of Tax Code Measure of Returns for Government BEI – Calculated Breakeven Earnings Level (just enough earnings to pay for Education) Marginal Effective Tax Rate on Skills (METR) Marginal Returns to Cost Ratio (MRCR) Earnings Increase based on Labour Market data from EAG Average Effective Tax Rate on Skills (AETR) Average Returns to Cost Ratio (ARCR)

Costs and Returns of skills investments shared between individuals (students/ workers) and the government (and firms). Direct Costs :  Individual pays direct costs, tuition fees, net of scholarships & tax expenditures,  Government pays for education institutions, some scholarship payments, costs of tax expenditures. Lost Earnings (often much larger than Direct Costs):  Individual pays in lost (net of tax) earnings while studying/ up-skilling,  Government pays in lost taxes while studying/ up-skilling. Returns:  Individual earns higher after-tax wages,  Government gets higher tax revenue. The tax system apportions the costs and returns between government and the individuals who invest in skills. 6 Apportioning Returns and Costs

Goal: Examine how the whole policy mix affects the decision to invest in human capital: tax rates, tax expenditures, educational funding, and direct costs. A wide range of topics can be analysed: Individual Incentives: If a worker decides to get a Master’s degree, how much will she need to earn to recoup the costs of her investment? Do skills tax expenditures really impact the financial incentives of workers, or are they dwarfed by other considerations such as lost earnings? Are they more or less effective than direct spending? 7 How can the ETR/RCR data be used?

Goal: Examine how the whole policy mix affects the decision to invest in human capital: tax rates, tax expenditures, educational funding, and direct costs. A wide range of topics can be analysed. Government Incentives: How much of state spending on education and training is returned to the government in the form of future tax revenue? How much is captured by the worker? How much of the costs of lifelong learning are borne by the worker? How much are borne by the government? If the government decides to raise tuition fees, can it use the tax code to compensate workers’ incentives to upskill? 8 How can the ETR/RCR data be used?

Overview 1.Introduction & Motivation 2.Methodology 3.Results 9

Overview 1.Introduction & Motivation 2.Methodology a.Breakeven Earnings Increment (BEI) b.Marginal Effective Tax Rates (METR) c.Average Effective Tax Rates (AETR) d.Marginal Returns to Costs Ratio (MRCR) e.Average Returns to Costs Ratio (ARCR) 3.Results 10

We calculate the costs of a marginal skill investment – factoring in costs of tuition, lost earnings and tax credits & deductions for costs of education. We then calculate the Earnings Increment necessary to pay for the investment over the years left working. How much does income need to rise to break-even? Factor in the effects of the tax code – higher earnings needs to pay for higher tax brackets, Tax progressivity can lead to higher tax rates on skills. Calculate the EI for the marginal workers – who is just indifferent between investing and not. Technically, we calculate the income after education such that the NPV of education is equal to zero. 11 Breakeven Earnings Increment

12 BEI Methodology – No Education We consider a worker contemplating a period of education. We assume that without education, her earnings remain constant.

13 BEI Methodology – Lost Earnings The main costs of education come in the form of lost earnings. These earnings are often offset by lower taxes. Sometimes there are special tax provisions for students.

14 BEI Methodology – Direct Costs There are also significant direct costs. The earnings after education must rise to make the overall investment worthwhile.

15 BEI Methodology – Recouping Costs The worker must, over the remainder of her life, earn extra to earn back her costs of education.

16 BEI Methodology – Recouping Opp. Cost She must also earn the returns on some alternative capital investment – say, shares or bonds she could have bought with her education spending.

17 BEI Methodology – The Tax Wedge In addition, she may owe some extra taxes because she is now earning more (because of tax progressivity). But this effect could be offset by deductions, credits etc. for the cost of studying.

18 Endogeneity of Income After Education Tax Paid After Education As the tax code takes more income after education, more must be earned to break even. Earnings after education Higher earnings, in progressive tax systems, means more tax must be paid.

Overview 1.Introduction & Motivation 2.Methodology a.Breakeven Earnings Increment (BEI) b.Marginal Effective Tax Rates (METR) c.Average Effective Tax Rates (AETR) d.Marginal Returns to Costs Ratio (MRCR) e.Average Returns to Costs Ratio (ARCR) 3.Results 19

We calculate the Earnings Increment with taxes - EI(Tax) - and without taxes EI(No Tax). Then, the Marginal Effect Tax Rate on Skills is simply the tax wedge as a share of the Earnings Increment. The Breakeven Earnings Increment (BEI) also adds value as an indicator, when compared to labour market data on what the earnings premium in the labour market really is. Is the Breakeven Earnings Increment, post-tax, actually available to the student in the labour market? Does it pay to go to school? 20 Calculating the METR

21 METR Methodology – The BEI and the ETR In other words, the METR is effectively the Tax Wedge as a fraction of BEI. Or, the answer to the question: “How much of the extra earnings needed to breakeven on a skills investment is because of taxation”

Overview 1.Introduction & Motivation 2.Methodology a.Breakeven Earnings Increment (BEI) b.Marginal Effective Tax Rates (METR) c.Average Effective Tax Rates (AETR) d.Marginal Returns to Costs Ratio (MRCR) e.Average Returns to Costs Ratio (ARCR) 3.Results 22

Marginal Effective Tax Rate on Skills examines the effect of the tax code when the student earns just enough to breakeven on a skills investment. Average Effective Tax Rate on Skills examines the effect of the tax code when the student earns what is available in the labour market. The formula used is the difference between the net present value of education (at a given non-breakeven earnings level) with and without taxes. This is expressed as a share of the discounted extra earnings after education. We use OECD labour market data to calculate the average returns to the student. 23 AETR Methodology

Usually, the returns to education are much higher than the breakeven earnings level. As students earn more, they get pushed into higher tax brackets. Therefore, usually AETR>METR. A better indication of the overall impact of taxes on skills. 24 AETR Methodology

Overview 1.Introduction & Motivation 2.Methodology a.Breakeven Earnings Increment (BEI) b.Marginal Effective Tax Rates (METR) c.Average Effective Tax Rates (AETR) d.Marginal Returns to Costs Ratio (MRCR) e.Average Returns to Costs Ratio (ARCR) 3.Results 25

Just as there are costs and benefits to education for the student, there are also costs and benefits for the government. Calculating these – the NPV of education with respect to the government - gives us a picture of the ‘returns to education’ for the government in the form of future tax revenue. Provides with an indicator of the financial costs and benefits for the government. Does not include non-tax benefits from education for the government e.g. higher growth, lower unemployment, social benefits etc. 26 Marginal Returns to Costs Ratio

27 Who Bears the Costs of Upskilling CostsBenefits Total Direct (private & public) training costs Foregone earnings Higher earnings after upskilling Private (Worker) Direct Costs + Lost post-tax earnings during upskilling - Offset by scholarship Income - Offset by education tax breaks Higher post-tax earnings after upskilling Public (Government) Direct educational spending + Lost tax revenue during upskilling + Cost of scholarships + Cost of educational tax breaks Higher tax revenue after upskilling

The MRCR can be expressed as a ‘ratio of ratios’ of the government and private share of the returns and costs to education: If the government pays a larger share of costs than the share of the returns it receives, then MRCR < 1. If the government receives a larger share of returns than the share of the costs it pays, then MRCR >1. 28 Calculating the MRCR

MRCR higher than 1 --> NPV of costs of upskilling are lower than NPV of returns --> Further spending on training will yield back its cost in tax revenue. MRCR lower than 1--> NPV of costs of upskilling are higher than NPV of returns --> Further spending on training will not yield back its cost in future tax revenue. 29 Marginal Returns to Cost Ratio

Overview 1.Introduction & Motivation 2.Methodology a.Breakeven Earnings Increment (BEI) b.Marginal Effective Tax Rates (METR) c.Average Effective Tax Rates (AETR) d.Marginal Returns to Costs Ratio (MRCR) e.Average Returns to Costs Ratio (ARCR) 3.Results 30

The METR and AETR examined the effect of the tax code on skills incentives for an average or marginal student respectively. Similarly, there is an equivalent ARCR to the MRCR. The MRCR examines the returns to costs ratio for the government from educating a student who just breaks even on a skills investment. The ARCR examines the returns to costs ratio for the government from educating a student who earns an average returns to the skills investment. Again, OECD labour market data are used to calculate returns to the student. 31 ARCR Methodology

Overview 1.Introduction & Motivation 2.Methodology 3.Results 32

33 Four Sample Cases College Education Graduate Education In-Work Training Lifelong Learning Age Length of Education 4 Years1 Year3 Months1 Year Earnings with No Education 70% AW100% AW Earnings During Education 25% AW Job-RelatedNo YesNo Scholarship Income Yes NoYes

34 Limitations and Caveats Technical Limitations – can all be relaxed: Simplified data on costs and scholarships (will greatly improve with next round of education data), No accounting for many financing aspects; student debt, parental spending, firm spending, student credit constraints, No accounting for later labour market consequences of skill investments: changes in unemployment probabilities, changes in participation probabilities, No accounting for how increased skills may result in higher rates of increase in wages (in addition to rises in in wage levels).

35 Limitations and Caveats Limited set of returns modelled – harder to relax accurately: No measurement of non-fiscal positive economic effects of skills investments: on productivity, on growth, on employment, No measurement of positive social effects of skills investments: on health, on crime, on job quality, on well- being, No measurement of some positive exchequer effects: higher indirect taxes from higher spending, lower social welfare payments. Our model almost certainly underestimates both the public and private benefits to education.

36 University education more than breaks even for the average student Compare the breakeven earnings increment to the average college premium available in the labour market. In all countries college is a financially worthwhile investment for the average student in the model. Where existing skill levels are low, the returns to skills are far higher than the BEI. Low BEIs driven by low lost earnings for college students and high levels of scholarship income. Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling. Data for Mexico and the United States are omitted du to data limitations.

37 The tax burden on a marginal college skills investment is low and sometimes negative METRs on college education are modest. Low rates at which breakeven returns are taxed away –breakeven earnings increments are modest, so the increased tax paid on them is modest too. Negative tax rates usually due to low or no taxation of generous grant income. For some countries, tax rates are probably even lower, due to tax subsidies for student debt (that we do not account for in this version). Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling.

38 For an average student, the tax burden on college education is higher, but still modest AETRs on college education are higher than METRs. Labour market returns are higher than the returns for a marginal student, so AETR > METR. Very profitable skills investments face a higher tax rate than less profitable skills investments. These tax rates could be higher than those on physical capital investment. Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling. Data for Mexico and the United States are omitted du to data limitations.

39 Average and Marginal ETRs on College Education are flat or slowly rising in income AETRs and METRs on college education usually rise modestly with income before education. Higher taxes on the returns to education is offset by higher tax subsidies for foregone earnings. In most OECD countries the tax code does not provide significantly higher incentives for higher or lower income students to attend college.

40 Government recoups most of its costs in most OECD countries in income tax revenue We calculate the ratio of returns to costs for governments, based on the average college premium earned by a student, and existing tax and spending levels. For many countries, income tax revenue alone covers the costs of education, often by a significant margin. This does not include positive effects on growth, productivity, employment etc. Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling. Data for Mexico and the United States are omitted du to data limitations.

41 Government recoups most of its costs in most OECD countries in income tax revenue For some countries, the returns to costs ratio is well above one – the projected returns to government far outweigh the current level of government costs (direct spending and lost taxes.  Increased education spending could yield positive returns to the government.  There could also be skills shortages in the labour market. Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling. Data for Mexico and the United States are omitted du to data limitations.

42 Government recoups most of its costs in most OECD countries in income tax revenue For other countries, the average returns to costs ratio is below one. This does not suggest that education is not a worthwhile investment overall. But the fraction of the returns to education accruing to government is below the fraction of the costs borne by government. Data are for a 17-year-old single taxpayer with no children, who undertakes a 4 year course of non-job-related education, earning 25% of the average wage during schooling. They earn 70% of the average wage in the absence of schooling. Data for Mexico and the United States are omitted du to data limitations.

43 Older workers face lower financial incentives to invest in education Older workers of all ages face higher breakeven earnings increments than younger workers. Older workers have fewer years to repay the costs of a skill investment before retirement, so the per- year investment must be higher. This is very challenging from a lifelong learning perspective.

44 The marginal tax burden on in-work training is also low The cross-country distribution of tax rates is more compressed for in- work training than for college education. While METRs on college are reduced through tax exempt scholarship income, METRs on in-work training are reduced more through tax allowances and credits of the costs of training. Data are for a 32-year-old single taxpayer with no children, who undertakes a 3 months course of job-related education, earning 25% of the average wage during schooling. They earn 100% of the average wage in the absence of schooling.

45 Subsidies for training quite significant in size Nearly half of the costs of education can be offset against tax in some cases. For some countries, however, no such provisions exist at all. Taxes reduce costs of education through offsetting foregone earnings and offsetting direct costs. In most countries, cheaper, lengthier forms of training are subsidised more. Data are for a 32-year-old single taxpayer with no children, who undertakes a 3 months course of job-related education, earning 25% of the average wage during schooling. They earn 100% of the average wage in the absence of schooling.

46 Subsidies for training quite significant in size Nearly half of the costs of education can be offset against tax in some cases. For some countries, however, no such provisions exist at all. Taxes reduce costs of education through offsetting foregone earnings and offsetting direct costs. In most countries, cheaper, lengthier forms of training are subsidised more. But for some countries, more expensive, shorter periods of training are subsidised more. Data are for a 32-year-old single taxpayer with no children, who undertakes a 3 months course of job-related education, earning 25% of the average wage during schooling. They earn 100% of the average wage in the absence of schooling.

47 Subsidies for training often regressive, and limited to ‘job-related training’ Tax allowances/credits for the direct costs of training often limited to ‘job-related training’. Ensuring skills spending as consumption is not subsidised. But more tax support is thus provided to those who already have jobs, instead of those without, or those who want to change careers. These provisions are also regressive; more support provided to those with larger tax liabilities.

Bert BRYS, Ph.D. Senior Tax Economist Head Country Tax Policy Team Head Personal and Property Taxes Unit Tax Policy and Statistics Division Centre for Tax Policy and Administration 2, rue André Pascal Paris Cedex 16 Tel: – Fax: || For more information, please contact: 48