The tax wedge on labour – i.e. the burden of taxes and social security contributions on labour income – is a frequently discussed topic. For Germany, this tax wedge is relatively large by OECD standards. A large tax wedge reduces incentives to work, thus potentially exacerbating the challenges an economy faces from skilled labour shortages and demographic ageing. 

A closer look at the OECD’s tax wedge on labour, however, reveals a fairly mixed picture. Insofar as a higher pension contribution payment, say, results in a greater pension entitlement (contribution equivalence), that payment is more akin to an investment in a compulsory pension scheme because, while it reduces the insured person’s take-home pay, just like a tax, it also increases their pension entitlements. If that person factors this into their considerations, the pension contribution dampens their incentives to work to a lesser degree. A clear and reliable link between contributions and benefits is important in this regard. 

This article decomposes the labour tax wedge ratio into a retirement savings component and a tax component. It does so by determining the portion of the tax wedge ratio attributable to pension contributions that are closely linked to benefits (equivalent pension contributions) – this constitutes the retirement savings component. The remainder of the labour tax wedge ratio then represents the tax component.

In many countries, including Germany, the tax component of the tax wedge ratio is markedly smaller than the total tax wedge ratio. This is because the retirement savings component of the tax wedge ratio is substantial in most cases on account of the fact that equivalent pension contributions have considerable weight. On average across the countries analysed, these are estimated here at 15 percentage points. Germany ranks around average in this regard. The tax component of the tax wedge ratio is thus relatively high by international standards, just like the total tax wedge ratio. 

Equivalence-oriented pension contributions are estimated here based on OECD data using a schematic and highly simplified method. It would therefore be wrong to read too much into the quantitative results, and the method may be refined going forward. What the article does illustrate, though, is that the retirement savings component of the tax wedge is sizeable in many countries. Therefore, examining the total tax wedge ratio alone does not paint the full picture. This aspect merits greater attention in economic policy analyses.

The OECD reports data on tax wedges on labour, which attract a great deal of attention. In Germany, the tax wedge is relatively large (see Chapter 2). Much of the tax wedge is made up of equivalent pension contributions, i.e. pension contributions that are based on a close link between contributions and benefits. These pension contributions are often more akin to an investment in a compulsory pension scheme than a wage tax payment. Equivalent pension contributions are intended to dampen incentives to work to a lesser degree than taxes (see Chapter 3). Cross-country comparisons of tax wedges need to take this difference into account so that the tax component of the tax wedge can be captured in a more nuanced manner.

This article splits the OECD labour tax wedge ratio into a tax component and a retirement savings component 1 by applying a simple schematic method (see Chapter 4). The starting point for this exercise is the tax wedges on labour reported by the OECD. A schematic method is used here to decompose these tax wedges into two components. These are, first, a retirement savings component of the pension contribution, i.e. the part of the pension contribution that grants old-age retirement benefits based on contribution equivalence, and, second, a tax component of the tax wedge ratio, which is calculated by deducting the retirement savings component from the total tax wedge ratio. 

The OECD calculates the tax wedge on labour income for different types of household, where the tax wedge is defined as tax and social security payments as a proportion of labour costs. 2  

In OECD comparisons, Germany ranks as a country with a relatively large tax wedge. 

When macroeconomic aggregates, rather than certain types of household, are compared to one another, Germany still counts among the countries with larger tax wedges. Germany does fare better in terms of its ranking, though (see Chart 3.2). According to the European Commission, Germany’s implicit tax on labour income as a percentage of total compensation of employees is slightly above the middle of the table, ranking eighth. This macroeconomic indicator is not calculated by the OECD. In methodological terms, it differs from the calculations presented above with regard to the components that it takes into account. 6 In addition, macroeconomic statistics involve different factors to the selected OECD household types. For one thing, the European Commission’s indicator is income-weighted across all households. For another, special tax deductions are also fed into the indicator, including the deduction options that are not captured in the standardised types of household and that are attached to certain conditions. The analyses presented below do not examine the macroeconomic indicator in any further detail. One reason is that the national accounts do not disaggregate social contributions by type of insurance for every country, which would be necessary for that exercise to work. In addition, as the OECD country comparisons often attract particular public attention, this article will focus on the OECD data.

The composition of the tax wedge in taxes and social security contributions differs significantly between the countries (see Chart 3.3). This is due, not least, to historical reasons. For example, Anglo-Saxon and Scandinavian countries, in particular, primarily finance their social security benefits through taxes. Other European countries, by contrast, finance their social security benefits to a greater extent via social security funds. Supplementary private pension products are also regulated and incentivised differently from country to country. However, these are not included in the tax wedge and are therefore not considered here.

Germany finances its social security system through social security contributions to a significantly higher degree than average. The burden of social contributions for a single person in Germany earning an average income is 33½%, which is markedly above the average of 27½% for the OECD countries under review. The burden of wage taxes in Germany, at 15 %, is more in the middle of the range and less significantly above the OECD average of 14 %.

Some portions of social security contributions are akin to a wage tax, and the negative effect of wage taxes on individual incentives to work has been plausibly demonstrated. 7  For individual taxpayers, paying wage taxes does not directly result in individual benefits. To a certain degree, this also applies to some social security contributions. In Germany, for example, statutory health insurance and social long-term care insurance are more akin to a tax for contributors, with the insurance benefits being independent of the amount of contribution payments – except in the case of sick pay. As contributions increase with rising wages up to the contribution assessment ceiling, this reduces the incentives to earn more (for example by working longer hours). 8  

By contrast, other social security contributions are more akin to investments in compulsory savings schemes. They should have less of a negative impact on incentives to work. This is the case if contributors can expect the amount of benefits they receive to be proportional to the size of their contributions. 9  For contributions to the statutory pension and unemployment insurance schemes, it is often the retirement savings and insurance aspects that dominate. Higher contributions increase entitlements to pension payments and wage replacement benefits in the event of unemployment (contribution equivalence). However, in order for this to be factored into the insured persons’ decision-making process, they need to actually be aware of these (additional) entitlements and consider them to be reliable; they need to regard the greater entitlements as a useful form of retirement savings or insurance. 

The tax wedge ratios of the individual countries are broken down into the two aforementioned components. The first is the savings component, which is more akin to an investment in an obligatory pension scheme than to a tax. The second is the tax component of the tax wedge.

The approach to the decomposition is based on simplifying assumptions. 

The calculations here are based on OECD data on pension contribution rates and gross replacement rates. The OECD calculates the gross replacement rates for a person entering the labour market at the age of 22 in 2022. This person works up to the applicable statutory retirement age and always earns the average income – or the higher or lower income of their respective type of household. In the case of Germany, for instance, this means that additional pension credit for periods of particularly low income, such as during training or education, are ignored. Where pension reforms were sufficiently specified at the time of calculation, the OECD has taken them into account. The macroeconomic assumptions necessary to calculate future pension entitlements (such as wage growth) are uniform across all countries. Mortality rates, by contrast, are country-specific.

All in all, the quantitative results should be interpreted with caution. 12 This article contributes to a more differentiated classification of tax wedge ratios. However, the methodology has constraints and limitations. For example, in the simplified method, pension contributions are decomposed into a tax component and a retirement savings component based solely on the extent to which they are equivalence oriented. The approach does not, for instance, take account of the potential returns that may be generated by mandatory pension contributions. 13 Returns perceived as too low will increase the tax character of these contributions. 14  An important role is also played by the extent to which contributors trust the pension system. Crucial factors here are the sustainability and credibility of the pension system. Overall, individual insured persons are likely to have very different perceptions of its advantages. For example, there will be employees with lower retirement savings requirements, for example if they have lower life expectancy or other means of financing their retirement. Furthermore, preferences regarding current consumption or alternative forms of savings will presumably not generally align entirely with the statutory pension insurance scheme – for example, if insured persons wish to purchase real estate as part of their retirement provisions. As far as incentives to work are concerned, the way pension benefits interact with any basic allowance is also significant. The number of years of contributions that are required to acquire any entitlement at all is also important. Such additional aspects were not able to be included with the method used here. However, they could potentially be taken into account in future in-depth analyses, for example in international comparisons conducted, say, by international organisations.

The OECD data show that the gross replacement rates of the pension systems in individual countries vary considerably in some cases (see Charts 3.4 and 3.5 for selected European countries and the United States). 

In most cases, however, the approach reveals large retirement savings components in pension contributions (see Chart 3.6). In other words, the tax component of pension contributions in many countries is considered to be low. Pension contributions in the German system are comprised largely of the retirement savings component, too. 

Given the mostly large retirement savings component of pension contributions, the tax component of the tax wedge is significantly smaller than the total tax wedge in many countries – the ranking of the countries is also markedly different in some cases (see Chart 3.7 and Chart 3.8). On average across the countries under review, the tax component of the tax wedge is 15 percentage points lower than the total tax wedge (not weighted). It thus falls from 41½% to 26½% for single persons and from 29½% to 14½% for four-person households with one earner. 15 In Germany, the tax component of the tax wedge is also 15 percentage points lower than the total tax wedge ratio. Germany’s cross-country ranking with regard to the tax component of its tax wedge therefore also remains relatively high. 

The tax wedge on labour is an important indicator, not least in terms of individual incentives to work. For example, wage taxes reduce the incentives to take up employment, increase working hours, or seek a better-paid job by means of higher qualification. 

In order to classify the tax wedge as adequately as possible, account would need to be taken of the fact that parts of social security contributions can be viewed more as mandatory provisions. Such contributions differ from wage taxes and should have less of a negative impact on incentives to work. If contributions to a pension insurance scheme are closely linked to benefits based on contribution equivalence, they are more akin to investments in a compulsory pension scheme. Although this initially reduces take-home pay, larger contributions grant entitlement to higher benefits in the future. 

In most countries, the tax components of tax wedges without equivalent pension contributions are significantly smaller than the total tax wedge. Equivalent pension contributions are important in many countries. On the basis of a simple schematic method, this article estimates that, on average across the OECD countries under review, old-age provision based on contribution equivalence corresponds to 15 percentage points of the total tax wedge ratio. The tax component of the tax wedge ratio is thus 26½% for single persons (total tax wedge ratio: 41½%) and 14½% for couples with a single earner and children (total tax wedge ratio: 29½%). 

In Germany, too, the tax component of the tax wedge ratio is significantly smaller than the total tax wedge ratio. The gap roughly corresponds to the average of the countries under review. Here, the tax component of the tax wedge ratio and the total tax wedge ratio are above average by international standards. This particularly applies to single persons and households with two earners. For multi-person households with one earner, Germany’s position in the ranking is more favourable. 

A nuanced analysis of tax wedge ratios makes an important contribution to enabling better interpretation of tax wedges. This applies both to purely national analyses as well as to international comparisons. As described above, the tax components of the tax wedge ratios for each country and across countries are markedly different from the total tax wedge ratios in some cases.

In this context, particularly given the highly simplified approach, the quantitative results presented here should be interpreted with great caution. Future analyses could further improve the informative value of tax wedge ratios. For instance, international organisations could use their comparative advantage and break down the ratios in more detail when carrying out comparative analyses. Notably, the degree of contribution equivalence in the calculations presented here is measured in a simplified manner using the coefficient of variation for three levels of earnings. Irrespective of these simplifications, contribution equivalence is also only an imperfect measure of the retirement savings component. Beyond the aspect of contribution equivalence, further analysis could, for example, take a closer look at what returns can be expected from pension systems. In addition, other branches of social security could be included in the analysis.

Insured persons’ confidence in the long-term sustainability of the pension system is crucial – it is necessary for pension contributions to actually be perceived as retirement provision rather than tax. Against this backdrop, policymakers are well advised to ensure that the system is financially sustainable and to evidence this using long-term projections. Insured persons should also be provided with enough information on their future entitlements and how they relate to their contributions. For countries with pay-as-you-go systems, a sound macroeconomic path is particularly important. The macroeconomic path is the main determinant of the amount of pension entitlements granted by contributions. Economic and fiscal policymakers are thus also called upon to ensure favourable business conditions and growth prospects in their countries.

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