The Effect of Labour Taxation on the Employment Level

Sammanfattning: Over the past decade an increase in labour taxation reforms have been observed across several countries. The main target of these reforms has generally been to encourage labour supply among different groups. In the case of Sweden, an earned income tax credit was introduced in 2007 and reinforced in 2008, 2009, 2010 and 2011 as a measure to deal with the high unemployment level. The relationship between labour taxation and the employment level might thus suffer from bias due to reverse causality. This paper examines the relationship between the income taxation rate and the employment level in Sweden, using panel data of Sweden’s municipalities over the time period 1993-2013. To overcome the endogeneity problems, an Instrumental Variable model has been used where the averaged neighbouring municipalities’ tax rates act as an instrument. The results suggest that the income taxation rate has a negative effect on the employment level, where the Instrumental Variable model presents an almost twice as high effect in comparison to the OLS results.