Taxing differently: How working more hours can pay off

10/06/24

Everyone agrees that the (Dutch) tax system needs to change. That working more hours should pay off. That it should be clear what a change in your working hours actually means for your income. These wishes are also included in the outline agreement of the PVV, BBB, VVD and NSC, and in various recent government reports such as ‘Taxes in a social perspective: Building blocks for a better and simpler tax system’ and ‘Final report on the Future of the Benefits System’.

But how can you achieve this? We have been unable to solve this within the existing frameworks for decades. Either a measure solves nothing, or the measure costs tens of billions. So we have to think outside the box.

The labour market shortage is large. PwC previously calculated that the gap between supply and demand on the labour market almost disappears if part-time workers work four extra hours per week. It sounds simple, but it isn't. Working more and therefore having more income can be quite disappointing in the bottom line. The marginal pressure, which is the tax rate you pay on your last earned euro including loss of benefits, is high and also non-transparent. It can be up to 92% (2024), which means that you only keep 8 cents net of every extra euro earned. There is hardly any financial incentive for many people to work more. In addition, whether you earn 50,000 euros per year in two or five days of work per week; you have the same amount of net income. Even though those who work five days a week contribute much more to solving the social problem of the labour market shortage.

Hourly wage leading

PwC proposes a system in which the tax rate is no longer linked to the total annual income, but to the level of the hourly wage. In this system it does make a difference whether someone earns their annual salary in two or five days of work per week. Because the person who works only two days has more 'potential earning capacity'. And may have room to work more days.

The system is basically as follows:

A progressive rate based on the hourly wage. In other words, the higher your hourly wage, the higher the tax percentage.
A declining rate based on the number of working hours per week (deployment of earning capacity). In other words, the tax percentage always decreases slightly if you work more hours per week and therefore provide more labour. This means that you pay less tax on the second day than on the first day, less on the third day than on the second day, etc.

In concrete terms, the percentages and cohorts below can be used. For now, these have been roughly determined and will need to be determined more precisely in further elaboration.

A degressive tax rate based on the number of working hours per week (the second bullet) reduces the marginal tax burden and working extra hours will always yield more, both absolutely and relatively. In such a system, it is not only your actual income that determines the tax burden, but also the number of hours in which you earn this income. The person who earns 50,000 euros per year in two days per week (high hourly wage and low percentage of deployed earning capacity) therefore pays more tax than someone who earns 50,000 euros in five days per week (lower hourly wage and higher percentage of deployed earning capacity).

Marginal pressure decreases

If we compare the above system with the current system (the brown line in graph 1), we see that the marginal pressure is lower compared to the current system if people work two (in most cases) or more days a week. This can provide an incentive to work more hours per week and thus reduce the labor market shortage.

In the current system (the brown line), allowances and the income-related combination discount have been removed in order to zoom in on the tax burden. The line of the current system shows the marginal pressure on your extra euro earned. In the proposed system, the graph shows the marginal pressure approximately if you work one extra hour. When you increase your working hours, you shift to an underlying line, so for example when you go from working 24 hours to 32 hours per week, you shift from the yellow to the red line.

In the new system, the strongest shoulders - those with high hourly wages - still bear the heaviest burdens. This is especially true if they make little use of their earning capacity. Naturally, when detailing this proposal, you can take into account the fact that people not only spend their time on paid work, but also on other socially valuable matters such as family care and education. For example, by taxing both the fourth and fifth working days equally favourably. Moreover, it can tempt both partners to take on (more) equal amounts of work and care responsibilities. And that is important, because a review of the CPB states, among other things, that social norms - even more than marginal pressure - ensure that many Dutch people work part-time.

Out-of-the-box solutions needed

Let us no longer use only annual income as a basis for income tax. By varying income tax based on both hourly wages and the number of hours worked per week, the marginal tax burden decreases. Our proposal creates an individual financial incentive to work more. This can reduce the labor market shortage and make the tax system more balanced. And of course we must pay attention to transition problems, special situations, people's capability and bottlenecks in implementation. Our call is therefore: be more creative and innovative with the revision of our tax system in relation to the labour market. And consider both the hourly wage and the earning potential. Because continuing to tinker with the current concept, as we have been doing for decades, simply does not work.

A short version of this text appeared in the FD on June 10th.