Tax Wedge

Published Oct 26, 2023

Definition of Tax Wedge

A tax wedge is the difference between what employers pay for an employee’s labor and what the employee receives in take-home pay. This difference includes both the employee’s income tax and the employer’s portion of any social security or payroll taxes. The tax wedge can be seen as a burden on both the employer and the employee.

Example

Let’s take the example of an employee who earns a monthly salary of $3,000. The employer is required to deduct income tax, social security tax, and any other applicable payroll taxes from the employee’s salary. In this case, let’s assume the income tax rate is 20% and the social security tax rate is 8%.

The employee’s take-home pay after deducting these taxes would be:
$3,000 – (20% * $3,000) – (8% * $3,000) = $3,000 – $600 – $240 = $2,160.

On the other hand, the total cost to the employer for hiring this employee would be:
$3,000 + (8% * $3,000) = $3,000 + $240 = $3,240.

Therefore, the tax wedge in this example would be the difference between what the employer pays ($3,240) and what the employee receives ($2,160), which is $1,080.

Why Tax Wedge Matters

The tax wedge plays a significant role in determining the cost of labor for both employers and employees. It has implications for employment rates, wage levels, and the overall competitiveness of the labor market. High tax wedges can discourage job creation, as employers may find it costly to hire new employees. On the employee side, a high tax wedge can reduce the incentive to work and take home a smaller portion of their earnings. Policy-makers often consider the tax wedge when designing tax and labor market policies to ensure an optimal balance between government revenue and economic growth.