work efforts, as effective marginal tax rates are relatively high due to the withdrawal of income dependent tax credits. With respect to undeclared work there are also positive and negative effects so that the net effect is ambiguous: The creation of more regular jobs will reduce informality and evasion while the higher effective marginal tax rates for some income groups tends to increase under-decaration of regular earnings in order not to lose benefits. Higher income earners who benefit from the new caps on social security contributions face lower marginal tax rates and have therefore fewer incentives to under-declare earnings. But the reforms do little to address the problem of low tax payments by the self-emploed.

76. The system of tax collection is particularly cumbersome in the Czech Republic, which may also contribute to tax evasion. **According to the World Bank’s Doing Business report, a typical firm in the Czech Republic needs 930 hours per year for the compliance of taxes.** This is the worst performance among the NM-EU countries and brings the Czech Republic to the seventh lowest rank of the all the 181 countries covered in this report. The government is responding to this problem and is now preparing a reform of tax collection in cooperation with the World Bank aiming at unifying the collection of general taxes, custom duties, and social insurance contributions, which should help to considerably ease tax compliance.

# **9. Employment Tax Credits Provide Incentives to Take up Declared Work but Disincentives to Increase It**

77. As part of a strategy of **“Making Work Pay”** , some countries inside and outside the region are granting an employment tax credit (such as the employment tax credits in Hungary, Sweden and the Netherlands, the US Earned Income Tax Credit, and the UK Working Family Tax Credit). This measure directly reduces the income tax (or in the Netherlands also the social security contribution) liability of workers and can be designed as ―refundable‖ or ―nonrefundable‖. If refundable, the worker receives the positive difference between the amount of the tax credit and of the tax liability in cash while with a non-refundable tax credit he/she can (at the maximum) reduce his tax liablility to zero. The tax credit is generally proportional to gross earnings up to a maximum amount and is – after a threshold – gradually withdrawn.

78. As the tax credit increases the after-tax income difference between working in the formal sector and not working or working informally, it provides an incentive to work in the formal sector. As in most of the new EU countries, labor taxes are relatively high even for low wage earners who are most vulnerable to informality; an employment tax credit could be an effective measure to combat informality. However, a generous employment tax credit can lead to high fiscal costs and also to high deadweight costs as those workers who are already working in the formal sector also benefit. Furthermore, as the tax credit is generally phased out at higher incomes, it raises the marginal effective tax rate (which is composed of the marginal labor tax rate and the benefit withdrawal rate) for incomes, which are affected by the phasing-out, which creates disincentives to increase work efforts and incentives to underdeclare earnings in order to (fully) benefit from the tax credit. The risk of excessive marginal tax rates is biggest in countries where the labor tax wedge at low incomes is high so that the withdrawal of the tax credit can lead to extremely high effective marginal tax rates. For example, in Hungary the gradual withdrawal of the tax credit increases the effective marginal 32