Executive Summary
This analysis evaluates the macroeconomic impact of expanding social protection (unemployment benefits) in Turkey by 33%. Using a micro-founded DSGE model calibrated to the Turkish economy, we find that financing methods determine policy success.
- Labor Tax Financing (The "Death Spiral"): Attempting to fund benefits via labor taxes causes the formal sector to collapse. The model identifies a "Fiscal Cliff" at a 40% tax rate.
- VAT Financing (The Viable Path): A Consumption Tax (VAT) increase from 18% to 20.6% successfully funds the program with significantly less damage to employment.
1. Country Context: The Turkish Economy in 2024-2025
To understand the simulation results, it is essential to situate them within Turkey's current macroeconomic reality. The economy is currently navigating a "rebalancing" phase characterized by several structural rigidities:
- Dual Labor Market & Informality: Turkey operates with a persistent duality. A highly regulated formal sector coexists with a large informal sector, which employs roughly 30% of the workforce. This informal sector acts as a massive "outside option" for workers, making formal employment highly sensitive to tax hikes.
- Low Labor Force Participation: Turkey has one of the lowest female labor force participation rates in the G20 (approx. 37%), limiting the potential tax base compared to peer economies.
- High Tax Wedge: The tax burden on formal labor (income tax + social security contributions) is high relative to OECD standards. This creates a disincentive for firms to hire formally, pushing activity underground.
- Fiscal Tightening: Following the 2023 earthquakes and the shift back to orthodox monetary policy, the government is currently pursuing fiscal consolidation. Deficits remain a concern (projected ~3.6% of GDP in 2025), meaning any new social spending must be strictly self-financed.
2. The Challenge: Modeling the Turkish Context
Standard macroeconomic models fail to capture these specific Turkish frictions. We used a Two-Agent New Keynesian (TANK) model with dual labor markets and search frictions. The key constraint is the worker's outside option:
$$ W_F (1 - \tau_{labor}) = (1-\beta)(W_I + \text{Benefits}) + \beta MPL_F $$If labor taxes (\(\tau_{labor}\)) rise, the net formal wage falls relative to the informal option, causing workers to exit the formal sector. This mechanism is central to the "Fiscal Cliff" finding.
3. The Fiscal Cliff: Why Labor Taxes Fail
Our simulation swept the labor tax rate from 0% to 70% to identify the economy's revenue capacity.
This confirms that Turkey has almost zero fiscal space to raise labor taxes. Any attempt to fund new benefits this way pushes the economy over the cliff (Unemployment > 40%).
4. The Solution: Consumption Tax (VAT) Financing
We tested an alternative financing mechanism: raising the VAT. Because VAT taxes consumption (spending) rather than production (hiring), it creates a broader, less distortive tax base.
While labor tax financing failed (gap remained), the model successfully balanced the budget by raising VAT from 18% to 20.6%.
Comparison of Financing Options
| Metric | Baseline | Labor Tax Fund | VAT Fund |
|---|---|---|---|
| Unemployment Rate | 21.0% | 41.9% (Collapse) | 25.4% (Manageable) |
| Deficit Gap | - | Huge (Unfundable) | Zero (Balanced) |
| Required Rate | - | > 40% (Impossible) | 20.6% (Feasible) |
5. Validation with International Research
The findings of this DSGE model align closely with recent empirical research and policy advice from major international financial institutions regarding the Turkish economy.
Alignment on Labor Taxes & Informality
The model's identification of a "Fiscal Cliff" for labor taxes is supported by the IMF's 2025 Article IV Consultation. The IMF explicitly warns against raising rates on the already-burdened formal workforce, recommending instead to "broaden the tax base" and "rationalize generous tax expenditures" to avoid discouraging formal employment. Similarly, the World Bank identifies high labor costs and rigid regulations as primary drivers of informality, noting that strict regulations often hurt the very workers they intend to protect.
Alignment on VAT Efficiency
The model's finding that VAT is the only viable self-financing option mirrors the OECD's Economic Survey of Türkiye (2025), which argues that "improving public finances will require more efficient consumption taxes" and harmonizing VAT rates. The IMF similarly advises simplifying the VAT structure to generate revenue without the productive distortions of labor taxes.
Alignment on Structural Unemployment
Our simulation showed that increasing benefits led to higher unemployment rather than just a flow to the informal sector. This matches World Bank research on labor cost shocks (such as the minimum wage hikes), which found that such shocks often lead to firm destruction and inactivity rather than a simple migration to informal employment.
6. Policy Recommendations
- Reject Labor Tax Increases: Do not finance social protection by increasing the tax wedge on formal labor. The formal sector is too fragile and the informal outside option is too attractive.
- Adopt Broad-Base Consumption Taxes: If self-financing is required, a 2.6 percentage point increase in VAT is the only macro-economically viable option found in this analysis.
- Mitigate VAT Regressivity: While VAT saves jobs, it taxes the poor's consumption. Policymakers should consider "targeted VAT" (higher rates on luxury goods) rather than a flat hike to balance efficiency with equity.
Sources:
[1.1, 3.5] OECD Economic Surveys: Türkiye 2025.
[1.3] World Bank Country Economic Memorandum: Jobs for Prosperity (2024).
[1.5] IZA World of Labor: The labor market in Turkey, 2000-2024.
[3.1] IMF Staff Concluding Statement of the 2025 Article IV Mission.
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