Taxes and Labour Supply Theory, Evidence and Policy David Phillips (IFS). Outline. The Basics: Income, Substitution and Deadweight Loss Enriching the Model: Fixed costs and more 3. Measurement Issues: Econometric Problems 4. A Review of the Emprical Evidence
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Theory, Evidence and Policy
David Phillips (IFS)
Higher tax rate reduces net income. If leisure is a normal good this reduces demand for leisure and increases Labour Supply.
Higher tax rate reduces the marginal wage and hence the price of an extra hour of leisure. This acts to decrease Labour supply.
Tax has an ambiguous effect on Labour Supply
And Cutting Basic Rate to 20p
Old Tax Schedule
What about Labour Supply??
New Tax Schedule
And Cutting Basic Rate to 20p
The uncompensated elasticity determines revenue:
Change in Revenue ≈ (1- εm)*(%Δ(1-t)w)*w*h*t
Here a tax rise increases revenue but if labour supply is elastic would see a fall in revenue.
When substitution occurs there is always deadweight loss. It is determined by the compensated elasticity.
Now imagine a tax cut. The model predicts some not working will enter work and do 1 or 2 hours per week.
But we don’t observe this... Why?
When you start work there are certain fixed costs:
Transport costs Work clothing costs
Childcare costs And others
Fixed costs mean not working better than working few hours -provided leisure and income are both ‘goods’
The welfare system (benefits and tax credits) mean that people on low incomes can face very high effective marginal tax rates. This ‘non convexity’ causes similar discontinuous labour supply responses.
Introducing non-convexities (e.g. WFTC) can encourage ‘jumps’ in labour supply (e.g. From 10 to 30 hours)
Family as a group of individuals who engage in (pareto-efficient) bargaining. This group of model allows one to extend models from just labour supply to looking at intra-household allocations of welfare.
hi = f(wi,wj, t, b, yi, yj, fi, fj, c, r)
t = tax system b = benefit system
f = fixed costs r = real interest rate
Analysis of Labour supply can’t be done by a simple OLS regression of hours on wages because of the complexity of the budget constraint and substitution over time and within the household.
H = α + βW + γY
.. are less for lone parents for 8 – 16 hours.
WTC reduces average hours, offsetting extra tax credits. Increased disregards also encourage 16 – 30 hours work, increasing average hours and earnings.
C. Meghir & D. Phillips (2008) – Labour Supply and Taxes
K. Bell, M. Brewer & D. Phillips (2007) – Lone Parents and Mini-jobs
Aaberge, Colombino, Strom (1999) "Labour Supply in Italy: An Empirical Analysis of Joint Household
Decisions with Taxes and Quantity Constraints", Journal of Applied Econometrics, Vol 14. No 4.
Ashenfelter & Heckman (1974) "The Estimation of Income and Substitution Effects in a model of Family Labor supply", Econometrica, Vol 42, No 1
Blomquist & Newey (2002), "Nonparametric Estimation with Nonlinear Budget Constraints", Ecometrica, Vol. 70, No. 6
Blundell, Duncan, Meghir, (1992), "Taxation in Empricial Labour Supply Models: Lone Mothers in the UK", The Economic Journal, Vol 102, No 411
Blundell, Duncan, Meghir (1998) "Estimating Labor Supply Responses using Tax Reforms, Econometrica, Vol 66, No 4
Bourguignon & Magnac (1990) "Labor Supply and Taxation in France", The Journal of Human Resources, Vol 25, No 3
Cogan (1981), "Fixed Costs and Labor Supply", Econometrica, Vol 49, No 4
Feldstein (1995), "The Effects of Marginal Tax Rates on Taxable Income: a Panel study of the 1986 Tax Reform Act", Journal of Political Economy, Vol 103, No 3
Goolsbee (1999) "Evidence on the High-Income Laffer Curve from Six Decades of Tax Reform", Brookings Papers on Economic Activity, Vol 1999, No 2
Gruber & Saez (2000) "The Elasticity of Taxable Income: Evidence and Implications", NBER Working Paper Series
Hausman (1981), Labour Supply: How Taxes affect Economic Behaviour", Tax and the Economy, Brookings Institute