Distortionary Taxation and Labor Supply

By Cardia, Emanuela; Kozhaya, Norma et al. | Journal of Money, Credit & Banking, June 2003 | Go to article overview

Distortionary Taxation and Labor Supply


Cardia, Emanuela, Kozhaya, Norma, Ruge-Murcia, Francisco J., Journal of Money, Credit & Banking


THIS PAPER examines empirically the effects of distortionary taxation on labor supply. The analysis is carried out using a general equilibrium model where public consumption can act as partial substitute of private consumption and taxes are paid on labor income. At the theoretical level, it is clear that because utility maximization equates the marginal rate of substitution of consumption and leisure to the real wage, labor taxation alters the agents' choice by reducing their take-home real wage. Since the government's intertemporal substitution of debt for (distortionary) taxes can affect the agents' consumption and labor supply decisions, Ricardian equivalence fails (see Barro, 1989, Trostel, 1993, Cardia, 1997). Although some researchers suggest that, for a given level of fiscal spending, distortionary taxation has only second-order implications (see, among others, Barro, 1989), the question of whether the magnitude of the effects just described is economically and statistically important is primarily an empirical question.

That distortionary taxation could affect labor supply is suggested by Figure 1, which plots the labor income tax rate and the number of hours worked per person per week in Canada, United States, Germany, and Japan. (1) Notice that the upward trend in the tax rate is mirrored (almost literally) by a downward trend in hours worked. While other causes, like sustained technological progress and demographic shifts, could also account for the reduction in the number of hours worked, Figure 1 is certainly provocative and motivates the inquiry of this paper.

[FIGURE 1 OMITTED]

More generally, the analysis of distortionary taxation is important for several reasons. First, alternative methods of public financing are associated with different levels of social welfare. Cooley and Hansen (1992) quantified the costs of various forms of taxation and find that replacing labor-income with lump-sum taxes reduces the welfare loss by 5.2% of GNP compared with a benchmark model that represents current U.S. tax policy. Ohanian (1997) compared war financing by debt or taxes and concludes that had World War II been financed solely with distorting capital and labor taxes, the welfare loss would have been approximately 2% of steady-state GDP. Second, the effect of government purchases might depend on whether they are financed by means of lump-sum or distortionary taxes. Baxter and King (1993) found that the government spending multiplier is positive when expenditure is financed by lump-sum taxes but negative when financed by distortionary taxes. Finally, taxes can be an important source of economic disturbances and/or play an important role in the transmission of shocks. For example, McGrattan (1994) found that 27% (4%) of the variance of output is explained by innovations to the labor (capital) tax rate.

In related research, Stuart (1981) constructed a two-sector model where labor taxes are paid on income earned in the market' sector. The calibration of the model to the Swedish economy indicates that increasing the marginal tax rate from 58 to 65% reduces labor supplied to the market sector by between 1.8% and 2.5% depending on the scenario considered. Braun (1994) showed that introducing distortionary taxes in a real business cycle (RBC) model improves its ability to reproduce features of the U.S. economy like the variability of hours worked and the weak correlation between real wages and employment. He suggested that substantial intertemporal substitution effects in the labor supply decision may be the result of changes in taxes.

The papers mentioned above employ as analyticals tool different versions of the neoclassical growth model and provide evidence primarily in the form of simulations of the model economy. Rather than using calibration to assess the relevance of taxation on labor supply, this paper derives and tests the empirical predictions of the general equilibrium model. …

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