Taxes and Labour Supply:
Theory, Evidence and Policy
David Phillips (IFS)
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Outline
1.
The theory: labour supply elasticities and more
2.
Measuring labour supply responsiveness
3.
How responsive are hours of work and employment?
4.
Beyond hours: taxable income elasticities
5.
Policies: Mini Jobs for Lone Parents
Conclusions
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The Basics
‘Labour Supply’ is the supply of effort and time by individuals
for monetary compensation.
•
Working out revenue implications of tax reforms
•
Working out the ‘optimal’ tax rate structure.
Theoretical and empirical work has traditionally focused upon
hours of work but more recently a recognition of:
•
The participation decision (extensive margin)
•
Effort and Compensation Form
But what basic lessons can we use from Econ 101?
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Income and Substitution Effects
NI
Higher tax rate reduces the
net
income. Ifwage
marginal
leisure
and
is hence
a
normal
the
price
good
of anthis
extra
reduces
hour of
demandThis
leisure.
for leisure
acts toand
decrease
increases Labour
Labour supply.
Supply.
A
A’
A’’
l
H
Substitution
Effect
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Income Effect
Tax has an
ambiguous effect
on Labour Supply
Elasticity of Labour Supply
There are two types of elasticity we are interested in:
•
The uncompensated elasticity (εm)
–
•
Includes both the income and substitution effect
The compensated elasticity (εh)
–
Includes only the substitution effect
When substitution occurs there is always deadweight loss due to
distortions of behaviour
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Elasticity of labour supply: effect on revenues
When a single tax rate, the uncompensated elasticity
determines revenue:
Change in Revenue ≈ (w*h Δt ) – (εm*w*h/(1-t))*(Δt+t)
NI
Initial
Revenue
New
Revenue
A
A’’
l
H
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Elasticity of labour supply: effect on revenues
The
elasticity determines revenue:
Theuncompensated
Laffer Point:
Change in Revenue ≈ 0  (1 – t) = tεm
Change in Revenue ≈ (w*h
Δt )=–1/(1+ε
(εm*w*h/(1-t))*(Δt+t)
 tmax
m)
NI
More complicated
when multiple rates
and bands: need to
know income,
compensated
elasticities and shape
of income distribution
A
A’’
l
H
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Elasticity of labour supply: tax incidence (1)
Labour supply
Labour demand
Wage
Tax
increase
Labour supply / demand
•
Inelastic labour supply: change in taxes = change in net wages
•
Taxes borne entirely by the workers
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Elasticity of labour supply: tax incidence (2)
Labour supply
Borne by purchaser
Borne by worker
Wage
Labour demand
Tax
increase
Labour supply / demand
•
Elastic labour supply: change in taxes > change in net wages
•
Taxes partly shifted onto those purchasing labour
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Distribution of working hours
Distribution of Male Hours (Aged 22 - 59, Employees Only)
20
18
16
14
Percentage
12
Percentage
of Male
Workers
10
8
6
4
2
1
4
8
11
14
17
20
23
26
29
32
35
38
41
44
47
50
53
56
59
62
65
68
71
74
78
81
0
Hours
Few people work only a small number of hours. Instead,
concentrations at zero or “full time”. Why?
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Adding Fixed Costs of Work
When you start work there are certain fixed costs:
Transport costs
Childcare costs
Work clothing costs
And others
NI
Fixed costs
mean not
working better
than working few
hours
A’
A
l
H
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So the theory tells us…
•
Income and substitution effects go in opposite directions
–
•
•
Uncompensated labour supply elasticity measures overall effect
Higher elasticity of labour supply means
–
More deadweight loss
–
Lower revenue
–
More of the tax shifted from workers to those buying their labour
More to modelling labour supply than measuring
elasticities as labour supply ‘jumps’ discretely
What about measuring the effect of taxes on labour supply?
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Econometric Issues (1)…
You have data – a cross section of hours, wages and
demographic characteristics. But theres a problem...
People have different preferences for work/leisure.
• Those who like work are likely to work longer hours.
• They are also likely to work harder, engage in training more, have tried harder
at school and are probably more able.
Spurious positive correlation between hours and wages
• If taxes exhibit increasing marginal rates, those working longer hours will face
higher marginal rates and have lower net wages.
 Spurious negative correlation between hours and wages
We call such problems the ‘endogeneity problem’.
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Econometric Issues (2)…
Solutions:
• Use time series changes in wages (potentially a panel data series).
•Preferably have exogenous reforms – e.g. Reduction of top rates of income
tax, introduction of E.I.T.C.
• Remember to control for aggregate preference changes (e.g. social
acceptability of women working).
E.G Blundell, Duncan & Meghir (1998)
• Avoid modelling the complex tax system by using only women paying basic
rate (nearly linear budget constraint).
• Avoid preference problem by making use of changes in income distribution
and tax reform in the 1980s.
• Makes use in differential changes in post-tax wages for different cohorts and
educational groups.
•This allows for differences in behaviour between groups but assumes these
differences are not time-varying
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Econometric Issues (3)…
Solutions:
Treat labour supply as discrete (e.g. full time, part time, not work) and estimate
income at these points using full tax and benefit system.
E.G Meghir & Phillips (2010)
• Men have a 1-0 choice of working or not, with income in work estimated as a
weighted average of income at various hours points.
• Use predicted wages for both non-workers and workers to account for
(spurious) correlation of hours of work and pre-tax wages due to preferences.
• Use the differential trends across regions in wages and housing benefits (out
of work income) as exogenous changes in work incentives making use of
multiple years of data.
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Elasticity Estimates (Female)
Author(s)
Basic Methodology
Estimated Elasticities
Wage: 0.906 – 0.995
Income: -0.121 – - 0.13
Hausman (1981)
Linear labour supply
with convex and nonconvex budget sets
Cogan (1981)
Log-linear labour
Wage: 0.864
supply, fixed costs,
Income: -0.16
linear budget constraint
Blundell, Duncan
and Meghir (1998)
Log-linear labour
supply, fixed costs,
accounts for taxes and
benefits.
Wage: 0.13 – 0.37
Income: -0.06 – -0.19
Aaberge et al
(1999)
Flexible labour supply,
taxes and benefits,
supply and demand
constraints
Wage: 0.654
Income: -0.014
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Elasticity Estimates (Male)
Author(s)
Basic Methodology
Estimated Elasticities
Ashenfelter &
Heckman (1974)
Labour supply linear in Wage: 0.06
differences. No account Income: -0.11
of taxes or benefits
Bourgiugnon and
Magnac (1990)
Linear labour supply,
convex budget with
taxes and fixed costs
Wage: 0.10
Income: -0.07
Blomquist & Newey
(2002)
Non-parametric and
allowance for ‘small’
non-convexities
Wage: 0.06 – 0.08
Income: -0.02
Meghir & Phillips
(2010)
Discrete choice with full ‘Wage’: 0.32 (low educ)
tax and benefit
0.13 (mid educ)
modelling and control
0.03 (high educ)
for endogenous wages
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Other aspects of Labour Supply
So far we have focused on hours but what about other aspects
of labour supply?
• intensity of effort (payment by results)
• effort to seek promotion
• investment in skills, education and complimentary capital
If substitution is easier for effort/investment than for work-hours
 hours elasticities underestimate welfare cost of taxation.
Problem: we cannot measure effort...
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Taxable Income Elasticity (1)
... but we can measure income.
Income reflects both hours of work and effort per hour.
• It is a proxy for total effort.
Two measures:
• Broad Income – reflects changes in effort.
• Taxable Income – reflects changes in effort but also shifts in income from
taxable to non-taxable forms (tax avoidance) and tax evasion.
Reallocation of income also entails welfare costs, and of course, revenue
implications.
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Taxable Income Elasticity (2)
Main method of calculating taxable income elasticities is
difference-in-differences.
• Two groups – one affected by a change in tax rates (H), the other not (L).
Elasticity =
Elasticity =
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difference in % change in income
.
difference in % change in marginal rate
ΔlnEH – ΔlnEL .
Δln(1-tH) - Δln(1-tL)
Taxable Income Elasticity (3)
Problems with this methodology:
• Mean Reversion
E = μ + αt + Xi’β +Uit
Some people in group H likely to have transitory high income, and vice versa.
 Revert to mean: expect high income to fall, low income to rise.
 Estimates of elasticity will be downwardly biased.
• General Equilibrium
Labour of different prices is probably labour of different ‘types’ to some extent.
Increased supply of those benefiting from tax cut (e.g. High skilled) will depress
price of this ‘type’, reducing income.
 Estimates of elasticity will be downwardly biased.
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Taxable Income Elasticity (4)
• Secular Trends in Skills prices
The price of various types of Labour may be changing for reasons other than
tax reforms – e.g. trade or technological change.
 Varies, but in 1980s/1990s, elasticity will be upwardly biased.
• Anticipation effects
If a tax rise (or cut) is announced, people will bring forward (or put back)
income if they have such flexibility – e.g. Bonuses, dividends, capital gains.
Estimates of elasticity upwardly biased unless account for these ‘timing’
effects.
• Re-allocation over the lifetime
People may respond to changes in taxes by changing how they spread their
earnings over their lifetime. Lower tax payments now but higher later.
Estimates of elasticity upwardly biased.
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Elasticity Estimates
Author(s)
Basic Methodology
Estimated Elasticities
Feldstein (1995)
No controls
1.1 (Low Income)
3.05 (High Income)
Goolsbee (1999)
No controls.
- 1.3 to 2.0 depending on
reform.
Gruber & Saez
(2000)
Includes (lagged) log
income, trends and a
10-piece spline.
0.12 (Broad Income)
0.4 (Taxable Income)
0.57 (High) 0.12 (Low)
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The empirical literature tells us…
•
It is difficult to measure the effects of taxes on labour
supply properly
–
Endogeneity plagues estimation of labour supply elasticities and
taxable income elasticities
–
Wages and tax rates are correlated with preferences for work
–
Diff-in-diff assumptions do not hold
•
Labour supply is more responsive for women than men
•
Taxable income elasticities pick up more margins of
adjustment than just hours and find evidence that
response is higher for the very highest earners
Now, lets use a labour supply model to analyse policy…
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Why is lone-parent employment low?
Fewer than 60% of lone parents employed versus about 70% of
mothers in couples:
• Similar number of lone parents working 16+ hours.
• But far fewer lone parents working 1 – 15 hours. Why?
Presently, no incentive to do so:
• Income Support is Tapered away at 100% above earnings of £20 a week.
• Housing Benefit and Council tax have tapers of 65% and 20%. When
combined with income tax, marginal effective tax rates (METRs) of over 95%.
• No working tax credit (WTC) unless you work 16 hours per week.
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£325
£470
£300
£445
£275
£420
£250
£395
£225
£370
£200
£345
£175
£320
With rent and CT
£150
£295
No rent or CT
£125
£270
Second earner
Weekly hours worked
.. are less for lone parents for 8 – 16 hours.
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50
45
40
35
30
25
20
15
10
£245
5
£100
0
Weekly family income net of taxes,
benefits and tax credits, rent and
council tax
The gains from working...
.. and they face high effective tax rates
0.7000
0.6000
Participation tax rate
0.5000
0.4000
0.3000
0.2000
Lone Parent (with rent and CTB)
0.1000
Second earner in couple with
children
0.0000
0
10
20
30
Weekly Hours Worked
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40
50
Making ‘mini jobs’ Pay...
In 2007 IFS and One Parent Families were asked by the Joseph
Rowntree Foundation to look at ways of improve work
incentives.
• Giving WTC to lone parents working less than 16 hours per
week.
• Increasing the earnings disregard for income support and other
means-tested benefits.
• Reducing the taper rate on income support and other meanstested benefits.
- does more to encourage jobs with higher rates of pay.
- but administratively more burdensome as still need to know about
small changes in income.
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Modelling Lone Parent’s Labour Supply...
Model used to model the reforms:
• estimated using repeated cross sections from the Family Resources Survey
(FRS) – roughly 17,000 lone parents.
• uses cross-sectional and time-series (policy reforms) variation in work
incentives.
• discrete choice: not work, 1 – 15 hours, 16 – 23, 24 – 29, 30 – 37, 38+.
• income estimated at each of these choices.
• they take up all benefits and tax credits entitled to.
• use of childcare determined by family circumstances and hours – not price or
subsidies.
• repeatedly draw a prediction for each lone parent to get weights for each
hours choice, before and after reform.
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Results
Cost
(no Ls)
Cost
(with Ls)
Change in
Earnings
Less than
16 hours
16 – 29
hours
30 +
hours
£85
million
£175
million
- £118
million
+2.10
-0.54
-0.57
Increase Income £269
Support, HB and million
CTB disregard to
£50.
£278
million
+ £71
million
+2.19
+0.66
-0.56
Increase
Income Support,
HB and CTB
disregard to
£88.32 (16*MW)
£791
million
+ £317
million
+3.55
+2.71
-0.86
Policy
Reduce WTC
hours from 16 to
8
£735
million
WTC reduces average hours, offsetting extra tax credits. Increased
disregards also encourage 16 – 30 hours work, increasing average hours
and earnings.
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Changes in policy announced since 2007…
Universal Credit to be introduced from 2013:
• replaces myriad benefits with a single benefit with multiple elements
• reduces the maximum METR rate from 100% to around 76%
• Increases the income disregard before benefits withdrawn
• For lone-parents it will be at least £50 per week and up to almost £150 a
week
•Some similarities with reforms described and modelled above
• Also similar to Brewer, Saez and Shepherd’s (2010) Integrated Family
Support proposal
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… will increase incentives for lone parents to work
Much lower participation (and marginal tax rates) for ‘mini jobs’
Slightly weaker incentive to work more than 30 hours per week
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Conclusions (1)
• Income and substitution effects go in opposite directions
- Tax rises have an ambiguous effect on labour supply and
revenue but always entail deadweight loss.
• Fixed costs of work and complicated benefit structures
give incentives for discrete jumps in labour supply
• Estimation of model made difficult due to complex budget
constraint and unobserved preferences for work.
- Use exogenous variation in incentives due to secular wage
changes or tax reforms as basis of estimation.
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Conclusions (2)
• Estimated responsiveness varies by group
- Low for men
- Higher for women, particularly lone parents
- Participation decision particularly sensitive
• Taxable Income Elasticities
- Picks up effort and reallocation of income
- But problems if simple diff-in-difference techniques used.
• Example: Lone Parents and Mini-jobs.
- Lone parents face poor incentives to enter work at low hours.
- Reforms to benefits and tax credits can have a big impact on
labour supply for this sensitive group.
- Universal credit aims to improve work incentives
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Main Readings
C. Meghir & D. Phillips (2010) – Labour Supply and Taxes
http://www.ifs.org.uk/mirrleesreview/dimensions/ch3.pdf
K. Bell, M. Brewer & D. Phillips (2007) – Lone Parents and Mini-jobs
http://www.jrf.org.uk/bookshop/eBooks/2110-lone-parents-minijobs.pdf
M. Brewer, J. Browne & W. Jin (2011) – Universal Credit: a
preliminary analysis
http://www.ifs.org.uk/bns/bn116.pdf
M. Brewer, E. Saez & A. Shepherd (2010) – Means testing and tax
rates on earnings
http://www.ifs.org.uk/mirrleesreview/dimensions/ch2.pdf
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Additional References
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
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