The Tax-Transfer System and
Labor Supply
Michael P. Keane
University of Oxford
Becker – Friedman Institute
University of Chicago
September 27, 2013
Why Labor Supply Matters for
Design of the Tax System
• “Optimal Taxation” – Basic Tradeoff:
• (1) Government needs to raise a certain
amount of money to pay for public goods.
• (2) Taxation causes people to work less.
This leads to an efficiency or welfare loss.
(The economic “pie” gets smaller).
Why Labor Supply Matters for
Design of the Tax System
• How bad is this “Shrinking Pie” problem?
• It depends how much people reduce their
labor supply if you tax them (How big is the
labor supply elasticity?).
• Basic Solution of “Optimal Tax” theory: Tax
people more if their labor supply is more
“inelastic” (i.e., less responsive to taxes)
The Labor Supply Literature
• Until recently there was a clear consensus
that labor supply elasticities are small:
• Saez, Slemrod and Giertz (JEL, 2012):
“…the profession has settled on a value
for this elasticity close to zero … This
implies that the efficiency cost of taxing
labor income … is bound to be low …”
The Labor Supply Literature
• I will argue that most existing estimates of
labor supply elasticities are biased downward
• This is because they ignore the fact that work
experience builds human capital
• See Imai and Keane (IER, 2004), Keane
(JEL, 2011), Keane-Rogerson (JEL, 2012)
• Recently this idea has started to gain traction
Why are Labor Supply Elasticity
Estimates Usually Small?
• Hours vs. Wages over the Life-Cycle (Men):
Wage
Hours,
Wages
Hours
Age
• Given this pattern, the elasticity looks very small
The Problem with Most Prior Work:
Assumes Wage = Price of Time
• But the after-tax wage is not the price of time
• If you work more hours (today) you get both:
1.The after-tax wage rate (today)
2.The increase in future earnings due to
the human capital gained from work
experience
• “Effective Wage” = After-Tax Wage
+ Human Capital Gained by Working
• See Heckman (1976), Shaw (1989)
The Effective Wage Rate
• Effective Wage over the life-cycle:
Effective wage =
Wage + HC return
Wage
Wage
HC return
Age
• It is much flatter than the measured wage
Labor Supply and the Effective Wage
• Hours vs. Effective Wage over the Life-Cycle
Wage,
Hours
Effective Wage
Hours
Age
• Hours look very responsive to effective wage
Human Capital and Long Run
Tax Effects
• If work experience builds human capital it
implies effect of taxes on labor supply will
grow over time
• I’ll illustrate this by simulating a permanent
5 percent tax rate increase in the model of
Imai and Keane (IER, 2004)
• Three Cases: The increase occurs when a
person is 25, 30 or 35
Effects of Permanent Tax Increases on Labor Supply At Different
Ages in a Model with Human Capital (Imai-Keane Model)
Age
25
30
35
40
45
50
55
60
65
Age 25
Hours
-2.7
-2.9
-3.2
-3.8
-5.1
-7.9
-13.3
-19.3
-29.2
Wage
Age 30
(unexpected)
Hours
Wage
Age 35
(unexpected)
Hours
Wage
-0.4
-0.7
-1.0
-1.3
-2.0
-3.6
-7.5
-11.6
-2.4
-2.7
-3.3
-4.4
-7.0
-12.2
-18.4
-28.1
-2.3
-2.7
-3.8
-6.2
-11.0
-17.4
-26.9
-0.3
-0.6
-0.9
-1.4
-2.9
-6.6
-10.7
-0.2
-0.5
-1.0
-2.3
-5.8
-9.7
Note: The tax increase is 5%. It takes effect (unexpectedly) at the indicated age and
lasts until age 65. The proceeds of the tax (in each year) are distributed back to agents
in lump sum form.
Effect of Permanent Tax Changes
• Note: The effect of a tax increase grows
over time
• It slows down the rate of human capital
accumulation, creating a “snowball” effect
on after-tax wages
• Seeing a small short-run effect may trick
us into thinking elasticities are small
Labor Supply Summary
• What economists call the “welfare cost” of
income taxation (how much it shrinks the pie)
is likely to be much higher than previously
thought, because:
• Economists have largely ignored how taxes
alter incentives to acquire human capital
• Ignoring human capital has led economists to
underestimate how much taxes can reduce
labor supply
Some Comments on Transfers
• A Typical Welfare or Transfer Program
Income
Earnings
Indifference Curve:
Income vs. Hours
Welfare
Grant level
Leisure
Full-Time Work
No Work
Some Comments on Transfers
• Lower Phase-Out Rates Don’t Work:
Income
Earnings
Indifference Curve:
Income vs. Hours
Welfare
Grant level
Leisure
Full-Time Work
No Work
• Making people appear insensitive to taxes
Some Comments on Transfers
• BUT, a modest increase in the after-tax
wage can cause a big jump in hours:
Income
Earnings
Indifference Curve:
Income vs. Hours
Welfare
Grant level
Leisure
Full-Time Work
No Work
• Suddenly labor supply looks very elastic!
Some Comments on Transfers
• Lesson: The “labor supply elasticity” is not
an absolute number
• It can be large or small depending on the
nature of the tax and/or transfer change
• Keane and Rogerson (JEL, 2012) give a
number of illustrations of this point in
different contexts
Smarter Transfers
A Bonus for Work (including subsidies of fixed costs)
Income
Earnings
New Higher
Indifference Curve:
Income vs. Hours
Welfare
Grant level
Leisure
Full-Time Work
No Work
Government Saves Money and the Person is Happier !!
Smarter Transfers
• This idea for welfare reform was proposed in:
Keane (1995). “A New Idea for Welfare Reform.”
Federal Reserve Bank of Minneapolis Quarterly
Review, 19:2, 2-28.
• Also discussed in: Keane and Moffitt (1998).
“A Structural Model of Multiple Welfare Program
Participation and Labor Supply.” International
Economic Review, 39:3, 553-589.
• The “working families tax credit” in the UK has a
similar design, with a 16 hour work requirement
A Subsidy for Working =
Subsidizing Costs of Work
• This is sometimes called “making work
pay” – i.e., subsidize work instead of
paying people not to work
• A big part of the cost of work is quality
child care/pre-school, especially for lone
mothers.
• Work cost subsidies play a dual role as
early childhood education and human
capital policy
Conclusion
In general, we should think more about
how the tax/transfer system interacts with
human capital development