Taxes and Labour Supply
Theory, Evidence and Policy
David Phillips (IFS)
© Institute for Fiscal Studies, 2008
Outline
1.
2.
3.
4.
5.
6.
The Basics: Income, Substitution and Deadweight Loss
Enriching the Model: Fixed costs and more
Measurement Issues: Econometric Problems
A Review of the Emprical Evidence
Alternate Measures: Taxable Income Elasticities
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
Tax has an
ambiguous effect
on Labour Supply
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Abolition of the 10p Starting Rate
And Cutting Basic Rate to 20p
NI
Old Tax
Schedule
What about
Labour Supply??
l
H
New Tax
Schedule
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Abolition of the 10p Starting Rate
And Cutting Basic Rate to 20p
•
•
•
•
Those not working or earning less than the personal
allowance are unaffected.
Those previously paying starting rate have lower income
(work more) but face a higher marginal rate (work less)
– Ambiguous.
Those paying basic rate and earning upto about
£19,000 have lower income (work more) and a lower
marginal rate (work more) – Work MORE.
Those paying basic rate and earning more than £19,000
have higher income (work less) but face a lower
marginal rate (work more) - Ambiguous
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Elasticity of Labour Supply
There are two types of elasticity we are interested in:
• The uncompensated elasticity.
• The compensated elasticity.
Linked together by the Slutsky Equation:
εh = εm - [(w*h)/(w*T+y)]* εi
εh = Compensated Elasticity
εm= Uncompensated Elasticity
εi = Income Elasticity
y = Unearned Income
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w = Wage
h = hours of work
T = time endowment
Tax Rates and Tax Revenues
The uncompensated elasticity determines revenue:
Change in Revenue ≈ (1- εm)*(%Δ(1-t)w)*w*h*t
NI
Here a tax rise
increases revenue
but if labour supply
is elastic would see
a fall in revenue.
A
A’’
l
H
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Tax Rates and Deadweight Loss
When substitution occurs there is always deadweight
loss. It is determined by the compensated elasticity.
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The Hours Distribution
Now imagine a tax cut. The model predicts some not
working will enter work and do 1 or 2 hours per week.
Distribution of Male Hours (Aged 22 - 59, Employees Only)
20
18
16
14
Percentage
12
10
Percentage
of Male
Workers
8
6
But we don’t
observe
this... Why?
4
2
Hours
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81
78
74
71
68
65
62
59
56
53
50
47
44
41
38
35
32
29
26
23
20
17
14
11
8
4
1
0
Adding Fixed Costs of Work
When you start work there are certain fixed costs:
Transport costs
Work clothing costs
Childcare costs
And others
NI
A’
A
H
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l
Fixed costs
mean not
working better
than working
few hours provided
leisure and
income are
both ‘goods’
The Welfare System: Non Convexity
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.
NI
Introducing nonconvexities
(e.g. WFTC) can
encourage
‘jumps’ in labour
supply (e.g. From
10 to 30 hours)
A’
A
l
H
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The Family: Harmony or Bargaining?
Unitary Model:
Family is a single unit with a single utility function and
behaviour of all members chosen to maximise this.
Uf(c, li, lj)
This implies:
• Full income pooling
• Symmetry of response to changes in other partners wage.
Neither Hold
Collective Model:
Family as a group of individuals who engage in (paretoefficient) bargaining. This group of model allows one to extend
models from just labour supply to looking at intra-household
allocations of welfare.
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Putting it together…
hi = f(wi,wj, t, b, yi, yj, fi, fj, c, r)
t = tax system
f = fixed costs
b = benefit system
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.
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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
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Econometric Issues (2)…
‘Second Generation’ models attempted to account for the
downward bias induced by increasing marginal rates of tax.
• very carefully modelled the tax system.
• assume utility maximising and rational behaviour.
People bunch at the ‘kinks’ as marginal rates change.
Desired labour supply below kink at post-kink tax rate, and above kink
at pre-kink tax rate.
When you combine this with a linear labour supply model
Restricts so that must estimate a positive uncompensated wage
elasticity.
H = α + βW + γY
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Econometric Issues (3)…
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.
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Econometric Issues (4)…
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 (2008)
• 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.
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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
(2008)
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 workhours  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 =
difference in % change in income
ΔlnEH – ΔlnEL .
Δln(1-tH) - Δln(1-tL)
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.
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)
Problems with this methodology:
• 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.
• Timing
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.
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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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Reforming Support for Lone Parents
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?
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, tapers of over 95%.
• No working tax credit (WTC) unless you work 16 hours per week.
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The Gains of Labour...
£470
Weekly family income net of taxes,
benefits and tax credits, rent and
council tax
£325
£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
5
£245
0
£100
.. and they face high effective tax rates
0.7000
0.6000
Participation tax rate
0.5000
0.4000
0.3000
0.2000
Lone Parent
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...
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
means-tested 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 is:
• 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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Conclusions (1)
• Income and substitution effects can give some important
insights (e.g. the ‘10p tax’).
- But non-convexities and fixed costs means can see
‘jumps’ in Labour supply in response to reforms.
• Compensated versus uncompensated elasticities
- Tax rises have an ambiguous effect on labour supply and
revenue but always entail deadweight loss.
• 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.
© Institute for Fiscal Studies, 2008
Main Readings
C. Meghir & D. Phillips (2008) – Labour Supply and Taxes
http://www.ifs.org.uk/wps/wp0804.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
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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
© Institute for Fiscal Studies, 2008