taxes and labour supply: theory, evidence and policy

© Institute for Fiscal Studies

Taxes and Labour Supply:Theory, Evidence and PolicyDavid Phillips (IFS)


Outline1. The theory: labour supply elasticities and more2. Measuring labour supply responsiveness3. How responsive are hours of work and employment?

4. Beyond hours: taxable income elasticities5. Policies: Mini Jobs for Lone Parents

Conclusions


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?


Substitution Effect

Income and Substitution Effects

H

l

NI

A

A’

A’’

Income Effect

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


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


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)

Hl

NI

A

A’’

Initial Revenue

New Revenue


Elasticity of labour supply: effect on revenues

The uncompensated elasticity determines revenue:

Change in Revenue ≈ (w*h Δt ) – (εm*w*h/(1-t))*(Δt+t)

Hl

NI

A

A’’

More complicated when multiple rates

and bands: need to know income,

compensated elasticities and shape of

income distribution

The Laffer Point:

Change in Revenue ≈ 0 (1 – t) = tεm

tmax = 1/(1+εm)


Elasticity of labour supply: tax incidence (1)

Labour supply

Labour demand

Tax

increase

Labour supply / demand

Wage

•Inelastic labour supply: change in taxes = change in net wages

•Taxes borne entirely by the workers


Elasticity of labour supply: tax incidence (2)

Labour supply

Labour demand

Tax

increase

Labour supply / demand

Wage

•Elastic labour supply: change in taxes > change in net wages

•Taxes partly shifted onto those purchasing labour

Borne by worker

Borne by purchaser


Distribution of working hours

Few people work only a small number of hours. Instead, concentrations at zero or “full time”. Why?

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

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Distribution of Male Hours (Aged 22 - 59, Employees Only)

Percentage of Male Workers

Hours

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enta

ge


Adding Fixed Costs of Work

When you start work there are certain fixed costs:

Transport costs Work clothing costs

Childcare costs And others

H

A

NI

A’

Fixed costs mean not working

better than working few hours

l


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?


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’.



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



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.


Elasticity Estimates (Female)

Author(s) Basic Methodology Estimated Elasticities

Hausman (1981) Linear labour supply with convex and non-convex budget sets

Wage: 0.906 – 0.995Income: -0.121 – - 0.13

Cogan (1981) Log-linear labour supply, fixed costs, linear budget constraint

Wage: 0.864Income: -0.16

Blundell, Duncan and Meghir (1998)

Log-linear labour supply, fixed costs, accounts for taxes and benefits.

Wage: 0.13 – 0.37Income: -0.06 – -0.19

Aaberge et al(1999)

Flexible labour supply, taxes and benefits, supply and demand constraints



Elasticity Estimates (Male)


Ashenfelter & Heckman (1974)

Labour supply linear in differences. No account of taxes or benefits


Bourgiugnon and Magnac (1990)

Linear labour supply, convex budget with taxes and fixed costs


Blomquist & Newey (2002)

Non-parametric and allowance for ‘small’ non-convexities

Wage: 0.06 – 0.08Income: -0.02

Meghir & Phillips(2010)

Discrete choice with full tax and benefit modelling and control for endogenous wages

‘Wage’: 0.32 (low educ) 0.13 (mid educ) 0.03 (high educ)


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...


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.



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 = difference in % change in income .

difference in % change in marginal rate

Elasticity = ΔlnEH – ΔlnEL .

Δln(1-tH) - Δln(1-tL)



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.



• 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.


Elasticity Estimates


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)


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…


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.


The gains from working...

0 5 10 15 20 25 30 35 40 45 50

£100

£125

£150

£175

£200

£225

£250

£275

£300

£325

£245

£270

£295

£320

£345

£370

£395

£420

£445

£470

With rent and CTNo rent or CTSecond earner

Weekly hours worked

Wee

kly

fam

ily in

com

e ne

t of t

axes

, be

nefit

s an

d ta

x cr

edits

, ren

t and

co

unci

l tax

.. are less for lone parents for 8 – 16 hours.


0.0000

0.1000

0.2000

0.3000

0.4000

0.5000

0.6000

0.7000

0 10 20 30 40 50

Part

icip

atio

n ta

x ra

te

Weekly Hours Worked

Lone Parent (with rent and CTB)

Second earner in couple with children

.. and they face high effective tax rates


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 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.

Making ‘mini jobs’ Pay...


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.

Modelling Lone Parent’s Labour Supply...


Results

Policy Cost (no Ls)

Cost (with Ls)

Change in Earnings

Less than 16 hours

16 – 29 hours

30 + hours

Reduce WTC hours from 16 to 8

£85 million

£175 million

- £118 million

+2.10 -0.54 -0.57

Increase Income Support, HB and CTB disregard to £50.

£269 million

£278 million

+ £71 million

+2.19 +0.66 -0.56

Increase Income Support, HB and CTB disregard to £88.32 (16*MW)

£735 million

£791 million

+ £317 million

+3.55 +2.71 -0.86

WTC reduces average hours, offsetting extra tax credits. Increased disregards also encourage 16 – 30 hours work, increasing

average hours and earnings.


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

Changes in policy announced since 2007…


Much lower participation (and marginal tax rates) for ‘mini jobs’

Slightly weaker incentive to work more than 30 hours per week

… will increase incentives for lone parents to work


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.


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


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


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

taxes and labour supply: theory, evidence and policy

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