taxes on labor supply

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 29

Taxes on Labor Supply

21.1 Taxation and Labor Supply—Theory

21.2 Taxation and Labor Supply—Evidence

21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit

21.4 The Tax Treatment of Child Care and Its Impact on Labor Supply

21.5 Conclusion


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C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y



21.1Taxation and Labor Supply—TheoryBasic Theory

The slope of Ava’s budget constraint is now the after-tax wage.




Substitution and Income Effects on Labor Supply

The decrease in the price of leisure will induce a substitution effect toward more leisure and less work.

A reduction in income will have an income effect that causes her to buy fewer of all normal goods, including leisure.

Because the substitution and income effects on labor supply pull in opposite directions, we cannot predict clearly whether labor supply rises or falls in response to the tax.

For understanding the intuition of the income effect on labor supply, it is sometimes helpful to think about an individual’s income target, his or her goal of earning a fixed amount of income.




Substitution and Income Effects on Labor Supply



21.1Taxation and Labor Supply—TheoryLimitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules

Production complementarities are features of the production process that make it important to have many workers on the job at the same time.

overtime pay rules Workers in most jobs must legally be paid one and a half times their regular hourly pay if they work more than 40 hours per week.



21.2Taxation and Labor Supply—Evidence

primary earners Family members who are the main source of labor income for a household.

secondary earners Workers in the family other than the primary earners.



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax Credit

Earned Income Tax Credit (EITC) A federal income tax policy that subsidizes the wages of low income earners.

The EITC subsidizes the wages of low-income earners to accomplish two goals:

Redistribution of resources to lower-income groups.

Increases in the amount of labor supplied by these groups.



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditBackground on the EITC

To be eligible for the EITC, a family must have annual earnings greater than zero and below about $35,463, if supporting one child, or $40,295 if supporting more than one child. A family that supports no children must have earnings greater than zero and below about $13,400. For childless families, the EITC is significantly smaller.



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditBackground on the EITC



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditImpact of EITC on Labor Supply: Theory



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditImpact of EITC on Labor Supply: Theory

This figure illustrates the impact of the EITC on four distinct groups:

1. People not in the labor force at all.

2. People already in the labor force who earn less than $11,340.

3. People already in the labor force and earning between $11,340 and $14,810.

4. People already in the labor force earning between $14,810 and $36,348.



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditImpact of EITC on Labor Supply: Evidence



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax CreditImpact of EITC on Labor Supply: Evidence

The literature assessing the effect of the EITC has reached several clear conclusions:

Effects on Labor Force Participation

There is a strong consensus across these studies that the EITC has played an important role in increasing the share of single mothers who work.

Effects on Hours of Work

The 1986 expansion in the EITC would have been expected to increase labor force participation, but it might also have reduced hours worked by those already in the labor force.

Impact on Married Couples

Although the EITC appears to have positive effects for the labor supply of single mothers, it might have negative impacts on a married couple’s labor supply decisions.



21.3

Tax Policy to Promote Labor Supply: The Earned Income Tax Credit

APPLICATIONEITC ReformWhile the EITC has been a major success story, there are significant flaws in its design:

There is only a very small EITC for childless workers, with a maximum of only $412 per year.

Families receive no additional EITC transfer as family size grows beyond two children.

It penalizes many single parents who subsequently marry because the credit is based on the income of the tax filing unit.

Not all marriages are, however, penalized by the EITC:

Take the case of a single mother with two children and no income. If she marries a man whose annual income is $12,000, then together they qualify for the maximum credit of $4,536, even though on her own she would not receive any credit.



Conclusion21.5

If higher taxes lead people to change their behavior to supply less labor, these changes can offset the gains from tax increases and there might be a natural limit to the revenue that can be raised by income taxation.

Most studies show that tax rates have little impact on the labor supply of primary earners but a more substantial impact on secondary earners.

We reviewed one of the major tax policies to promote labor supply, the Earned Income Tax Credit (EITC), and discussed evidence showing that the EITC has raised the labor supply for low-income earners.

Finally, we discussed the appropriate tax treatment of child care.



Taxes on Savings

FERNANDO QUIJANO AND SHELLY TEFFT

P R E P A R E D B Y

22.1 Taxation and Savings—Theory and Evidence

22.2 Alternative Models of Savings

22.3 Tax Incentives for Retirement Savings

22.4 Conclusion



http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=PSAVERT


C H A P T E R 1 9 ■ T H E E Q U I T Y I M P L I C A T I O N S O F T A X A T I O N : T A X I N C I D E N C E

capital income taxation The taxes levied on the returns from savings.



22.1Taxation and Savings—Theory and EvidenceTraditional Theory

intertemporal choice model The choice individuals make about how to allocate their consumption over time.

savings The excess of current income over current consumption.



A Simplified Model


1+r= interest earning1-t = tax rate



A Simplified Model


intertemporal budget constraint The measure of the rate at which individuals can trade off consumption in one period for consumption in another period.

The opportunity cost of first-period consumption is the interest income not earned on savings for second-period consumption.



Substitution and Income Effects of Taxes on Savings


The price change that results from the tax on savings interest will have two effects:

The lower after-tax interest rate will cause consumption in period one to rise through the substitution effect. This will in turn lead savings to fall.

There is also, however, an income effect of lower after-tax income.

When thinking about the income effect of changes in the after-tax interest rate on savings, it is helpful to reflect on the extreme case of a target level of consumption for retirement in period two. If Jack has a certain amount of consumption he wants in period two, then when the after-tax interest rate falls, he must save more and reduce CW in period one to achieve that target.





Intertemporal Substitution vs. Income Effect • If the substitution effect is larger than the income effect, individuals will move from point A to point B, consuming more in the first period (CW

2) and thus saving less (S2). As a result, their consumption in period two (CR

2) falls by a lot.





Intertemporal Substitution vs. Income Effect • If the income effect is larger, individuals will move from point A to point C, consuming less in the first period (CW

3) and thus saving more (S3). Their consumption in period two (CR

2) still falls, but not by as much.



22.1Taxation and Savings—Theory and EvidenceEvidence: How Does the After-Tax Interest Rate Affect Savings?

Studying the connections between after-tax interest rates and savings is a difficult problem.

Although we can measure a given worker’s wage, it is hard to measure the appropriate interest rate for any given saver.

The interest that can be earned on any type of savings typically changes over time in the same way for all individuals, making it hard to find appropriate treatment and control groups for studying how savings respond to interest rate changes.



22.1Taxation and Savings—Theory and EvidenceInflation and the Taxation of Savings

Before 1981, the tax brackets on which taxation is based were denominated in constant dollars that did not change with inflation.

This practice led to a phenomenon known as bracket creep, whereby individuals would see an increase in their tax rate despite no increase in their real income.




Inflation and Capital Taxation

nominal interest rate The interest rate earned by a given investment.

real interest rate The nominal interest rate minus the inflation rate; this measures an individual’s actual improvement in purchasing power due to savings.





We can define the relationship between the real and nominal interest rates as:

Real interest rate (r) =[1 + Nominal interest rate (i)] / [(1 + Inflation rate ()] – 1

The problem is that taxes are levied on nominal, not real, interest earnings.



22.2Alternative Models of SavingsPrecautionary Savings Models

precautionary savings model A model of savings that accounts for the fact that individual savings serve, at least partly, to smooth consumption over future uncertainties.

liquidity constraints Barriers to credit availability that limit the ability of individuals to borrow.



22.2Alternative Models of SavingsPrecautionary Savings Models

Evidence for the Precautionary Model

Studies have shown that more uncertainty leads to more savings, and that reducing uncertainty reduces savings.

Other studies have shown that expansions in social insurance programs that lower income uncertainty also lower savings.



22.2Alternative Models of SavingsSelf-Control Models

In this model, a key determinant of savings behavior is the ability of individuals to find ways to commit themselves to save, so that they can keep their income out of the hands of their impatient “short-run self.”

Evidence for the Self-Control Model

Individuals with self-control problems will demand commitment devices to help curb their self-control problems.

A classic example is the “Christmas club,” a bank account into which individuals put money throughout the year, at low or no interest, to make sure they have money available at Christmastime to buy gifts.



M P I R I C A L E V I D E N C EE

SOCIAL INSURANCE AND PERSONAL SAVINGS

22.2Alternative Models of Savings

A central prediction of the precautionary savings model is that when the government provides insurance against income uncertainty, individuals will reduce the buffer stock of precautionary savings they have built up to deal with that uncertainty.

Perhaps the most striking is the study by Chou et al. (2003) of the introduction of National Health Insurance (NHI) in Taiwan in 1995:

• Among government workers, from before NHI to after, savings rose by $30,000 Taiwanese dollars (U.S. $1,165) on average, consistent with the strong economic growth of this era.

Similar evidence is available for the United States as well. For example, Gruber and Yelowitz (1999) found that the Medicaid expansions significantly reduced the savings of low-income groups.



22.3Tax Incentives for Retirement SavingsAvailable Tax Subsidies for Retirement Savings

Tax Subsidy to Employer-Provided Pensions

pension plan An employer sponsored plan through which employers and employees save on a (generally) tax-free basis for the employees’ retirement.

defined benefit pension plans Pension plans in which workers accrue pension rights during their tenure at the firm, and when they retire, the firm pays them a benefit that is a function of that worker’s tenure at the firm and of their earnings.

defined contribution pension plans Pension plans in which employers set aside a certain proportion of a worker’s earnings (such as 5%) in an investment account, and the worker receives this savings and any accumulated investment earnings when she retires.




401(k) Accounts

401(k) accounts Tax-preferred retirement savings vehicles offered by employers, to which employers will often match employees’ contributions.

Individual Retirement Accounts

Individual Retirement Account (IRA) A tax-favored retirement savings vehicle primarily for low- and middle-income taxpayers, who make pre-tax contributions and are then taxed on future withdrawals.




Individual Retirement Accounts

For low- and middle-income households, IRAs function as follows:

They are not a special type of savings. Almost any form of asset can be put in an IRA (from stocks to bonds to holdings of gold).

Individuals can contribute up to $5,000 tax-free each year (deducted from their taxable income).

Unlike the interest on a regular savings account, the interest earned on IRA contributions accumulates tax-free.

IRA balances can’t be withdrawn until age 59 1⁄2, and withdrawals have to start at age 70 (or there is a 10% tax penalty).

IRA balances are taxed as regular income on withdrawal.



Keogh accounts Retirement savings accounts specifically for the self-employed, under which up to $44,000 per year can be saved on a tax-free basis.


Keogh Accounts



22.3Tax Incentives for Retirement SavingsWhy Do Tax Subsidies Raise the Return to Savings?

With tax-preferred retirement savings, you get to hold on to any taxes you would have paid on both your initial contribution and any interest earnings, and you get to earn the interest on the money that would have otherwise been paid in taxes.



22.3Tax Incentives for Retirement SavingsTheoretical Effects of Tax-Subsidized Retirement Savings




Limitations on Tax-Subsidized Retirement Savings





Low Savers vs. High Savers • Mr. Grasshopper saves little before the IRA is introduced (point A), consuming CW

1 and saving only $1,000. For Mr. Grasshopper, the effect of the IRA on savings is ambiguous: if substitution effects dominate, he will move from point A to point B (with savings rising); if income effects dominate, he will move from point A to point C (with savings falling).





Low Savers vs. High Savers • Ms. Ant was a high saver before the IRA was introduced, consuming CW

1 and saving $6,000 (point A). For Ms. Ant, the introduction of the IRA does not change the price of first–period consumption, but it does have an income effect, causing her period–one consumption to rise to CW

2 and her savings to fall to S2, $5,000.



22.3Tax Incentives for Retirement Savings

APPLICATIONThe Roth IRA

Roth IRA A variation on normal IRAs to which taxpayers make after-tax contributions but may then make tax-free withdrawals later in life.

This account has many similarities to a regular IRA, but has two key differences:

• Individuals contribute after-tax dollars to a Roth IRA, and when withdrawals are eventually made, the withdrawals are not taxed.

• Individuals are never required to make withdrawals, so that earnings on assets can build up tax-free indefinitely.

Why did policy makers introduce this new option?

• The government collects tax revenues today and loses them in the future (since we don’t tax interest earnings on the account or withdrawals from it).

• The plan allows politicians to enact a tax break while delaying the budgetary pain of paying for it.



22.3Tax Incentives for Retirement SavingsImplications of Alternative Models

Precautionary Savings

Asset reshuffling will be likely if two conditions are met: if a large share of IRA contributors would have saved $5,000 anyway in the absence of the IRA, and if IRA savings and non-IRA savings are viewed as highly substitutable.

Self-Control Models

Retirement accounts such as pension and 401(k) accounts provide excellent commitment devices because the contributions are taken directly out of the paycheck and individuals can’t access their money until retirement.



22.3Tax Incentives for Retirement SavingsPrivate vs. National Savings

The comparison of private to national savings comes back to the notion of marginal impacts of tax incentives (new behavior encouraged) versus inframarginal impacts of tax incentives (old behavior rewarded).

The size of the marginal and inframarginal response to tax incentives for savings will depend on two factors:

• The size of the income and substitution effects for retirement savers below the savings limit.

• The share of retirement savers who are above the savings limit, for whom there is only an inframarginal response.



22.3Tax Incentives for Retirement Savings

M P I R I C A L E V I D E N C EE

ESTIMATING THE IMPACT OF TAX INCENTIVES FOR SAVINGS ON SAVINGS BEHAVIOR

Those who contribute to IRAs may be “savers,” who save more in every form than the “non-savers” who don’t contribute to IRAs.

The literature on 401(k)s has taken a different approach, with researchers comparing the amount of savings put aside by workers in firms with 401(k)s (the treatments) with the savings put aside by workers in firms that do not offer 401(k)s (the controls).

Two studies have, however, developed convincing means of assessing the impact of these savings incentives on savings.

More recent evidence on the impact of retirement savings incentives on savings behavior comes from a randomized trial run by Duflo et al. (2005).

The study found that those who randomly received a 20% match contributed four times as much to their IRA accounts, and that those who randomly received a 50% match contributed seven times as much relative to the control group.

Providing further incentives for people to contribute to their retirement savings can raise the level of savings.



22.3Tax Incentives for Retirement SavingsEvidence on Tax Incentives and Savings

Evidence from recent studies suggests that individuals do respond to these savings incentives by saving more—and might even respond enough to raise not only private but national savings.

Several studies suggest that it is not tax savings but other factors in program design that have the most impact on the effect of retirement incentives.

These types of findings have motivated President Barack Obama’s recent plans to reform our retirement savings system.



22.4Conclusion

One of the most important decisions made by taxpayers in the United States is how much to save, and it seems likely that taxes factor into that decision.

Neither theory nor existing empirical evidence offers a clear lesson for the magnitude (or even the direction) of the effect of taxes on savings.

In 1975, the tax expenditure on incentives for savings was less than $20 billion; in 2006, it had grown to $105 billion.

Clearly, policy makers believe that tax incentives can make a difference in the savings decisions of individuals.

Are more savings instruments needed?

What can be done to encourage more savings?

taxes on labor supply

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