Home > Fiscal Policy > Tax Rates and Labor Supply

Tax Rates and Labor Supply

With the election over, the political discussion has now changed to the government deficit and the impending increase in tax rates called the “fiscal cliff.” As part of this discussion, it is necessary to know how tax rates affect the labor supply decisions of the public so that, if tax rates are increased, political leaders will know the impact of higher tax rates on economic activity. The Congressional Budget Office (CBO) has provided a timely survey of empirical evidence by economists on the relationship between tax rates and labor supply.

First it needs to be stated that economists are interested in measuring the effects on labor supply of marginal tax rates. The marginal tax rate (MTR) is the increase in taxes paid in response to a one-dollar increase in pre-tax real wages, a number between zero and unity. Marginal tax rates are important for incentives in the labor market because variations in the MTR will change labor supply decisions. Economists assume that households are interested in what their money wages will buy in terms of goods and services so it is the after-tax real wage that affects labor supply decisions.

Second, it is important to state that economic theory does not say how labor supply will vary with the after-tax real wage. The reason is that there are conflicting substitution and income affects associated with changes in after-tax real wages. If the after-tax real wage rises, another unit of leisure (time spent not working) has become more expensive in terms of lost income so people substitute more labor supply for reduced leisure. But a higher after-tax real wage also makes the household richer which is likely to cause the household to take more leisure. The end result is that it takes empirical evidence to settle the issue of how tax rates affect labor supply.

This table (Results_Table2) reports the findings of a variety of studies (the complete study is Recent_Research_on_Labor_Supply_Elasticities). The results for substitution elasticities are reported as positive numbers even though, as our discussion above shows, substitution effects are negative. The table reveals that substitution effects are generally larger in magnitude than income effects. This implies that a higher after-tax real wage will increase, rather than decrease, labor supply. Equivalently, a higher MTR lowers labor supply, all else the same. The table shows that higher after-tax real wages will increase labor force participation meaning that people will enter the workforce if the MTR declines. Finally, the table also shows that people will work more hours if the MTR declines but the evidence is somewhat more ambiguous than other results in the table.

Bottom line: a higher MTR reduces labor supply and Potential GDP, the output produced by employed workers. The magnitude of the effects depend upon the size of an increase in the MTR, as well as the results in the table, but the direction of change is clear. So if the President and Congress increase marginal tax rates, the size of the economic pie, Potential GDP, will be reduced.

  1. November 9, 2012 at 4:48 PM

    Remeber the backward bending labor supply curve for high earners? Even without that effect, I still suspect that increases in marginal tax rates will have a much smaller effect on high earners than low earners. Those above $250,000 per annum (>$125 per hour if calculated on 2000 hours per year) may be in the position to either raise their fees or work more hours to meet their financial commitments. In the case of medical doctors and similarly situated high earners, they may work the same amount as their professional dictates demand. As long as marginal rates are not increased for the middle and lower-middle classes, there may not be a significant effect. As with a sales tax on groceries, I suspect that increases in marginal income tax rates would be regressive. Depending on the mix of necessity to comfort and luxury goods in one’s market basket, a marginal rate increase may have a greater impact on the demand for goods and services. –John

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Economics One

A blog by John B. Taylor

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One economist's views on economic policy.

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