Tax Policy Lessons from the 2000s Evidence on Labor Supply and Taxes, and Implications for Tax Policy By Nada Eissa Remarks by Steven J. Davis American Enterprise Institute 30 May 2008

Outline of Remarks 1.Labor supply responds to taxes on many margins 2.Long run vs. short run responses (at the individual level) 3.Individual vs. aggregate responses 4.Welfare effects of Bush tax cuts

1. Labor Supply Responds to Taxes on Many Margins Hours worked (intensive margin) Employment (extensive margin) Occupation choice Schooling and training Compensation form Immigration and emigration –Numbers and Composition (selection) Market provision vs. home production Legal (taxed) vs. underground (untaxed)

The Deadweight Burden of Taxes on Labor Income The efficiency costs of taxes on labor income are potentially large even when the tax elasticities of hours worked and employment are small. Under reasonable conditions, what matters for efficiency is the tax elasticity of reported income (Feldstein, 1999) Chetty (2008) generalizes the Feldstein formula to cover situations where part of the cost of evasion and avoidance involves a transfer of resources to other persons in the economy.

So How Much of the Story Are Hours Worked and Employment? What fraction of the reported income response to tax changes is captured by responses on the hours and employment margins? How does that fraction vary across demographic groups and income deciles?

Fredriksson and Topel (forthcoming)

Fredricksson and Topel (forthcoming)

Personal Taxes and the Industry Mix of Employment Source: Davis and Henrekson (2005)

Time Use: Sweden vs. the US Men and Women, Years Old Avg. Hours Per Year, USA Minus Sweden Paid Employment+138 Domestic Work, Excluding Child Care -95 Leisure Activities+37 Leisure Activities + Child Care +84 Source: Davis and Henrekson (forthcoming)

2. LR vs. SR Responses (At the Individual Level) Responses at the extensive margin are lifestyle changes -- they often take time to bring about Fixed costs of –Altering work schedule and/or switching jobs –Learning about the tax code –Changing child care arrangements –Adjusting consumption patterns Fixed costs induce (S,s) behavior of labor supply responses to tax changes

3. Individual vs. Aggregate Responses Underground economy is a network (and probably exhibits IRS in relevant range) Social norms regarding –Tax evasion –Whether to work (Lindbeck et al., 1999) Is it OK to be a slacker, free loader, etc.? –Institutional constraints on choice of work hours Horizontal coordination

What’s the Thought Experiment? 1.Tax revenues fund G, where G is not substitutable with private consumption  offsetting income and substitution effects 2.Tax revenues fund lump-sum transfers to households  pure substitution effect 3.Tax revenues fund transfer payments that discourage labor supply  even bigger effects than in 2.

4. Welfare Effects of Bush Tax Cuts What are the most and least effective elements of the Bush tax cuts from an efficiency perspective? Implicit policy prescription: tax high-wage workers at the intensive margin and use proceeds to reduce (average) tax burden on low-wage persons, encouraging a response on the extensive margin. –Does this prescription survive when we consider the tax elasticity of reported income?

Final Word The evidence summarized in this paper understates labor supply responses to taxation for three sets of reasons: 1.Missing margins 2.Responses are bigger in the longer run 3.Aggregate responses are bigger than suggested by individual responses considered in isolation

Additional Papers Cited Chetty, Raj (2008) “Is the Taxable Income Elasticity Sufficient to Calculate Deadweight Loss? The Implications of Evasion and Avoidance,” working paper Davis, Steven J. (2005) “Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons” in Labour Supply and Incentives to Work in Europe. Davis, Steven J. and Magnus Henrekson (forthcoming) “Economic Performance and Work Activity in Sweden after the Crisis of the Early 1990s” in Reforming the Welfare State. Feldstein, Martin (1999) “Tax Avoidance and the Deadweight Loss of the Income Tax,” Review of Economics and Statistics. Fredriksson, Peter and Robert H. Topel (forthcoming) Lindbeck, Assar (1995) “Hazardous Welfare State Dynamics,” American Economic Review. Lindbeck, Assar, Sten Nyberg and Jorgen W. Weibull (1999) “Social Norms and Economic Incentives in the Welfare State,” Quarterly Journal of Economics.