Gruber4e_ch21

1 of 29Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth PublishersCopyright © 2010 Worth Publishers

2 of 29Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

21

Dan Sacks

P R E P A R E D B Y

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

Taxes on Labor Supply

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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

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

21.1

Iceland’s Supply-Side Experiment

• In 1987, Iceland’s income tax rate was zero.

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21.1

• Ava trades off consumption (which requires work) against leisure.

• Each hour of leisure costs Ava her wage, $12.50, in foregone consumption, so the slope of her budget constraint is −12.5.

• A 30% tax rate alter this trade-off. The slope of Ava’s budget constraint is now the after-tax wage, −8.75.

Basic Theory

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Consumption

Leisure hours0

Indifference curve, IC1

A

BC1BC2

900

C1 = $13,750

C2 = $9,625

slope = −12.50slope = −8.75

Basic Theory21.1

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21.1

• Taxes have two effects:

o The fall in the price of leisure induces a substitution effect toward less work.

o The fall in income has an income effect, so Ava buys less of all normal goods, including leisure.

• Effects are opposite-signed, so the theoretical impact of taxation on labor supply is ambiguous.

Substitution and Income Effects on Labor Supply

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Consumption

Leisure hours0

(a) Substitution effect is larger

BC1

7,000

1,200

(b) Income effect is larger

BC2

$13,750

900

A

BIC1

IC2

Consumption

Leisure hours0BC1

12,250

900BC2

600

A

IC1

$13,750C

IC3

Substitution versus Income Effect21.1

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21.1

• Theory assumes free adjustment of hours worked.

• Firms may want all workers to work the same hours, perhaps because of production complementarities.

• Overtime pay rules also make it difficult to adjust hours at a constant wage.

o 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.

Limitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules

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21.2

• Separately examine primary and secondary earners.

o Primary earners: Family members who are the main source of labor income for a household.

o Secondary earners: Workers in the family other than the primary earners.

• General conclusions:

o Primary earners’ labor supply elasticity

o Secondary earners’ elasticity .

Taxation and Labor Supply—Evidence

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21.2

Cross-Sectional Linear Regression Evidence: • These studies estimate regressions of labor supply as a

function of the after-tax wage and other control variables.

• Generally, find very elastic labor supply.• But many sources of bias, especially from a correlation

between “work propensity” and wages.

EVIDENCE: Estimating the Elasticity of Labor Supply

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21.2

Experimental Evidence: • One of the most significant social experiments in the

United States was a randomized evaluation of a negative income tax (NIT) system.

• Replaced tax system with a guarantee amount and a (flat) phase-out rate.

• Focused on men, finding an elasticity of labor supply for primary earners of about 0.1.

EVIDENCE: Estimating the Elasticity of Labor Supply: Cross-Sectional Linear Regression

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Quasi-Experimental Evidence: • Looks at how labor supply changes as tax policy

changes.• Eissa (1995) studied Tax Reform Act of 1986 (TRA 86).• TRA 86 reduced marginal tax rates for very high

earners but not middle or low earners.• Eissa compared wives of very high earners to wives of

moderately high-income men (75th percentile).• Estimated secondary earners’ elasticity of about 0.8.

EVIDENCE: Estimating the Elasticity of Labor Supply

21.2

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21.2

• Blurring line between primary and secondary earners:

o In 1970, 31.9% of married women were working, but almost 60% were in 2008.

• Hours worked is a narrow measure of labor supply response. It misses:

o Effort on the job.

o Occupation or career choice.

o Human capital investment.

Limitations of Existing Studies

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21.3

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

• The EITC has two goals: o Redistribution of resources to lower-income groups. o Increases in the amount of labor supplied by these

groups.• EITC spending totaled nearly $60 billion in 2011 and

has increased dramatically over the last two decades.

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

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Background on the EITC21.3

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21.3

• The EITC is a refundable tax credit; the exact amount depends on earnings.

• Eligibility depends on the number of children:

o For families with more than two children, maximum earnings are $50,270.

o With two children, the maximum is $47,162.

o With one child, the maximum is $42,130.

o With no children, the maximum is $19,190.

Background on the EITC

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21.3

The EITC Benefit Structure

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21.3

Impact of EITC on Labor Supply: Theory

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21.3

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.

Impact of EITC on Labor Supply: Theory

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21.3

• Effects on Labor Force Participation: The EITC has increased the LFP of single mothers.

• Effects on Hours of Work: No effect, conditional on working.

• Impact on Married Couples: Married men’s labor supply appears not to respond to the EITC.

• Summary: EITC supports redistribution without reducing labor supply, accomplishing its goals.

Impact of EITC on Labor Supply: Evidence

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21.3

• Eissa and Leibman (1996) studied the impact of the 1986 EITC expansion.

• Comparing single women with children (the treatment group) to single women without children (controls).

• The EITC expansion increased labor supply by 1.4 to 3.7 percentage points.

EVIDENCE: The Effect of the EITC on Single Mother Labor Supply

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21.3

EVIDENCE: Changes in the EITC Structure

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21.3

• The EITC, though successful, has some flaws:o Very small benefit for childless workers. o No credit increase for children beyond the second.o Marriage penalty, as it is based on family income.o The EITC is very complex; about 1/7 of eligible

people do not participate, and the majority of EITC recipients hire professionals to help prepare their taxes.

APPLICATION: EITC Reform

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21.4

• Child care: Care provided for children by someone other than the parents of those children.

• Child care expenditures in the United States: at least $73 billion.

• Child care expenditures are effectively a tax on parent’s labor supply, so they reduce labor supply, and child care subsidies can increase labor supply.

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

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21.4

• Child care creates a tax wedge because home work is not taxed, but formal sector work is.

o Broadest definition of tax wedges: Any difference between pre- and post-tax returns to an activity caused by taxes.

• Solutions: Tax home work by imputing earnings, make child care tax-deductible.

o Imputing home earnings: Assigning a dollar value to the earnings from work at home.

The Tax Treatment of Child Care

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21.4

The Tax Treatment of Child Care

BaseImpute Earnings

Deduct Child Care

Pre-tax/child care earnings 1,000 1,000 1,000Child care costs 600 600 600Child care deduction 0 0 600Imputed earnings 0 600 0Taxes if work 500 500 200Taxes if home 0 300 0After-tax value of work 500 500 800After-tax value of home 600 300 600

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21.4

• Imputing income and deducting expenses are not equal: The deduction for child care costs lowers the tax base.

• Three choices, all of which have drawbacks:o The status quo lowers social efficiency by deterring

mothers from market work.o Taxing home work makes the most economic sense

but is an administrative nightmare.o Offering subsidies to market work reduces the

overall efficiency of the tax system.

Comparing the Options

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21.4

• Can’t correlate LFP with child care costs because wages are the majority of child care costs.

• (Quasi-)experimental approaches:

o Berger and Black (1992): Randomly assigned child care subsidies for some welfare recipients.

o Gelbach (2002): Kindergarten birthday cutoffs.

o Baker, Gruber and Milligan (2005): Examine Quebec subsidy for child care.

• Clear but moderate elasticities: −0.1 to −0.35.

EVIDENCE: The Effect of Child Care Costs on Maternal Labor Supply

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21.5

• Optimal tax trades off:

o The benefits of redistribution.

o The efficiency cost of taxation, which depends on how peoples’ labor supply responds to taxes.

• Primary earner are not very responsive, secondary earners are.

• The EITC is a successful redistribution program designed to encourage labor supply.

• Child care costs are an impendent to the labor supply of secondary earners.

Conclusion

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