Income tax and labour supply: Let’s acknowledge what we don’t know

Charles F Manski, 23 August 2012

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Predicting how income tax rates affect labour supply has long been an important concern for economic policy analysis. Much recent debate has centred on the appropriate tax rate on high earners.

  • Conservatives assert that high earners would work substantially longer and harder if their tax rates were reduced.
  • Liberals counter that the effort of high earners is insensitive to tax rates.

Who is right? To be frank, the profession does not know the direction of the effect of tax rates on labour supply, never mind the magnitude. This column explains why.

Taxation and labour supply in theory

To begin, it is essential to understand that standard economic theory does not predict the response of labour supply to income taxation. According to pure theory, a tax rate increase may lead a rational person to work less, more, or the same.

The silence of theory on the direction question has long been appreciated. A clear statement appeared over 80 years ago in an article by Lionel Robbins (1930). A simple model familiar to undergraduate students suffices to see that a person may respond to income taxes in different ways.

This textbook model considers a person who must allocate a unit of time (perhaps a day or week) between paid work and the various non-paid activities that economists traditionally call leisure. Labour supply arises from a balancing act between after-tax income and leisure – economists suppose that workers want, but cannot have, more of both. When taxes go up, after-tax income dips and this would – all else equal – dip the balance towards choosing more leisure and less work. But not all else is equal. The tax hike lowers after tax income and this may shift the worker into a different range of the income-leisure trade-off. Specifically, the worker may value income more highly (compared to leisure) when his or her income falls.

In short, there are two forces at play – both well known to economic students – the income and substitution effects. Which way the combination works out depends upon preferences. For some preferences labour supply increases with taxation, with others it decreases. Other preferences yield more complex relationships between net wage and labour supply. A comprehensive review article by Nicholas Stern (1986) describes many possibilities.

Empirical research

As theory does not predict how income taxation affects labour supply; empirical analysis is needed. Economists have performed numerous empirical studies, using two approaches.

  • One approach makes no reference to theory.

Researchers may compare the work effort of persons living in different tax jurisdictions, or they may compare labour supply in a single jurisdiction before and after a change in policy. A basic problem is that such analyses are valid only if the jurisdictions being compared are, in fact, comparable. Another is that geographic and historical variation in tax policy spans only a small subset of the policies that a society may contemplate.

  • The second approach directly uses economic theory.

A researcher observes the time allocation that a person chooses under an existing tax policy and assumes that the person prefers the chosen allocation to all others that he could have chosen. Then observation of labour supply under the existing policy reveals something about the person’s preferences. This elegant idea, revealed preference analysis, originated with Paul Samuelson in the 1930s.

Unfortunately, the assumption that persons choose their most preferred time allocations has little predictive power per se. So researchers have made strong preference assumptions in order to obtain sharp predictions of behavioural responses to new tax policies. They begin with the reasonable assumption that more is better, and then they add further assumptions that lack credibility. For example, researchers may assume that all working-age males would adjust their time allocation in the same way in response to a change in their wage. The assumption that different persons have the same preferences has no foundation in theory nor support in actuality.

The methodologies, data, and findings of modern research have been summarized and critiqued in multiple lengthy review articles including recent ones by Meghir and Phillips (2010), Keane (2011), and Saez et al. (2012).

  • Attempting to distil the huge literature, Meghir and Phillips (2010) write (p. 204): “Our conclusion is that hours of work do not respond particularly strongly to the financial incentives created by tax changes for men, but they are a little more responsive for married women and lone mothers.”
  • Saez et al. (2012) reach a similar conclusion.
  • Keane (2011) expresses a different perspective, writing (p. 1071): “My review suggests that labour supply of men may be more elastic than conventional wisdom suggests.”

Reading the recent empirical literature, I have been struck to find that while authors may differ on the magnitude of labour-supply elasticities, they largely agree on the sign. The consensus is that increasing tax rates usually reduces work effort. Considering the effect of a rise in a proportional tax, Meghir and Phillips (2010) write (p. 207): “in most cases this will lead to less work, but when the income effect dominates the substitution effect at high hours of work it may increase effort.” Keane (2011) states the directionality of the effect without reservation, writing (p. 963): “the use of labour income taxation to raise revenue causes people to work less.” Here and elsewhere, empirical researchers may recognize the theoretical possibility that effort may increase with tax rates but view this as an empirical rarity rather than a regularity.

Are the estimates artefacts of assumed preferences?

Examining the models of labour supply used in empirical research, I have become concerned that the prevailing consensus on the sign of elasticities may be an artefact of model specification rather than an expression of reality. Models differ across studies, but they generally share two key assumptions.

  • First, they suppose that labour supply varies monotonically with net wages.

Thus, model specifications do not generally permit backward-bending labour supply functions or other non-monotone relationships.

  • Second, they suppose that the response of labour supply to net wage is homogeneous within broad demographic groups.

That is, they assume that all group members would adjust hours worked in the same way in response to a conjectural change in net wage.

The reality may be that persons have heterogeneous income-leisure preferences and, consequently, heterogeneous labour-supply functions. Some may increase work effort with net wage, others may decrease effort, and still others may exhibit a non-monotone wage-effort relationship. If so, estimates of models that assume monotonicity and homogeneity of labour supply can at most characterise the behavior of an artificial ‘representative’ person. The estimates may not have even this limited interpretation.

A fresh look at the inference problem

In light of the above, I have recently examined anew the problem of identification of income-leisure preferences and have drawn implications for evaluation of tax policy. In Manski (2012), I study what happens when one strips away the strong preference assumptions made in empirical research and maintains only the reasonable assumption that people prefer to have both more income and more leisure. Then revealed preference analysis takes a form similar to that originally studied by Samuelson. I find that one cannot obtain sharp predictions of time allocation under new policies. Indeed, one cannot predict whether labour supply would increase or decrease in response to changes in tax rates.

I then explore the identifying power of adding assumptions that restrict the population distribution of preferences. As in my past research, I find it illuminating to begin with weak assumptions and then to characterize the identifying power of stronger assumptions. (See Manski 2007 for a textbook exposition of the approach.) My generic finding is partial identification of the preference distribution. Rather strong and implausible assumptions are needed to make sharp predictions.

Thus, we really do not know how labour supply responds to tax rates. This conclusion will comfort neither conservatives nor liberals. Yet our society deserves to be aware of what we do not know.

References

Keane, M. (2011), “Labor Supply and Taxes: A Survey”, Journal of Economic Literature, 49, 961-1075.

Manski, C (2007), Identification for Prediction and Decision, Harvard University Press.

Manski, C (2012), “Identification of Income-Leisure Preferences and Evaluation of Income Tax Policy”, Cemmap Working Paper 07/12, Institute for Fiscal Studies.

Meghir, C and D Phillips (2010), “Labour Supply and Taxes”, in T Besley, R Blundell, M Gammie, and J Poterba (eds.), Dimensions of Tax Design: the Mirrlees Review. Oxford University Press, 202-274.

Robbins, L (1930), “On the Elasticity of Demand for Income in Terms of Effort”, Economica, 29:123-129.

Saez, E, J Slemrod, and S Giertz (2012), “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review”, Journal of Economic Literature, 50:3-50.

Stern, N (1986), “On the Specification of Labour Supply Functions”, in R Blundell and I Walker (eds.), Unemployment, Search and Labour Supply, Cambridge University Press, 143-189.

Topics: Frontiers of economic research, Labour markets, Taxation
Tags: Income tax, labour supply

Charles F Manski
Professor in Economics, Northwestern University
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