How responsive is the labor market to tax policy?

A life-cycle perspective

Many recent studies emphasize a life-cycle perspective, noting that although responses may appear small at certain points in the life cycle, they are large at other points. Viewed over the whole life cycle, labor supply can be quite responsive to taxes even for those who appear not to respond to changes in incentives early in their working career. In a life-cycle analysis, tax reforms can substantively alter the input of hours and effort over a lifetime.

A micro-data-based model of retirement choices, which allows for disincentives in social security and medical insurance at the individual level, has been developed to explore these lifetime responses. Weakening these disincentives is found to have much larger impacts for older workers than for younger ones. At older ages there are more workers who are close to their labor market participation margin and who are more likely to respond to incentives. These workers provide more convincing micro-evidence on the potential of supply-side responses through the extension of the working life.

Interactions between human capital investments and labor supply

Added to this life-cycle view is a greater focus on the interaction between human capital investments and labor supply. A lifetime framework accounts for responses in investments in education and on-the-job training alongside labor supply. Human capital investments increase the payoff to work and augment earnings over the working life. Micro-based studies increasingly acknowledge features of both labor supply and human capital behavior in tax policy analysis. A recent study noted that the payoff to human capital investments may be greater among workers with higher initial education investments [3]. In turn, education investments depend on perceived returns that can be clearly influenced by redistributive taxation. A long line of research relating experience capital and future wages convincingly supports the argument that allowing for human capital increases the responsiveness of labor supply to tax changes and that these effects differ over the life cycle.

Interactions of tax and welfare systems

While hardly new, this life cycle–human capital setting for analyzing labor supply responses deserves more attention and better integration in the general analysis of supply-side reforms of tax, welfare, and social insurance systems. Assessing the effective incentive, or disincentive, to work induced by the tax and welfare systems requires careful analysis of how tax rates, tax credits, and welfare benefits overlap. Benefits change incentives to work, first by providing income to those who are out of work and then by withdrawing those benefits as income is earned in work. When considered together with tax credits, employer taxes, and income tax rates, effective tax rates can be extremely high, especially for low-wage workers.

Fixed costs and information costs

The distinction between whether to work and how much to work seems a natural one to make in a study of work incentives. Yet it is not as simple as it seems. Should the unit of analysis of the decision on whether to work be a day, a week, a month, a year, a job, or a lifetime? The answer depends partly on where the “fixed costs” of work are important. Potentially important aspects of fixed costs include child care, travel to work, and work clothing. Even then, the strength of the responses at the extensive and intensive margins can have a large effect on where work incentives are placed and where they are likely to be most effective. At the extensive margin, responses are strongest for younger workers, parents of young children, and older workers.

Information is also vital for understanding responses and properly measuring effective incentives in the tax system, as shown in a series of studies that consider bunching at the “kinks” in hours of work and in earnings and the role of information on the earned income tax credit [6]. If the information requirements are too complex, some people will be unwilling, unable, or too uninformed to access all the benefits and tax credits for which they are eligible. It is difficult to argue against a policy reform that makes an individual’s eligibility for certain benefits and tax credits more transparent and clarifies the effective tax rates in the system.

Tax avoidance and shifting

The focus here on hours, employment, and human capital is not meant to ignore other key ways that earnings respond to taxes, such as taxation of top income earners and the self-employed. In that context concerns about the tax base come back into play. For example, a convincing case can be made for looking directly at taxable income. The more opportunities for tax exemptions and deductions and for tax shifting to lower tax jurisdictions, the more difficult it is to raise revenue from the top income earners. Analysis requires a general elasticity measure that captures these other avenues of response. The taxable income elasticity does just that.

A higher tax rate on a smaller base will raise less revenue and will probably be harder to sustain. The responsiveness of taxable income to the tax rate is a key parameter for setting top tax rates (see Higher tax rates on a smaller base). This elasticity captures additional avoidance and tax-shifting responses and can be expected to fall as the tax base broadens. For a given tax base a simple formula can give an idea of the revenue maximizing rate for the top tax bracket—the Laffer rate [7].

Younger, low-education workers and workers with young families

The evidence suggests that younger workers with little formal education are likely to experience a low payoff from investments in on-the-job training, whether through passive learning by doing or active investment, because of the complementarities between human capital investments [8]. Consequently, at least in buoyant economic times, low-education workers have little dynamic incentive to stay in work over and above the current-period incentives modeled in standard labor supply analyses. Typically, they face important complexities in the tax and welfare benefit systems through the interaction and overlap of the tax, tax credit, and welfare systems, especially if they have children. To understand their responses, it is important to model these nonlinear budget constraints and to account for awareness and take-up of welfare and tax credit entitlements.

The distribution of younger, low-education workers is likely to be closer to the participation margin than the distribution of their more educated counterparts, making the low-education workers particularly sensitive to incentives at the extensive margin. For these workers it becomes important to allow for fixed costs of work, including child-care costs. There is evidence that once these details are accounted for, standard static models of labor supply behavior that account for demographic differences and differences at the extensive and intensive margins, as well as program take-up, can provide a reasonably good guide to the behavioral responses to tax and welfare reform [3].

The literature on labor supply responses for low-education workers suggests moderately high extensive margin elasticities, especially for women with young children, and somewhat lower intensive margin elasticities (often also pointing to important income effects for such groups) [4]. This combination of elasticities can be used to argue for the introduction or expansion of earned income tax credit-style subsidy programs for certain groups of low-wage workers [7].

Perhaps the most responsive segment of labor supply is low-education mothers returning to work after having a child. Well documented in the empirical literature, this phenomenon deserves to be a key part of the design of work incentives for low-wage workers. A suggested means of reaching these women is “tagging” implicit tax rates in tax credits and in the taper rate of means-tested benefits according to the age of the youngest child.

Children play a key role. Even if fertility decisions are exogenous to the tax system (which may be an assumption worth relaxing), the reforms that follow from these Mirrlees-style arguments often make a case for targeted wage subsidies that encourage work among young low-education women. There are of course other arguments to justify these policies. But if early childhood investments by parents (through time spent interacting with and reading to their children, for example) are key to child development, subsidizing work for low-education mothers with younger children might seem counterproductive. However, if human capital begets human capital from one generation to the next, then this concern may be less compelling. Instead, the argument for early child human capital investment might suggest targeted subsidies or targeted loans for high-quality child care to complement earnings incentives for low-wage parents.

Human capital investments

Human capital investment decisions have often been left aside in arguments about labor supply incentives. But progressive taxes will change the incentives to acquire education and to invest in human capital over the working life by reducing the expected return to education and by insuring against very low-wage outcomes that might otherwise occur for low-education workers. Both considerations have been shown to be potentially important in incentives for high school and college enrollment. On the flip side, targeted financial incentives to remain in school have met with some success. However, the degree to which progressive taxes reduce education investments is still far from fully researched.

Human capital investments take two forms: formal education and on-the-job training. The higher the education level, the longer into the working life that wages grow and the higher they peak (see Figure 3). Research has also found that on-the-job investments tend to complement formal education investments. Education complements experience capital, increasing earnings, extending the life-cycle profile, and making early retirement less advantageous. There is some evidence that this complementarity also extends to workplace qualification training.

For younger workers who have acquired higher levels of formal education before entering the labor market, an enhanced dynamic incentive adds to the static current-period incentives for work. That human capital investments enhance incentives to work and to work for longer is perhaps no surprise [9]. For educated workers, employment generates valuable experience, which is likely to depreciate with time out of the labor market. Consequently, very few educated young workers will be near the participation margin, and so they are unlikely to respond strongly to employment incentives or disincentives in the tax system while they are young. But from a lifetime labor supply perspective, the overall impact of taxation on the career length and earnings profile of higher-educated workers can be substantial. Incentives for early retirement implicit in some social security, earnings tests, and medical insurance schemes may then act to reduce the incentive to acquire human capital.

Added to this, part-time work produces little in the way of experience payoff, at least for women [3]. So there is a dynamic incentive to stay in full-time work. The part-time experience penalty adds to the other fixed-cost and work organization arguments about why part-time work is often less financially rewarding.

For people leaving school with lower educational qualifications, the key is to design a transition into work that avoids long spells of unemployment. This transition also appears responsive to work subsidy incentives and monitoring. But the policy design issue here is to prevent young people from leaving school too early and experiencing spells when they are neither in work nor in school. Financial incentives to stay in school can help. In general, work decisions by people with less education do appear to be sensitive to incentives in the tax benefit system.

Older workers

Even workers with high human capital investments are likely to become more responsive to incentives at the extensive margin as they approach retirement. This pattern of responsiveness over a lifetime is confirmed by high labor-supply responses at the extensive margin among older workers. The greater density of older workers around this margin has important implications for tax policy. That work decisions later in life are responsive to incentives is well documented [2].

The evidence shows strong variation in labor market activity for men and women in their late 50s and 60s. In most developed countries labor market activity declines at older ages, though with some recent reversals. In the UK, for example, people at the lower and upper ends of the wealth distribution are more likely to leave employment early than those in the middle. Broadly speaking, the poor are more likely to move onto disability benefits, while those with higher pension income and greater financial wealth are more likely to retire early and live on private pension income. Those in the middle are more likely to remain in paid work.