Gruber4e ch21

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 29
Taxes on Labor Supply
21
21.1 Taxation and Labor SupplyTheory

21.2 Taxation and Labor SupplyEvidence
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
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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21.1
C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY
Icelands Supply-Side Experiment
In 1987, Icelands income tax rate was zero.
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21.1
Basic Theory
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 Avas budget constraint is now the
after-tax wage, 8.75.
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21.1
Basic Theory
Consumptio
n
slo
pe
=
1
slo
2.
pe
50
=
8
.7
5
C1 = $13,750
A
Indifference curve, IC1
C2 = $9,625
BC2
0
900
BC1
Leisure
hours
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21.1
Substitution and Income Effects on Labor Supply
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.
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21.1
Substitution versus Income Effect
Consumption
$13,7
50
7,000
(a) Substitution effect is

larger
$13,7
50
12,25
0
IC
B
Consumption
(b) Income effect is

larger
A
C
IC
900 1,200
IC
BC 2 BC1
2
Leisure
hours
IC
1
BC
0
600 900
BC1
Leisure
hours
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21.1
Limitations of the Theory: Constraints on Hours

Worked and Overtime Pay Rules
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.
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21.2
Taxation and Labor SupplyEvidence
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 .
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21.2
EVIDENCE: Estimating the Elasticity of Labor

Supply
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.
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21.2

Supply: Cross-Sectional Linear Regression
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.
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21.2

Supply
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.
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21.2
Limitations of Existing Studies
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.
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21.3
Tax Policy to Promote Labor Supply: The Earned

Income Tax Credit
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 lowerincome 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.
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21.3
Background on the EITC
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21.3
Background on the EITC
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.
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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
Impact of EITC on Labor Supply: Theory
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.
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21.3
Impact of EITC on Labor Supply: Evidence
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
mens labor supply appears not to respond
to the EITC.
Summary: EITC supports redistribution
without reducing labor supply,
accomplishing its goals.
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21.3
EVIDENCE: The Effect of the EITC on Single Mother

Labor Supply
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.
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21.3
EVIDENCE: Changes in the EITC Structure
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21.3
APPLICATION: EITC Reform
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.
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21.4
The Tax Treatment of Child Care and Its Impact on

Labor Supply
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 parents labor supply, so they reduce
labor supply, and child care subsidies can
increase labor supply.
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21.4
The Tax Treatment of Child Care
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 posttax 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.
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21.4
The Tax Treatment of Child Care

Imput Deduct
e
Child
Bas
Care
e Earnin
gs
Pre-tax/child care
earnings
1,00
0
1,000
1,000
Child care costs

Child care deduction
Imputed earnings
600
0
0
600
0
600
600
600
0
Taxes if work
Taxes if home
After-tax value of
Publicwork
Finance and Public Policy Jonathan Gruber
500
0
500
500
300
500
200
0
800
Fourth Edition Copyright 2012 Worth Publishers
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21.4
Comparing the Options
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.
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21.4
EVIDENCE: The Effect of Child Care Costs on

Maternal Labor Supply
Cant 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.
Public Finance
and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
28 of 29
21.5
Conclusion
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.
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Public Finance and Public Policy Jonathan

Taxes on Labor Supply

21.1 Taxation and Labor SupplyTheory

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Icelands Supply-Side Experiment

In 1987, Icelands income tax rate was zero.

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Ava trades off consumption (which requires

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Substitution and Income Effects on Labor Supply

Taxes have two effects:

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Substitution versus Income Effect

(a) Substitution effect is

(b) Income effect is

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Limitations of the Theory: Constraints on Hours

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Taxation and Labor SupplyEvidence

Separately examine primary and secondary

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

EVIDENCE: Estimating the Elasticity of Labor

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

EVIDENCE: Estimating the Elasticity of Labor

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

EVIDENCE: Estimating the Elasticity of Labor

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Limitations of Existing Studies

Blurring line between primary and

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Tax Policy to Promote Labor Supply: The Earned

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Background on the EITC

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Background on the EITC

The EITC is a refundable tax credit; the

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

The EITC Benefit Structure

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Impact of EITC on Labor Supply: Theory

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Impact of EITC on Labor Supply: Theory

This figure illustrates the impact of the EITC

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

Impact of EITC on Labor Supply: Evidence

Effects on Labor Force Participation:

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

EVIDENCE: The Effect of the EITC on Single Mother

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

EVIDENCE: Changes in the EITC Structure

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

APPLICATION: EITC Reform

The EITC, though successful, has some

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

The Tax Treatment of Child Care and Its Impact on

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

The Tax Treatment of Child Care

Child care creates a tax wedge because

C HAP T E R 2 1 TAX E S O N LAB O R S U P P LY

The Tax Treatment of Child Care

Child care costs

Fourth Edition Copyright 2012 Worth Publishers