Labor Supply and Taxes

by Veronique de Rugy

I just got back from a four-day trip to France. During that time I got to hear an interview of the head of la CGT, one of the big labor unions there, about the alleged austerity plan that the government would like to put in place. He was not happy.

First, he was really annoyed by the fact that reforms implemented in Germany are now often referenced as a model for reform. For instance, ten years ago, the Germans made some important changes to labor-market laws, and in particular to unemployment policies, that could be at the core of its 6.2 percent unemployment rate today. One of the goals of that reform was to enable Germans to get “mini-jobs” without a large penalty; another was to make unemployment relatively uncomfortable so that people would look for jobs.

Second, he was very vocal about the fact that taxes and other government interventions had no impact whatsoever on unemployment levels or on labor supply. While I was listening, I wished he would read this Arpit Gupta piece about labor supply and taxes. Gupta does a good job at summarizing some of the issues around this question — for instance, why is it that macroeconomists tend to find that taxes have a large impact on labor supply while some microeconomists find a much smaller impact? Here is an important step in the direction of answering this question:

One resolution to this puzzle has come from Richard Rogerson, who has emphasized the difference between measuring the intensive and extensive margin. His argument is that people finding smaller labor supply estimates have focused on the response of individuals already in the workforce. But there are many reasons to think that people who are already working have limited ways, at least over the course of a few years, to alter their hours. On the other hand, people tend to have far greater discretion over their lifetime to choose whether to work or not. For instance, mothers in particular tend to face a sizable tradeoff between working or not, as do the elderly. Failing to properly account for this extensive margin decision would lead to the impression that higher taxes had little impact on labor supply; when in fact taxes might have a large impact through the channel of entry or exit into the labor force.  

In a new paper, Raj Chetty and co-authors provide estimates of this extensive margin:

“Macroeconomic calibrations imply much larger labor supply elasticities than microeconometric studies. The most well known explanation for this divergence is that indivisible labor generates extensive margin responses that are not captured in micro studies of hours choices… We find that micro estimates are consistent with macro evidence on the steady-state (Hicksian) elasticities relevant for cross-country comparisons. However, micro estimates of extensive-margin elasticities are an order of magnitude smaller than the values needed to explain business cycle fluctuations in aggregate hours. Hence, indivisible labor supply does not explain the large gap between micro and macro estimates of intertemporal substitution (Frisch) elasticities. Our synthesis of the micro evidence points to Hicksian elasticities of 0.3 on the intensive and 0.25 on the extensive margin and Frisch elasticities of 0.5 on the intensive and 0.25 on the extensive margin.

Chetty’s et al. suggests the the labor supply elasticity on the extensive may not be as large as Rogerson and some colleagues had hoped, but remains sizable. A 1% increase in taxes is associated with a .55% reduction in hours. The implication is that the entry or exit into the workforce does seem to be highly sensitive to taxes.

Gupta also has a good discussion about the value of labor elasticity of different groups. I wrote about Ed Precott’s work and some of these issues back in November here.

The Corner

The one and only.