My colleague Arpit Gupta has written a fantastic commentary on how to think about a changing tax burden. In it he describes the still-unfolding debate over how to understand the impact of high marginal tax rates on GDP. Arpit contrasts the Prescott view (taxes have a big impact on GDP) with the Alesina-Glaeser view (taxes aren’t as important union density and labor market regulation and increasing returns to leisure) before introducing the work of Raj Chetty and his colleagues.

Ultimately, a review of these two research strands still leaves the key question unanswered – why do the negative impact of taxes appear much larger at the national level than the firm level?
A clever resolution is suggested by a set of papers by Raj Chetty, an economist at Harvard. Chetty points out that the micro estimates rely on instantaneous adjustment to higher tax rates, and typically focus on short durations after law changes. However, a variety of factors may combine to make the behavior responses to tax cuts a more long-run effect. People face costs in switching jobs or entering the job force. They may simply be unaware of tax changes or lazy. Any of these plausible frictions are compatible with large long-term effects of tax cuts that are difficult to capture in micro data.

This certainly resonates with our basic intuitions: while it’s certainly true that some people are keenly attuned to their effective marginal tax rate, work effort is closely tied to peer effects and identity. Raise marginal taxes by 3 or 4 points and a banker won’t immediately quit her job to open a surf shop. Over a longer period of time, however, changing tax levels will change the culture, and inform incremental decisions, e.g., should I move to this branch office, should I gun for this promotion, etc. Our banker might find that a large and growing number of her friends are taking time out from the workforce, or enjoying leisurely dinner parties when they used to spend long hours at the office. The cumulative impact is a discernible shift in the number of hours worked.

To get even more anecdotal, I see this effect in my own life. And again, there’s always the danger of confirmation bias, so take my observations with a grain of salt. Among otherwise comparable groups of youngish professionals in big European capitals and big U.S. cities, the former are far more likely to entertain at home than the latter, even when the binding constraint isn’t the small size of the typical New York apartment. The outsourcing of household labor is often stymied by high rates of VAT and high marginal tax rates. It should go without saying that there might be something good about this emphasis on leisure and friendship over work and consumption. But one can underestimate the charms of a healthy amount of net disposable income as well.