1. The Tax-Transfer System and Labor Supply Michael P. Keane University of Oxford Becker – Friedman Institute University of Chicago September 27, 2013

2. Why Labor Supply Matters for Design of the Tax System “Optimal Taxation” – Basic Tradeoff: (1) Government needs to raise a certain amount of money to pay for public goods. (2) Taxation causes people to work less. This leads to an efficiency or welfare loss. (The economic “pie” gets smaller).

3. Why Labor Supply Matters for Design of the Tax System How bad is this “Shrinking Pie” problem? It depends how much people reduce their labor supply if you tax them (How big is the labor supply elasticity?). Basic Solution of “Optimal Tax” theory: Tax people more if their labor supply is more “inelastic” (i.e., less responsive to taxes)

4. The Labor Supply Literature Until recently there was a clear consensus that labor supply elasticities are small: Saez, Slemrod and Giertz (JEL, 2012): “…the profession has settled on a value for this elasticity close to zero … This implies that the efficiency cost of taxing labor income … is bound to be low …”

5. The Labor Supply Literature I will argue that most existing estimates of labor supply elasticities are biased downward This is because they ignore the fact that work experience builds human capital See Imai and Keane (IER, 2004), Keane (JEL, 2011), Keane-Rogerson (JEL, 2012) Recently this idea has started to gain traction

6. Why are Labor Supply Elasticity Estimates Usually Small? Hours vs. Wages over the Life-Cycle (Men): Given this pattern, the elasticity looks very small Age Hours, Wages Hours Wage

7. The Problem with Most Prior Work: Assumes Wage = Price of Time But the after-tax wage is not the price of time If you work more hours (today) you get both: 1.The after-tax wage rate (today) 2.The increase in future earnings due to the human capital gained from work experience “Effective Wage” = After-Tax Wage + Human Capital Gained by Working See Heckman (1976), Shaw (1989)

8. The Effective Wage Rate Effective Wage over the life-cycle: It is much flatter than the measured wage Wage Age Effective wage = Wage + HC return Wage HC return

9. Labor Supply and the Effective Wage Hours vs. Effective Wage over the Life-Cycle Hours look very responsive to effective wage Wage, Hours Age Hours Effective Wage

10. Human Capital and Long Run Tax Effects If work experience builds human capital it implies effect of taxes on labor supply will grow over time I’ll illustrate this by simulating a permanent 5 percent tax rate increase in the model of Imai and Keane (IER, 2004) Three Cases: The increase occurs when a person is 25, 30 or 35

12. Effect of Permanent Tax Changes Note: The effect of a tax increase grows over time It slows down the rate of human capital accumulation, creating a “snowball” effect on after-tax wages Seeing a small short-run effect may trick us into thinking elasticities are small

13. Labor Supply Summary What economists call the “welfare cost” of income taxation (how much it shrinks the pie) is likely to be much higher than previously thought, because: Economists have largely ignored how taxes alter incentives to acquire human capital Ignoring human capital has led economists to underestimate how much taxes can reduce labor supply

14. Some Comments on Transfers A Typical Welfare or Transfer Program Income Leisure No Work Welfare Grant level Full-Time Work Earnings Indifference Curve: Income vs. Hours

15. Some Comments on Transfers Lower Phase-Out Rates Don’t Work: Making people appear insensitive to taxes Income Leisure No Work Welfare Grant level Full-Time Work Earnings Indifference Curve: Income vs. Hours

16. Some Comments on Transfers BUT, a modest increase in the after-tax wage can cause a big jump in hours: Suddenly labor supply looks very elastic! Income Leisure No Work Welfare Grant level Full-Time Work Earnings Indifference Curve: Income vs. Hours

17. Some Comments on Transfers Lesson: The “labor supply elasticity” is not an absolute number It can be large or small depending on the nature of the tax and/or transfer change Keane and Rogerson (JEL, 2012) give a number of illustrations of this point in different contexts

18. Smarter Transfers A Bonus for Work (including subsidies of fixed costs) Income Leisure No Work Welfare Grant level Full-Time Work Earnings New Higher Indifference Curve: Income vs. Hours Government Saves Money and the Person is Happier !!

19. Smarter Transfers This idea for welfare reform was proposed in: Keane (1995). “A New Idea for Welfare Reform.” Federal Reserve Bank of Minneapolis Quarterly Review, 19:2, 2-28. Also discussed in: Keane and Moffitt (1998). “A Structural Model of Multiple Welfare Program Participation and Labor Supply.” International Economic Review, 39:3, 553-589. The “working families tax credit” in the UK has a similar design, with a 16 hour work requirement

20. A Subsidy for Working = Subsidizing Costs of Work This is sometimes called “making work pay” – i.e., subsidize work instead of paying people not to work A big part of the cost of work is quality child care/pre-school, especially for lone mothers. Work cost subsidies play a dual role as early childhood education and human capital policy

21. Conclusion In general, we should think more about how the tax/transfer system interacts with human capital development