1. © Institute for Fiscal Studies Taxes and Labour Supply: Theory, Evidence and Policy David Phillips (IFS)

2. © Institute for Fiscal Studies Outline 1.The theory: labour supply elasticities and more 2.Measuring labour supply responsiveness 3.How responsive are hours of work and employment? 4.Beyond hours: taxable income elasticities 5.Policies: Mini Jobs for Lone Parents Conclusions

3. © Institute for Fiscal Studies The Basics ‘Labour Supply’ is the supply of effort and time by individuals for monetary compensation. Working out revenue implications of tax reforms Working out the ‘optimal’ tax rate structure. Theoretical and empirical work has traditionally focused upon hours of work but more recently a recognition of: The participation decision (extensive margin) Effort and Compensation Form But what basic lessons can we use from Econ 101?

4. © Institute for Fiscal Studies Substitution Effect Income and Substitution Effects H l NI A A’ A’’ Income Effect Higher tax rate reduces net income. If leisure is a normal good this reduces demand for leisure and increases Labour Supply. Higher tax rate reduces the marginal wage and hence the price of an extra hour of leisure. This acts to decrease Labour supply. Tax has an ambiguous effect on Labour Supply

5. © Institute for Fiscal Studies Elasticity of Labour Supply There are two types of elasticity we are interested in: The uncompensated elasticity (ε m ) –Includes both the income and substitution effect The compensated elasticity (ε h ) –Includes only the substitution effect When substitution occurs there is always deadweight loss due to distortions of behaviour

6. © Institute for Fiscal Studies Elasticity of labour supply: effect on revenues When a single tax rate, the uncompensated elasticity determines revenue: Change in Revenue ≈ (w*h Δt ) – (ε m *w*h/(1-t))*(Δt+t) H l NI A A’’A’’ Initial Revenue New Revenue

7. © Institute for Fiscal Studies Elasticity of labour supply: effect on revenues The uncompensated elasticity determines revenue: Change in Revenue ≈ (w*h Δt ) – (ε m *w*h/(1- t))*(Δt+t) H l NI A A ’’ More complicated when multiple rates and bands: need to know income, compensated elasticities and shape of income distribution The Laffer Point: Change in Revenue ≈ 0  (1 – t) = tε m  t max = 1/(1+ε m )

8. © Institute for Fiscal Studies Elasticity of labour supply: tax incidence (1) Labour supply Labour demand Tax increase Labour supply / demand Wage Inelastic labour supply: change in taxes = change in net wages Taxes borne entirely by the workers

9. © Institute for Fiscal Studies Elasticity of labour supply: tax incidence (2) Labour supply Labour demand Tax increase Labour supply / demand Wage Elastic labour supply: change in taxes > change in net wages Taxes partly shifted onto those purchasing labour Borne by worker Borne by purchaser

10. © Institute for Fiscal Studies Distribution of working hours Few people work only a small number of hours. Instead, concentrations at zero or “full time”. Why?

11. © Institute for Fiscal Studies Adding Fixed Costs of Work When you start work there are certain fixed costs: Transport costsWork clothing costs Childcare costsAnd others H A NI A’ Fixed costs mean not working better than working few hours l

12. © Institute for Fiscal Studies So the theory tells us… Income and substitution effects go in opposite directions –Uncompensated labour supply elasticity measures overall effect Higher elasticity of labour supply means –More deadweight loss –Lower revenue –More of the tax shifted from workers to those buying their labour More to modelling labour supply than measuring elasticities as labour supply ‘jumps’ discretely What about measuring the effect of taxes on labour supply?

13. © Institute for Fiscal Studies Econometric Issues (1)… You have data – a cross section of hours, wages and demographic characteristics. But theres a problem... People have different preferences for work/leisure. Those who like work are likely to work longer hours. They are also likely to work harder, engage in training more, have tried harder at school and are probably more able.  Spurious positive correlation between hours and wages If taxes exhibit increasing marginal rates, those working longer hours will face higher marginal rates and have lower net wages.  Spurious negative correlation between hours and wages We call such problems the ‘endogeneity problem’.

14. © Institute for Fiscal Studies Econometric Issues (2)… Solutions: Use time series changes in wages (potentially a panel data series). Preferably have exogenous reforms – e.g. Reduction of top rates of income tax, introduction of E.I.T.C. Remember to control for aggregate preference changes (e.g. social acceptability of women working). E.G Blundell, Duncan & Meghir (1998) Avoid modelling the complex tax system by using only women paying basic rate (nearly linear budget constraint). Avoid preference problem by making use of changes in income distribution and tax reform in the 1980s. Makes use in differential changes in post-tax wages for different cohorts and educational groups. This allows for differences in behaviour between groups but assumes these differences are not time-varying

15. © Institute for Fiscal Studies Econometric Issues (3)… Solutions: Treat labour supply as discrete (e.g. full time, part time, not work) and estimate income at these points using full tax and benefit system. E.G Meghir & Phillips (2010) Men have a 1-0 choice of working or not, with income in work estimated as a weighted average of income at various hours points. Use predicted wages for both non-workers and workers to account for (spurious) correlation of hours of work and pre-tax wages due to preferences. Use the differential trends across regions in wages and housing benefits (out of work income) as exogenous changes in work incentives making use of multiple years of data.

16. © Institute for Fiscal Studies Elasticity Estimates (Female) Author(s)Basic MethodologyEstimated Elasticities Hausman (1981)Linear labour supply with convex and non- convex budget sets Wage: 0.906 – 0.995 Income: -0.121 – - 0.13 Cogan (1981)Log-linear labour supply, fixed costs, linear budget constraint Wage: 0.864 Income: -0.16 Blundell, Duncan and Meghir (1998) Log-linear labour supply, fixed costs, accounts for taxes and benefits. Wage: 0.13 – 0.37 Income: -0.06 – -0.19 Aaberge et al (1999) Flexible labour supply, taxes and benefits, supply and demand constraints Wage: 0.654 Income: -0.014

17. © Institute for Fiscal Studies Elasticity Estimates (Male) Author(s)Basic MethodologyEstimated Elasticities Ashenfelter & Heckman (1974) Labour supply linear in differences. No account of taxes or benefits Wage: 0.06 Income: -0.11 Bourgiugnon and Magnac (1990) Linear labour supply, convex budget with taxes and fixed costs Wage: 0.10 Income: -0.07 Blomquist & Newey (2002) Non-parametric and allowance for ‘small’ non-convexities Wage: 0.06 – 0.08 Income: -0.02 Meghir & Phillips (2010) Discrete choice with full tax and benefit modelling and control for endogenous wages ‘Wage’: 0.32 (low educ) 0.13 (mid educ) 0.03 (high educ)

18. © Institute for Fiscal Studies Other aspects of Labour Supply So far we have focused on hours but what about other aspects of labour supply? intensity of effort (payment by results) effort to seek promotion investment in skills, education and complimentary capital If substitution is easier for effort/investment than for work-hours  hours elasticities underestimate welfare cost of taxation. Problem: we cannot measure effort...

19. © Institute for Fiscal Studies Taxable Income Elasticity (1)... but we can measure income. Income reflects both hours of work and effort per hour. It is a proxy for total effort. Two measures: Broad Income – reflects changes in effort. Taxable Income – reflects changes in effort but also shifts in income from taxable to non-taxable forms (tax avoidance) and tax evasion. Reallocation of income also entails welfare costs, and of course, revenue implications.

20. © Institute for Fiscal Studies Taxable Income Elasticity (2) Main method of calculating taxable income elasticities is difference-in-differences. Two groups – one affected by a change in tax rates (H), the other not (L). Elasticity = difference in % change in income. difference in % change in marginal rate Elasticity = ΔlnEH – ΔlnEL. Δln(1-tH) - Δln(1-tL)

21. © Institute for Fiscal Studies Taxable Income Elasticity (3) Problems with this methodology: Mean Reversion E = μ + αt + Xi’β +Uit Some people in group H likely to have transitory high income, and vice versa.  Revert to mean: expect high income to fall, low income to rise.  Estimates of elasticity will be downwardly biased. General Equilibrium Labour of different prices is probably labour of different ‘types’ to some extent. Increased supply of those benefiting from tax cut (e.g. High skilled) will depress price of this ‘type’, reducing income.  Estimates of elasticity will be downwardly biased.

22. © Institute for Fiscal Studies Taxable Income Elasticity (4) Secular Trends in Skills prices The price of various types of Labour may be changing for reasons other than tax reforms – e.g. trade or technological change.  Varies, but in 1980s/1990s, elasticity will be upwardly biased. Anticipation effects If a tax rise (or cut) is announced, people will bring forward (or put back) income if they have such flexibility – e.g. Bonuses, dividends, capital gains.  Estimates of elasticity upwardly biased unless account for these ‘timing’ effects. Re-allocation over the lifetime People may respond to changes in taxes by changing how they spread their earnings over their lifetime. Lower tax payments now but higher later.  Estimates of elasticity upwardly biased.

23. © Institute for Fiscal Studies Elasticity Estimates Author(s)Basic MethodologyEstimated Elasticities Feldstein (1995)No controls1.1 (Low Income) 3.05 (High Income) Goolsbee (1999) No controls.- 1.3 to 2.0 depending on reform. Gruber & Saez (2000) Includes (lagged) log income, trends and a 10-piece spline. 0.12 (Broad Income) 0.4 (Taxable Income) 0.57 (High) 0.12 (Low)

24. © Institute for Fiscal Studies The empirical literature tells us… It is difficult to measure the effects of taxes on labour supply properly –Endogeneity plagues estimation of labour supply elasticities and taxable income elasticities –Wages and tax rates are correlated with preferences for work –Diff-in-diff assumptions do not hold Labour supply is more responsive for women than men Taxable income elasticities pick up more margins of adjustment than just hours and find evidence that response is higher for the very highest earners Now, lets use a labour supply model to analyse policy…

25. © Institute for Fiscal Studies Why is lone-parent employment low? Fewer than 60% of lone parents employed versus about 70% of mothers in couples: Similar number of lone parents working 16+ hours. But far fewer lone parents working 1 – 15 hours. Why? Presently, no incentive to do so: Income Support is Tapered away at 100% above earnings of £20 a week. Housing Benefit and Council tax have tapers of 65% and 20%. When combined with income tax, marginal effective tax rates (METRs) of over 95%. No working tax credit (WTC) unless you work 16 hours per week.

26. © Institute for Fiscal Studies The gains from working..... are less for lone parents for 8 – 16 hours.

27. © Institute for Fiscal Studies.. and they face high effective tax rates

28. © Institute for Fiscal Studies In 2007 IFS and One Parent Families were asked by the Joseph Rowntree Foundation to look at ways of improve work incentives. Giving WTC to lone parents working less than 16 hours per week. Increasing the earnings disregard for income support and other means-tested benefits. Reducing the taper rate on income support and other means- tested benefits. - does more to encourage jobs with higher rates of pay. - but administratively more burdensome as still need to know about small changes in income. Making ‘mini jobs’ Pay...

29. © Institute for Fiscal Studies Model used to model the reforms: estimated using repeated cross sections from the Family Resources Survey (FRS) – roughly 17,000 lone parents. uses cross-sectional and time-series (policy reforms) variation in work incentives. discrete choice: not work, 1 – 15 hours, 16 – 23, 24 – 29, 30 – 37, 38+. income estimated at each of these choices. they take up all benefits and tax credits entitled to. use of childcare determined by family circumstances and hours – not price or subsidies. repeatedly draw a prediction for each lone parent to get weights for each hours choice, before and after reform. Modelling Lone Parent’s Labour Supply...

30. © Institute for Fiscal Studies Results PolicyCost (no Ls) Cost (with Ls) Change in Earnings Less than 16 hours 16 – 29 hours 30 + hours Reduce WTC hours from 16 to 8 £85 million £175 million - £118 million +2.10-0.54-0.57 Increase Income Support, HB and CTB disregard to £50. £269 million £278 million + £71 million +2.19+0.66-0.56 Increase Income Support, HB and CTB disregard to £88.32 (16*MW) £735 million £791 million + £317 million +3.55+2.71-0.86 WTC reduces average hours, offsetting extra tax credits. Increased disregards also encourage 16 – 30 hours work, increasing average hours and earnings.

31. © Institute for Fiscal Studies Universal Credit to be introduced from 2013: replaces myriad benefits with a single benefit with multiple elements reduces the maximum METR rate from 100% to around 76% Increases the income disregard before benefits withdrawn For lone-parents it will be at least £50 per week and up to almost £150 a week Some similarities with reforms described and modelled above Also similar to Brewer, Saez and Shepherd’s (2010) Integrated Family Support proposal Changes in policy announced since 2007…

32. © Institute for Fiscal Studies Much lower participation (and marginal tax rates) for ‘mini jobs’ Slightly weaker incentive to work more than 30 hours per week … will increase incentives for lone parents to work

33. © Institute for Fiscal Studies Conclusions (1) Income and substitution effects go in opposite directions - Tax rises have an ambiguous effect on labour supply and revenue but always entail deadweight loss. Fixed costs of work and complicated benefit structures give incentives for discrete jumps in labour supply Estimation of model made difficult due to complex budget constraint and unobserved preferences for work. - Use exogenous variation in incentives due to secular wage changes or tax reforms as basis of estimation.

34. © Institute for Fiscal Studies Conclusions (2) Estimated responsiveness varies by group - Low for men - Higher for women, particularly lone parents - Participation decision particularly sensitive Taxable Income Elasticities - Picks up effort and reallocation of income - But problems if simple diff-in-difference techniques used. Example: Lone Parents and Mini-jobs. - Lone parents face poor incentives to enter work at low hours. - Reforms to benefits and tax credits can have a big impact on labour supply for this sensitive group. - Universal credit aims to improve work incentives

35. © Institute for Fiscal Studies Main Readings C. Meghir & D. Phillips (2010) – Labour Supply and Taxes http://www.ifs.org.uk/mirrleesreview/dimensions/ch3.pdf K. Bell, M. Brewer & D. Phillips (2007) – Lone Parents and Mini-jobs http://www.jrf.org.uk/bookshop/eBooks/2110-lone-parents-minijobs.pdf M. Brewer, J. Browne & W. Jin (2011) – Universal Credit: a preliminary analysis http://www.ifs.org.uk/bns/bn116.pdf M. Brewer, E. Saez & A. Shepherd (2010) – Means testing and tax rates on earnings http://www.ifs.org.uk/mirrleesreview/dimensions/ch2.pdf

36. © Institute for Fiscal Studies Additional References Aaberge, Colombino, Strom (1999) "Labour Supply in Italy: An Empirical Analysis of Joint Household Decisions with Taxes and Quantity Constraints", Journal of Applied Econometrics, Vol 14. No 4. Ashenfelter & Heckman (1974) "The Estimation of Income and Substitution Effects in a model of Family Labor supply", Econometrica, Vol 42, No 1 Blomquist & Newey (2002), "Nonparametric Estimation with Nonlinear Budget Constraints", Ecometrica, Vol. 70, No. 6 Blundell, Duncan, Meghir, (1992), "Taxation in Empricial Labour Supply Models: Lone Mothers in the UK", The Economic Journal, Vol 102, No 411 Blundell, Duncan, Meghir (1998) "Estimating Labor Supply Responses using Tax Reforms, Econometrica, Vol 66, No 4 Bourguignon & Magnac (1990) "Labor Supply and Taxation in France", The Journal of Human Resources, Vol 25, No 3 Cogan (1981), "Fixed Costs and Labor Supply", Econometrica, Vol 49, No 4 Feldstein (1995), "The Effects of Marginal Tax Rates on Taxable Income: a Panel study of the 1986 Tax Reform Act", Journal of Political Economy, Vol 103, No 3 Goolsbee (1999) "Evidence on the High-Income Laffer Curve from Six Decades of Tax Reform", Brookings Papers on Economic Activity, Vol 1999, No 2 Gruber & Saez (2000) "The Elasticity of Taxable Income: Evidence and Implications", NBER Working Paper Series Hausman (1981), Labour Supply: How Taxes affect Economic Behaviour", Tax and the Economy, Brookings Institute