Research on the effects of taxation on the economy, including labour supply

In the first of three articles, Bernd Hayo, Professor at the University of Marburg highlights recent macroeconomic research on the effects of taxation on the economy, including labour supply

This is the first of a series of three articles briefly highlighting recent macroeconomic research on the effects of taxation on the economy. The present article investigates inasmuch taxation has an impact on the labour supply. The second article will study the relationship between consumption and taxation. In the last article, we will take a look at the efficacy of tax changes as an instrument for stabilising the business cycle.

The link between taxation and labour supply is of considerable interest to both academics and policymakers. For instance, labour supply responses to taxation are important for assessing the efficiency loss associated with distortive income taxation. To answer the question as to what extent taxation influences the labour supply, Hayo and Uhl (2015) provide evidence based on a nonstandard methodological approach. Rather than relying on indirect estimates of labour supply based on observable economic data, they use a specifically designed, representative survey of the German population.

In the survey, they directly ask the respondents whether taxation matters for their labour supply decisions and, if so, how they adjusted their labour supply in response to a recent payroll tax change in Germany. Their results indicate that taxation matters for around 41% of the respondents, implying that the majority is unresponsive to taxation. One implication of this finding is that a significant part of the German population does not react to tax change and that taxation of this non-reacting group should lead to small efficiency losses.

Hayo and Uhl (2015) then use a 2013 payroll tax change to investigate specific labour supply responses to a real-world tax policy change. They discover that 17% of those respondents indicating that taxation is important for their labour supply decision increased, and 12% decreased their labour supply. The labour supply changes can be distinguished into an income and a substitution effect (Keane, 2011). The former refers to the situation that workers achieve a higher net income when the tax rate declines. A higher net income is then supposed to lead to a greater demand for leisure time, i.e. a reduction in the labour supply.

In contrast, the substitution effect refers to the higher net income making it more attractive to work, which should increase the labour supply. Since we find both people increasing and decreasing their labour supply, its suggest that both income and substitution effects of tax changes are empirically relevant, which is consistent with results reported in Borjas (2005).

Finally, Hayo and Uhl (2015) discover that results do not vary across individuals who believe these tax changes to be either temporary or permanent, which further supports the conclusion that the deadweight loss associated with progressive income taxation is rather small in Germany.

References

Borjas, G.J. (2005), Labor Economics, 3rd ed., Boston: McGraw-Hill/Irwin.

Hayo, B. and M. Uhl (2013), Taxation and Labour Supply: Evidence from a Representative Population Survey, Journal of Macroeconomics 45, 336–346, 2015.

Keane, M.P. (2011), Labor Supply and Taxes: A Survey, Journal of Economic Literature 49, 961–1075.

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Bernd Hayo

Professor

University of Marburg

Tel: +49 (0)6421 282 3091

hayo@wiwi.uni-marburg.de

www.uni-marburg.de/en/fb02/research-groups/economics/macroeconomics