Automatic Stabilization and Labor Supply Mathias Dolls (ZEW Mannheim) Clemens Fuest (ifo Institut) Andreas Peichl (ZEW Mannheim) Christian Wittneben (ZEW Mannheim) Very preliminary draft. Please do not cite or distribute! This version: August 10, 2016 This paper estimates the stabilizing effects of tax and transfers systems through a marginal incentives channel. When income taxes are progressive, the tax rate that a household faces will fall following an income decline in a recession, thereby increasing work incentives and hence labor supply. This effect offsets part of the initial income decline, stabilizing aggregate income and output. The magnitude of the effect depends on the change in the marginal tax rate after a change in gross income, as well as the elasticity of labor supply with respect to a change in the after-tax wage. We estimate a structural discrete choice labor supply model and individual tax rates for households in the EU28 using the microsimulation model EUROMOD and EU-SILC household data. Our estimations show that up to ten percent of a fall in household income is offset by an increase in labor supply. The EU average is roughly two percent. The results reveal a large heterogeneity across countries, which is mainly due to differences in the progressivity of the tax systems across Europe: the incentive effect is large in countries with a highly progressive tax schedule, while it is zero for countries with a flat tax, where the marginal tax rate is constant. Differences in labor supply elasticities also play a significant role. JEL classification: H31, H24, C25, H12 Keywords: Stabilization; Household Labor Supply; Elasticity; Income insurance; I
1 Introduction Tax and transfer systems redistribute incomes across households. They also serve as Automatic Stabilizers, providing insurance against income fluctuations over the business cycle. By Automatic Stabilizers we mean those elements of the tax and transfer system that mitigate fluctuations in output without discretionary government action (Dolls et al., 2012b). This paper estimates the stabilizing effects of tax and transfers systems through a marginal incentives channel. When income taxes are progressive, the tax rate that a household faces will fall following an income decline in a recession, thereby increasing work incentives and hence labor supply (Christiano, 1984). This effect offsets part of the initial income decline, stabilizing aggregate income and output. The magnitude of the effect depends on the change in the marginal tax rate after a change in gross income, as well as the elasticity of labor supply with respect to a change in the after-tax wage. In general, the stabilizing power of taxes and transfers can work through four channels (McKay and Reis, 2016): 1. Disposable Income channel 2. Marginal Incentives channel 3. Redistribution Channel 4. Social Insurance Channel The disposable income channel works through a mechanical effect of the tax system to absorb fluctuations in gross income, which stabilized aggregate demand through the stabilizing effect on disposable income (Pechman, 1973; Auerbach and Feenberg, 2000; Dolls et al., 2012b). In the presence of nominal rigidities, this stabilization of aggregate demand will stabilize output. The marginal incentives channel works through the change in the marginal tax rate when a household is subject to an income shock. In a progressive tax system this will lead to an increase in work incentives, which increases labor supply. The redistribution channel takes into account that receivers of transfers may have higher propensities to spend out of their income, which leads to the stabilization of aggregate demand. Through the social insurance channel, automatic stabilizers influence precautionary savings, in particular, they might reduce savings to the point that households encounter liquidity constraints after they face a shock. Contribution This paper focuses on the marginal incentives channel. We estimate labor supply elasticities for households in the EU27, as well as the responsiveness of the tax and transfer system. In particular, we estimate the change of the marginal tax rate with respect to a percentage change in the gross income. The marginal tax itself gives an indication of the tax system s automatic stabilization capacity according to the disposable incomes channel (Pechman, 1973; Auerbach and Feenberg, 2000; Dolls et al., 2012b). When households face a sudden and temporary income decline, they may temporarily be subject to a lower marginal tax rate. This triggers an intertemporal substitution of labor. The magnitude of this effect is mainly driven by the change 1
in the marginal tax rate that follows the income shock, and the elasticity of labor supply with respect to the net wage. Our first contribution is the estimation of labor supply elasticities in a consistent manner for a large set of countries. We use a compelling methodology that allows to compare labor supply elasticities consistently across countries. Secondly, we contribute to the literature that assesses the incentive effects of the tax system by providing estimates of effective marginal tax rates and the progressivity of the tax and transfer system (see Auerbach and Feenberg, 2000; Saez, 2002; Immervoll et al., 2007; Wallenius, 2013). Thirdly, we contribute an estimate of the Automatic Stabilization effect that operates through the marginal incentives channel. Literature [TBC] McKay and Reis (2016); McKay and Reis (2016), Mattesini and Rossi (2012), Oh and Reis (2012) Auerbach and Feenberg (2000); Auerbach (2009) Dolls et al. (2012b, 2011, 2012a) Kniesner and Ziliak (2002a,b) Blundell and MaCurdy (1999); MaCurdy et al. (1990); Ziliak and Kniesner (1999); Bargain et al. (2014); Bargain and Peichl (2013) 2 Estimation 3 Datasets 4 Stabilization Framework 5 Results 6 Conclusion 2
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