Effects of Taxes on Labor Income

Higher tax rates on labor income and consumption expenditures lead to less work time in the legal market sector, more time working in the household sector, a larger underground economy, and smaller shares of national output and employment in industries that rely heavily on low-wage, low-skill labor inputs.

Taxes on labor income and consumption spending encourage households to shift away from work in the legal market sector and toward untaxed uses of time such as leisure, household production, and work in the shadow economy. In Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons (NBER Working Paper No. 10509), authors Steven Davis and Magnus Henrekson assess the long-term effects of persistent tax rate differences among countries. The authors stress that taxes affect work activity directly through labor supply-and-demand channels and indirectly through government spending responses to available tax revenues. They find that higher tax rates on labor income and consumption expenditures lead to less work time in the legal market sector, more time working in the household sector, a larger underground economy, and smaller shares of national output and employment in industries that rely heavily on low-wage, low -skill labor inputs.

The estimated tax effects are large for the authors' preferred tax measures. Cross-country comparisons in the mid-1990s indicate that a tax hike of 12.8 percentage points (one standard deviation) leads to 122 fewer hours of market work per adult per year and a 4.9 percentage point drop in the employment-to-population ratio. It also increases the size of the shadow economy by 3.8 percent of official GDP, and it reduces by 10 to 30 percent the share of national output and employment in "Retail Trade and Repairs," in "Eating, Drinking, and Lodging," and in a broader category that includes "Wholesale Trade and Motor Trade and Repair." The evidence suggests that tax rate differences among rich countries are a major reason for large international differences in market work time and in the industry mix of market activity.

The authors' broad-brush international comparisons are useful for several reasons. First, the focus on national outcomes provides information about the impact of taxes through their effects on the composition of labor demand. Because home production is highly substitutable for many market goods and services produced by less skilled workers, taxes on labor and consumption twist labor demand away from less skilled workers, amplifying their negative effects on aggregate employment.

Second, countries with high tax rates on labor income and consumption expenditures have relatively generous tax-funded programs for social security, disability insurance, sick leave assistance, unemployment insurance, and general assistance. The benefit sides of these programs also alter labor supply incentives in ways that discourage market work activity and increase employment in the underground economy. To the extent that government spending on these programs responds to the availability of tax revenues, the full response to differences in taxing capacity must take into account the indirect effects that show up through the expenditure side of government behavior. Conceivably, the indirect expenditure effects are larger than the direct effects of taxes.

Third, there are large, highly persistent differences among countries in tax rates on labor and consumption and in the scale of tax-funded social insurance programs. The persistent character of national differences in tax rates makes them well suited to assessing long-term effects.

-- Les Picker