Micro vs Macro Labor Supply Elasticities: The Role of Dynamic Returns to Effort

We investigate long-run earnings responses to taxes in the presence of dynamic returns to effort. Our main contributions are as follows. First, we develop a theoretical model of earnings determination with dynamic returns to effort. In this model, earnings responses are delayed and mediated by job switches. Second, using administrative data from Denmark, we verify our model’s predictions about earnings and hours-worked patterns over the lifecycle. Third, we provide a quasi-experimental analysis of long-run earnings elasticities. Informed by our model, the empirical strategy exploits variation among job switchers. We find that long-run elasticities are considerably larger than short-run elasticities.