2. Labour Supply And Payroll Taxes Flashcards
Payroll taxes
Comprise of:
Income taxes
Social security contributions
All modern economies use payroll taxes:
-to generate revenue for general expenditure (income taxes) - used for infrastructure, military, energy…
-to fund public programs (taxes and SSC) e.g. unemployment benefits, family benefits, pensions…
-to redistribute income
Issue with payroll taxes
Introduce inefficiency (deadweight loss) into labour market:
-drive wedge between cost of labour to the firm (increase) and net wage of worker (decrease)
Drives employment below the optimal level
optimal level: employment without tax - no DWL
Measures when classifying tax schedules
Average tax rate
Marginal tax rate
Average tax rate
For each £ earned, how many pence are paid in taxes on average?
Marginal tax rate
For the next £ earned, how many pence does the individual have to pay in taxes?
Properties of tax schedules
Proportional
Progressive
Regressive
Properties of tax schedules: Proportional
Independent of the level of income, every worker pays the same tax tax rate
Properties of tax schedule: Progressive
The average tax rate is increasing in income
UK tax schedule is progressive
Properties of tax schedule: Regressive
The average tax rate is decreasing in income
Minimum Guaranteed Income Scheme (MGI)
Social assistance scheme topping up income to guarantee individuals a consumption/ income floor (subsistence income)
Effects: MGI increases the reservation wage - some low income individuals choose not to work and claim MGI - without MGI these individuals would have worked (extensive margin decision)
To offset effect that discourages employment - MGI programs often integrated with employment-conditional incentives
Key questions
How high should taxes be?
Discussion so far: taxes distort labour supply decisions (reduce labour supply), so why do governments impose taxes? :
-need source of revenue to fund programs (transfers, public goods…)
Trade off: How to raise revenue for these programs while keeping distortions to a minimum?
Optimal linear tax rate
Depends on social value of what the government does with taxes
if you believe social value of government tax revenue close to 0 —–> optimal tax rate is 0
Maximizing tax revenue not the goal of the policy maker
Actual Incidence of taxation
Refers to economic burden of a tax, who actually bears the cost of the tax?
in our context:
-which side of the labour market bares the cost of taxes?
-who actually pays for the tax?
Formal incidence of taxation
The formal incidence of taxation refers to the legal assignment of the tax burden, which is determined by the laws and regulations governing the tax. It is the party or entity, as specified by tax laws, that is responsible for paying the tax.
They may pass on the cost of the tax (actual incidence of taxation) to someone else, but they are the one that is technically required to pay for the taxation
Income effect (tax context)
Taxes reduce net-income holding labour supply fixed
As individuals are poorer —–> work more hours to make up for lost income
Substitution effect (tax context)
Taxes reduce price of leisure (forgone net wage)
You lose less from not working because you are not earning as much as you were before tax was put in place
—–> people may consume more leisure by reducing their hours worked
How do individuals/ aggregated labour supply respond to income taxation?
If tax affects labour supply along the extensive margin —-> reduce participation (substitution effect)
If taxes affect number of hours worked, total effect on hours depends on relative size of income and substitution effect:
- substitution effect > income effect - progressive tax reduces labour supply
- income effect > substitution effect - progressive tax increases labour supply
Determining these effects and their size is an empirical question
Three margins of labour supply adjustment in response to taxes (Meghir and Phillips, 2010)
Extensive margin
Intensive margin
Effort of worker
Extensive margin
Whether to work or not
Intensive margin
Hours worked conditional on working
Effort of worker
Amount of effort that a worker puts forth can be affected by taxation
Differ by demographic and education group:
-Male hours of work not responding to male incentives
-Males with low/medium income respond to tax incentives
-women with young children / single mothers are sensitive to financial incentives at both the extensive and intensive margin
-Highly educated insensitive to work incentives
Eissa, 1995 - US TAX REFORM ACT (1996)
Natural experiment that allows us to estimate labour supply responses to tax reform:
Description:
-large tax cuts for high income earners
-small tax cuts for low income earners
Study: compare women married to husbands with different income levels
Results:
-labour supply of high income married women increased at least half along the extensive margin
-married women may have more elastic labour supply
Caveat: three groups used to estimate responses are very different - especially high income group
Follow up:
-studies using more data and tax reform
result: found elasticities around 0.1 - 0.4
Bastani and Waldenström, 2021 - ESTIMATE ABILITY GRADIENT IN TAX RESPONSIVENESS
How do responses to income taxation differ by cognitive ability?
Description:
-Estimate responsiveness to income taxation using a bunching estimator:
-use first “kink” point of Swedish central gov tax schedule —-> MTR increases by 20% at this point for income above 33K
Idea: individuals with income slightly above the threshold have an incentive to locate below it
-income distribution around the kink point should show excess mass below the threshold and missing mass above
Data: Linked administrative tax and military enlistment data for Sweden (focus on men)
Bunching estimator
Based on idea that individuals and firms will adjust their behaviour in response to changes in tax incentives - such as tax brackets or tax credits - creating “bunches” of tax payers at certain income levels
Uses micro-data from tax returns to identify these bunches of taxpayers and compare the behaviour before and after the tax change - allows researchers to estimate behavioural responses of individuals and firms to changes in tax incentives - such as changes in labour supply, savings or investment
Goal:
-estimate the (compensated) earnings elasticity of individuals to changes in the net-of-tax rate i.e. how does people’s income respond to taxation?
Idea: use discrete increase in marginal tax rate at some income - creates convex kink in budget set
Bunching estimator: identifying assumptions
1) Smoothness
2) Shape of counterfactual
3) Aggregation bias in elasticity e
Bunching estimator: smoothness
Counterfactual distribution is smooth around the kink
Threats:
Several policies change at the same threshold - even absent the analysed policy - the distribution would not be smooth
Threshold serves as reference point - which people target in their estimation
Estimates are thus confounded - making it difficult to uncover causal effect of studied policy
Solution: obtain additional bunching observations - e.g. from variation in size of the discontinuity or over time that do not affect the confounding factors
Bunching estimator: shape of the counterfactual
We estimate a specific shape of the counterfactual distribution (i.e. specific functional form)
Approximation might be very well locally (within tight windows around the threshold) but less so for policies leading to large behavioural responses (where individuals even far off from the threshold still respond)
Solution: sensitivity analysis - vary order of polynomial and the excluded range and assess robustness of your estimates
