Marginal tax rates and labour supply

Americans now work 50 per cent more than do the Germans, French, and Italians. This was not the case in the early 1970s, when the Western Europeans worked more than Americans.

Edward Prescott found that taxes accounted for these differences in labour supply across time and across countries; in particular, the effective marginal tax rate on labour income. The population of countries considered is the G-7 countries, which are major advanced industrial countries. Prescott concluded that

virtually all of the large differences between U.S. labour supply and those of Germany and France are due to differences in tax systems.

Prescott and many that followed him were truly puzzled by the lack of a role for employment mandates, employment protections and product market regulation in Europe’s poor economic performance

Richard Rogerson is a very sharp fellow who built on Prescott’s work. Most anything Rogerson writes is worth a look.

A non-technical note by Rogerson made these key points:

  1. Europe’s taxes punish working outside the home, so Europeans don’t work as much as they would otherwise;

  2. Dramatic differences in the overall change in hours worked per person aged 16 to 64 across countries between 1960 and 2000;

  3. at one extreme the U.S., with an increase of 10 per cent between these two dates;

  4. At the other extreme are Germany and France, with declines of more than 30 per cent;

  5. For the U.S. and France, the difference is staggering—more than 45 per cent;

  6. Richard Freeman and Ronald Schettkat (2001) studied time allocation by married couples in Germany and the United States.

  7. Their striking finding is about total time devoted to work (i.e., market work plus home production) turns out in the two countries is virtually the same.

In The Impact of Labor Taxes on Labor Supply: An International Perspective (AEI Press, 2010) Rogerson finds that:

• a 10 percentage point increase in the tax rate on labour leads to a 10 to 15 per cent decrease in hours of work.

• Even a 5 per cent decrease in hours worked would mean a decline in labour output equating to a serious recession.

• While recessions are temporary, permanent changes in government spending patterns have long-lasting repercussions.

• Although government spending provides citizens with important benefits, such benefits must be weighed against the disincentive effects of increased labour taxes.

• Policymakers who fail to account for the decrease in labour output risk expanding government programs beyond their optimal scale.


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