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Taxes and the labour supply in Europe

Richard Rogerson, 2008. "Structural Transformation and the Deterioration of European Labor Market Outcomes", Journal of Political Economy found that:
1. Hours worked per adult in France, Germany, Italy Europe decline by almost 45% compared to the US since 1956
2. The decline occurs at a steady pace from 1956 until the mid 1990s, in contrast to the fact that the relative increase in unemployment occurs in the mid 1970s.
3. The decline in hours worked in Europe is almost entirely accounted for by the fact that Europe develops a much smaller service sector than the US.
4. Relative increases in taxes and technological catch-up can account for most of the differences between the European and American time allocations to the market and outside over this per.

Ohanian, Rao and Rogerson 2008 in "Work and taxes: allocation of time in OECD countries" found
1. A steep decline in average hours worked per adult and large variations across OECD member countries in the magnitude of this decline.
2. Changes in labour taxes accounted for a large share of the trend differences.
3. Countries with high tax rates devote less time to market work, but more time to home activities, such as cooking and cleaning.
4. This reallocation of time from market work to home work is much stronger for females than for males.

The higher elasticities of labour supply of women, and married women and mothers are beyond dispute. Modern empirical labour economics as led by Mincer was built around explaining female and joint labour supply.

Richard Rogerson, 2007 in "Taxation and market work: is Scandinavia an outlier?" Economic Theory, found that how the government spends tax revenues when assessing the effects of tax rates on aggregate hours of market work.
1. Different forms of government spending imply different elasticities of hours of work with regard to tax rates.
2. While tax rates are highest in Scandinavia, hours worked in Scandinavia are significantly higher than they are in Continental Europe with differences in the form of government spending can potentially account for this pattern.
3. There is a much higher rate of government employment and greater expenditures on child and elderly care in Scandinavia.

Examining how tax revenue is spent is central to understanding labour supply effects:
1. If higher taxes fund disability payments which may only be received when not in work, the effect on hours worked is greater relative to a lump-sum transfer.
2. If higher taxes subsidise day care for individuals who work, then the effect on hours of work will be less than under the lump-sum transfer case.

The empirical foundations of supply-side economics – Michael Keane – YouTube

Most economists believe male labour supply elasticities are small, but a sizable minority of studies have large values. There is no clear consensus on this point.

The key factor driving these tensions is the failure of most studies to account for human capital returns to work experience.

In a model that includes human capital, even modest elasticities—as conventionally measured—can be consistent with large efficiency costs of taxation.

Conventional estimates of male labour supply elasticities have a severe downward bias because of their failure to include human capital accumulation. The opportunity cost of time includes their after tax wage and present value of increased earnings in all future years.

The return to work experience is high so working more has large long-term payoffs for younger male workers. Wages start low for young grow and then peak in 40s. When adjusted for the return for work experience, a large part of compensation when younger is human capital, and this peters away by the 40s.

Estimates where wages grow with work experience, with the accumulation of human capital, yield large male labour supply elasticities, as high as 3.8 rather than close to zero (Keane 2010, 2011). That is a profound difference.

Women have high labour supply elasticities, especially on the labour force participation margin, as most agree.

Estimates of long-run female labour supply elasticities—estimates that allow for dynamic effects of wages on fertility, marriage, education and work experience—are generally quite high.

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.

The rise of the Swedish welfare state, Swedosclerosis and Director’s Law

Sweden is a common example of a generous welfare state that is compatible with a prosperous society. One interpretation of the UN Development Index is you improve your national ranking by becoming more like Sweden.

Assar Lindbeck has shown time and again in the Journal of Economic Literature and elsewhere that Sweden became a rich country before its highly generous welfare-state arrangements were created

Sweden moved toward a welfare state in the 1960s, when government spending was about equal to that in the United States – less that 30% of GDP.

Sweden could afford this at the end of the era that Lindbeck labelled ‘the period of decentralization and small government’. Sweden was one of the fastest growing countries in the world between 1870 and 1960.

Swedes had the third-highest OECD per capita income, almost equal to the USA in the late 1960s, but higher levels of income inequality than the USA.

By the late 1980s, Swedish government spending had grown from 30% of gross domestic product to more than 60% of GDP. Swedish marginal income tax rates hit 65-75% for most full-time employees as compared to about 40% in 1960.

Swedish economists named the subsequent economic stagnation Swedosclerosis:

  • Economic growth slowed to a crawl in the 1970s and 1980s.
  • Sweden dropped from near the top spot in the OECD rankings to 18th by 1998 – a drop from 120% to 90% of the OECD average inside three decades.
  • 65% of the electorate receive (nearly) all their income from the public sector—either as employees of government agencies (excluding government corporations and public utilities) or by living off transfer payments.
  • No net private sector job creation since the 1950s, by some estimates!

In 1997, Lindbeck suggested that the Swedish Experiment was unravelling.


Sweden is a classic example of Director’s Law of Public Expenditure. Once a country becomes rich because of capitalism, politicians look for ways to redistribute more of this new found wealth.

Studies starting from Sam Peltzman (1980) showed that government grew in line with the growth in the size and homogeneity of the middle class that became organised and politically articulate enough to implement a version of Director’s law. Director’s law augmented by Gary Becker’s 1983 model of competition among pressure groups for political influence explain much of modern public policy.

Government spending grew in many countries in the mid-20th century because of demographic shifts, more efficient taxes, more efficient spending, shifts in the political power from those taxed to those subsidised, shifts in political power among taxed groups, and shifts in political power among subsidised groups.

The Swedish economic reforms from after 1990 economic crisis and depression are an example of a political system converging onto more efficient modes of income redistribution as the deadweight losses of taxes on working and investing and subsidies for not working both grew. Improvements in the efficiency of taxes or spending reduce political pressure to suppress the growth of the welfare state and thus increase or prevent cuts to both total tax revenue and spending.

After the rise of Swedosclerosis, the taxed, regulated and subsidised groups had an increased incentive to converge on new lower cost modes of redistribution. More efficient taxes, more efficient spending, more efficient regulation and a more efficient state sector reduced the burden of taxes on the taxed groups. Most subsidised groups benefited as well because their needs were met in ways that provoked less political opposition.

Reforms ensued led by parties on the Left and Right, with some members of existing political groupings benefiting from joining new political coalitions.

The Nordic median voter was alive to the power of incentives and to not killing the goose that laid the golden egg. The deadweight losses of taxes, transfers and regulation limit inefficient policies and the sustainability of redistribution.

For example, while tax rates are high in Sweden and the rest of Scandinavia, hours worked in Scandinavia are significantly higher than in Continental Europe.

Richard Rogerson found in Taxation and market work: is Scandinavia an outlier? that how the government spends tax revenues imply different rates of labour supply with regard to tax rate increases.

Rogerson considered that differences in the composition of government spending can potentially account for the high rate of labour supply in Sweden and elsewhere in Scandinavia. Specifically, examining the conditions on which how tax revenue is returned to Swedes as income transfers or other conditional payments is central to understanding the labour supply effects of taxes:

  • If higher taxes fund disability payments which may only be received when not in work, the effect on hours worked is greater relative to a lump-sum transfer with no conditions; and
  • If higher taxes subsidise day care for individuals who work, then the effect on hours of work will be less than under the lump-sum transfer with no conditions.

A much higher rate of government employment and greater expenditures on child and elderly care explain the high rates of Swedish labour supply.

Swedes are taxed heavily, but key parts of this tax revenue are then given back to them conditionally if they keep working. Policies that significantly cut the total wealth available for redistribution by Swedish governments were avoided relative to the germane counter-factual, which are other even costlier modes of income redistribution.