Seminar

Income Taxation with Frictional Labor Supply

Nicolas Werquin (Yale University)

November 28, 2014, 11:00–12:15

Room MF 323

Public Economics Seminar

Abstract

This paper studies the effects of taxes on labor income and social welfare in an environment where labor supply choices are constrained by adjustment frictions. I analyze a dynamic model in which individuals choose their labor supply on the intensive margin as a function of their stochastic idiosyncratic productivity shocks and the non-linear tax schedule. Agents incur a fixed cost of adjusting their labor supply in response to productivity or tax changes, which can be thought of as the cost of searching for a new job. In the frictionless economy, I derive sufficient statistic formulas for the long-run effects of local tax reforms on social welfare. In the frictional model, the first main result is that, for a given labor income elasticity, the long-run effects of tax changes on social welfare differ significantly from those in the frictionless economy. The frictionless model ignores the heterogeneity in the utility of individuals who earn the same income level, and thus systematically underestimates the welfare costs of raising marginal tax rates. Moreover, this distribution is endogenous to taxes, leading to higher welfare gains from a budget-neutral increase in the progressivity of the tax schedule. The second main result is that the three-year elasticity of labor income to marginal tax rates typically estimated in the data may underestimate the long-run aggregate elasticity when frictions are present, more so when the proportion of exogenously received to endogenously chosen labor supply adjustments increases.