Working Paper: CEPR ID: DP5594
Authors: Henrik Jacobsen Kleven; Claus Thustrup Kreiner
Abstract: This paper extends the theory and measurement of the marginal cost of public funds (MCF) to account for labour force participation responses. Our work is motivated by the emerging consensus in the empirical literature that extensive (participation) responses are more important than intensive (hours-of-work) responses. In the modelling of extensive responses, we argue that it is crucial to account for the presence of non-convexities created by fixed costs of work. In a non-convex framework, tax and transfer reforms give rise to discrete participation responses generating first-order effects on government revenue and the marginal cost of funds. Based on analytical expressions accounting for both margins of labour supply response, and allowing for heterogeneity in productivities and preferences, we calculate MCF for 15 European countries using micro data on taxes and benefits for each country. The MCF estimates depend crucially on the country under consideration and on the properties of the tax reform. In general, we find that extensive responses have very important effects on MCF, especially in the Scandinavian and the Central/Northern Continental European countries where participation tax rates are very high at the bottom of the distribution resulting from generous out-of-work benefits along with high tax rates on workers. For these countries, the estimated MCFs centre around 2 in the case of proportional tax changes.
Keywords: Fixed work costs; Income transfers; Intensive and extensive responses; Labor supply; Marginal welfare costs; Taxation
JEL Codes: H21; H41; J20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tax and transfer reforms (H29) | discrete participation responses (C25) |
| discrete participation responses (C25) | government revenue (H27) |
| government revenue (H27) | marginal cost of public funds (MCF) (D61) |
| Tax and transfer reforms (H29) | marginal cost of public funds (MCF) (D61) |
| participation tax rate (H29) | marginal cost of public funds (MCF) (D61) |