Working Paper: NBER ID: w10509
Authors: Steven J. Davis; Magnus Henrekson
Abstract: Guided by a simple theory of task assignment and time allocation, we investigate the long run response to national differences in tax rates on labor income, payrolls and consumption. The theory implies that higher tax rates reduce work time in the market sector, increase the size of the shadow economy, alter the industry mix of market activity, and twist labor demand in a way that amplifies negative effects on market work and concentrates effects on the less skilled. We also describe conditions whereby cross-country OLS regressions yield unbiased estimates of the total effect of taxes, inclusive of indirect effects that work through government spending responses to tax revenues. Regressions on rich-country samples in the mid 1990s indicate that a unit standard deviation tax rate difference of 12.8 percentage points leads to 122 fewer market work hours per adult per year, a drop of 4.9 percentage points in the employment-population ratio, and a rise in the shadow economy equal to 3.8 percent of GDP. It also leads to 10 to 30 percent lower employment and value added shares in (a) retail trade and repairs, (b) eating, drinking and lodging, and (c) a broader industry group that includes wholesale and motor trade.
Keywords: Taxation; Labor Supply; Shadow Economy
JEL Codes: D13; H24; J22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tax rate differences (H29) | Total response to tax rate differences (H29) |
| Higher tax rates (H29) | Reduce work time in the market sector (J29) |
| Higher tax rates (H29) | Increase the size of the shadow economy (E26) |
| Higher tax rates (H29) | Alter the industry mix of market activity (L16) |
| Higher tax rates (H29) | Distort labor demand (J29) |
| Higher tax rates (H29) | Amplify negative effects on less skilled workers (F66) |