The elasticity of earnings to work incentives is a key parameter for predicting the effects of tax reforms and measuring the public costs of social insurance programs such as unemployment and disability insurance. While estimating this labor supply elasticity empirically has a long tradition in public and labor economics, the research has yielded a wide range of estimates. Understanding the sources of this heterogeneity is important for whether and how governments can shape behavioral responses with policy (see, e.g., Slemrod and Kopczuk, 2002) and for the design of optimal tax and transfer policies (e.g. Farhi and Gabaix, 2020), and thus a task at the core of the economics profession. At the same time, many individuals face considerable fluctuations in their earnings within and across years, a phenomenon that has received relatively little attention in the economics literature while arguably shaping individuals’ ability and to respond to tax incentives.
The literature has suggested a wide variety of potential explanations for the heterogeneous - and often weak - labor supply responses to tax incentives. One widely recognized explanation is that people face a variety of optimization barriers. These barriers include hours constraints imposed by firms or negotiated by unions which make finding a job with the desired number of hours costly or hard, both in terms of money and time. Misperceptions of the tax and benefit systems have been shown to play an important role as work incentives in social programs are often based on complex and non-linear tax and benefit schedules, subject to informational barriers, cognitive ability or reference-dependence. The ability to understand complex work incentives depends on individuals' work arrangements, e.g. stability and predictability of monthly earnings. Furthermore, people could be willing to work at high marginal tax rates due to high marginal utility of consumption or liquidity constraints.
Similarly, individuals climbing the career ladder may be willing to pay higher taxes in exchange for quicker career growth. Future earnings expectations may shape individuals' labor responses through the potential coverage from unemployment and disability insurance programs. Finally, variation in empirical methods may explain some of the observed heterogeneity of estimates.
At the same time, most individuals interact with the system for withholding taxes much more often than the real tax system, as most individuals see taxes withheld every month, but only interact with the overall tax system at the time of filing taxes. Thus, people could misperceive the withholding tax schedule for the real tax schedule, an important and understudied mechanism that could change how taxes shape labor supply.
The first goal of this project is to provide a comprehensive study of the various frictions that shape labor supply responses to taxes and benefits and to explore the implications of this heterogeneity for welfare and design of tax and transfer systems. While the response and nonresponse to tax incentives is a classical topic in economics, the broad focus on heterogeneous incentives across a range of benefits and taxes affecting heterogeneous groups as well as the broad set of explanations for limited responses investigated allows us to provide a novel research project with significant potential to improve our understanding of what shapes behavioral responses to taxes when, for whom and why.
In the first work package (WP1), we will offer a comprehensive analysis of labor supply responses to taxes and the social safety net, comparing estimates across a range of benefits and subgroups to provide descriptive evidence of the potential mechanisms be at work. Furthermore, unique Norwegian registry data and quasiexperimental variation in withholding taxes – holding real taxes fixed – enables us to provide novel evidence of whether and how withholding taxes influence the labor supply responses to taxation.
In the second work package (WP2), we focus on the role of income volatility within and across years, and the role of this in shaping labor supply elasticities to taxation. In this working package, we first document the importance of earnings fluctuations within and across years in Norway and the US, and next move on to evaluate how this shapes labor supply responses. We describe how we directly test the role of information and income volatility, exploiting a unique combination of quasi-random access to information about work incentives and the stability of the economic environment as well as cross-sectional variation in the income volatility that individuals phase. Together, the proposef work packages aim to provide a broad view on the factors that shape people's response to incentives in the tax and benefit systems of central interest to policymakers and academics.
