Why Americans Work So Much
Edward C. Prescott
9
Spain and sufficiently large to increase U.S. labor supply
by 10 percent, then the predicted increase in Spanish
labor supply would be the observed 12 percent. More
research is needed to determine whether the hypothesis
that the flattening of the tax schedule is the principal
reason for the large increases in labor supply in both the
United States and Spain after their tax reforms.
The welfare gains from reducing the effective
marginal tax rate on labor income in the high tax rate
countries are large. The measure of welfare used is the
standard one, namely, by what percentage consumption
today and in all future periods must be increased in order
that the households would be indifferent to the policy
change in question. This measure is called the lifetime
consumption equivalent measure. If France were to
reduce its effective tax rate on labor income from 60
percent to the U.S. 40 percent rate, the welfare of the
French people would increase by 19 percent in terms
of lifetime consumption equivalents. This is a large
number for a welfare gain. This measure of the welfare
gain takes into consideration the reduction in leisure
associated with the change in the tax system and the
cost of accumulating capital associated with the higher
balanced growth path. The reduction in leisure is from
81.2 hours a week to 75.8 hours, which is a 6.6 percent
decline in leisure. I am surprised to find that this large
tax rate decrease did not lower tax revenues.
3
The welfare gains if the United States reduced its
marginal tax rate on labor income are smaller. If the
tax rate is reduced from 40 percent to 30 percent, the
gains in terms of lifetime consumption equivalents are
7 percent.
Implications for Policy
Tax system modifications have implications for public
retirement programs, such as U.S. Social Security. If
labor supply is fixed, a pay-as-you-go social security
system cannot be converted to a fully funded system in a
way that makes every generation better off. If, however,
the labor supply is not fixed, the transition can be made
in a way that makes every generation better off. The
only issue is how long the transition will take. Using
the utility of leisure parameter,
�
, obtained in the first
part of this article, I now explore this issue of how long
such a transition will take.
The model economy is modified is two respects. First,
I follow Auerbach and Kotlikoff (1987) and use the over-
lapping generations structure rather than the infinitely
lived family structure employed earlier.
4
In the modified
structure, the key relation used to forecast labor supply
continues to hold. Second, the technology assumed has
perfect substitution between capital and labor. The pro-
ductivity of labor grows at the rate of 2 percent a year,
which implies that the real wage will grow at 2 percent
a year as it has on average throughout the twentieth cen-
tury. The productivity of capital is constant and is such
that the after-tax return is 4 percent.
Alternatively, I could have assumed that capital in-
come tax rates, which are not formally modeled, are
adjusted to maintain a 4 percent return on capital if the
capital/output ratio changes as a result of the reform.
This 4 percent return is the after-tax real return that has
prevailed in the United States in the 1880–2002 period
(McGrattan and Prescott 2003). Having some dynastic
families would also work in the direction of keeping the
interest rate constant.
I assume that an equal number of people begin their
working career every year at age 22, they work for 41
years, and then they live an additional 19 years. This
implies that they retire at 63, which is the average U.S.
retirement age. They receive social security benefits
equal to 0.319 of the wage that prevailed when they were
66 beginning when they are 67 and continuing for 14
additional years. In fact, for the U.S. system, the wage
base is the one that prevailed when an individual was
60 years old, so the replacement rate is approximately
36 percent. The effective tax rate on labor income is 40
percent, as it is in the United States, with 10 percent
of this being a social security retirement tax. I use 10
percent rather than the U.S. 12.4 percent rate because
some social security taxes are used to provide disability
and survivors’ benefits in the United States.
The assumption of no population growth is not real-
istic and introduces two errors. These errors, however,
are of opposite sign and offsetting, so my example is
still valid for building quantitative economic intuition.
One error is that the relative number of people with
social security claims is smaller if population growth
is positive. This reduces the initial implicit liabilities
relative to GDP of the pay-as-you-go system. The other
3
Mendoza and Tesar (2002) also find that revenue is maximized with a tax rate
slightly above 50 percent.
4
See the July 1999 issue of the Review of Economic Dynamics, which is devoted
entirely to studies of the U.S. Social Security system. These studies are much richer
in detail than this one. But they do not use the utility function used in this study, and
as a result, my results are different. Conesa and Garriga (2003) address the status
quo problem in Social Security reform.
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error is that with a growing population the pay-as-you-
go system will have higher levels of benefit payments
associated with a given social security retirement tax.
This increases the implicit liabilities of the current sys-
tem. The pay-as-you-go system that I consider has the
property that social security benefits paid are equal to
social security taxes collected.
The model economy’s time period is a year. The
steady state of a pay-as-you-go system and a fully
funded system are reported in Table 4. With the fully
funded system, steady-state labor supply is 11 percent
higher, consumption 17 percent higher, and welfare in
lifetime consumption equivalents 9 percent higher. The
problem with just switching from the current pay-as-
you-go system to a fully funded system is that the initial
old would suffer. The following reform makes all better
off. There are still better reforms than this one, in par-
ticular, plans that have tax rates that depend upon age
at the time of reform.
Proposed Reform
People are given the option to continue with the current
system or to shift to a new system. With the new system,
8.7 percent of wage income is put into an individual
account with the government that earns a 4 percent real
return. Upon retirement, savings in this account are
annuitized. Effectively, people have the option to have
their tax rate on labor reduced from 40 percent to 31.3
percent and to save 8.7 percent of their labor income in
a government retirement account or to continue with
the current social security system. With the reform, non–
social security transfers are left unchanged.
Steady-state social security liabilities of the pay-
as-you-go system are large: 4.62 times gross national
income (GNI). With the reform, those aged 37 and
younger choose the new system. The welfare gain to the
22-year-old at the time of the change exceeds 4 percent
in lifetime consumption equivalents. Associated with
the change, the annual capital/output ratio increases
from 2.7 to 3.3, as seen in Table 5. This increase takes
45 years.
Table 5 also shows that pension liabilities of the pay-
as-you-go system are large: 2.30 times GNI. With the
new system, the decline steadily becomes zero 35 years
after the reform.
Some Equity Considerations
In the model, all individuals earn the same wage when,
in fact, some people earn higher wages than others.
Given that earning a 4 percent after-tax real return is an
attractive investment, equity considerations suggest an
upper bound on contributions. Similarly, lower-income
households should have the right to contribute more than
8.7 percent of their labor income.
Still another consideration is how to deal with mar-
ried couples. An equitable solution is that each party has
an account and household contributions are split equally
between the two accounts with the contribution limit
discussed above applying to an individual account and
not to a household account. Some will be so unfortunate
that the amount in their account will be insufficient to
provide for a minimal acceptable retirement. This sug-
Table 4
Effects of a Shift to a Fully Funded
Social Security System
Steady States in a Model With Each System
Soc. Sec.
Effective
Capital
Labor Consumption Liabilities
Labor Tax
System Output Output Supply Per Person Net Output Welfare* Rate
Pay-As-You-Go 100 2.77 100 100 4.62 100 40.0%
Fully Funded 123 4.91 111 117 0 109 27.05
*Welfare here is measured in lifetime consumption equivalents.
Why Americans Work So Much
Edward C. Prescott
11
gests adding means-tested supplementary benefits.
Why force people to save, as this scheme does? The
answer is that it gets around the time inconsistency
problem. Some individuals will not save if they know
that others will provide for their consumption whether
the others are taxpayers, family members, or charities.
In the process of determining the effect of differences
in effective marginal labor tax rates on labor supply
across countries and time in the advanced industrial
countries, I have estimated the elasticity of labor supply
and have found it to be large, nearly 3 when the fraction
of time allocated to the market is in the neighborhood
of the current U.S. level. This estimate of the elasticity
is essentially the same one needed to account for busi-
ness cycle fluctuations. That this elasticity is large is
good news. If labor supply were inelastic, the advanced
industrial countries would face a cruel choice of either
increasing taxes on the young, thereby lowering young
people’s welfare, or not honoring the promises made to
the old, making the old worse off.
The large labor supply elasticity means that as popu-
lations age, promises of payments to the current and
future old cannot be financed by increasing tax rates.
These promises can be honored by reducing the effective
marginal tax rate on labor and moving toward retire-
ment systems with the property that benefits on margin
increase proportionally to contributions. Requiring
people to save for their retirement years is not a tax and
does not reduce labor supply. My example establishes
that reforms are possible that benefit the current young
workers and future workers while honoring promises
made to the old.
One factor that I ignored in my social security reform
example is that a larger capital/labor ratio increases wag-
es with any reasonable aggregate production function.
If this factor is taken into consideration, the welfare
gains are larger. It is beyond the scope of this article to
more than scratch the surface of how best to reform the
social security retirement system and what the resulting
welfare gains would be. But it is clear, given the high
responsiveness of labor supply to marginal labor tax
rates, that the potential gains are great.
Table 5
Effects of a Shift to an Optimal Government
Individual Retirement Account
For 60 Years After Reform, Assuming Workers
Aged 15–37 Years Choose the New Account
Soc. Sec.
Liabilities Capital
Year Output Output
1 2.30 2.71
15 1.57 2.80
30 .63 3.08
45 0 3.31
60 0 3.32
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Appendix
Data Sources
1. Source of national accounts (SNA) statistics: United Na-
tions (1982, 2000).
2. Source of civilian employment, noncivilian employment,
annual hours per employee, population aged 15–64: OECD
Labour Database, available at http://www.oecd.org/home/.
Follow links to Statistics, Labour, and Labour Force Sta-
tistics—Data.
“Hours of work: manufacturing” data are used for Japan
in 1970–71 because annual hours per employee for Japan
in 1970–71 are not in the OECD Labour Database. These
data are obtained from United Nations (1981). They are
based on establishment study.
3. Source of purchasing power parity GDP numbers in Table
1: OECD Annual National Accounts Statistics, Table B.3
(OECD 2001), available at http://www.sourceoced.org.
Follow links to Statistics, OECD Statistics, and National
Accounts.
4. Source of income taxes and contributions for Social Se-
curity, United States: BEA Table 3.2., available at
http://www.bea.gov/bea /dn /nipaweb/SelectTable.
asp?Selected=Y#S3.
5. Source of national accounts statistics for Spain: Instituto
Nacional de Estadística (Spain Statistical Office), available
at http://www.ine.es/inebase/menu3i.htm#15.
Download the annual national accounts for the period
1993–2001.
Why Americans Work So Much
Edward C. Prescott
13
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