Taxes, Hours and Employment

Taxes, Hours and Employment

• Edward C. Prescott

• Reykjavik, Iceland, July 26, 2007

• Cutting Taxes to Increase Prosperity

Two Economic Diseases

• Low productivity
• Low market hours

• Output per person is productivity times market hours per person

Examination

Statistics for 2004 relative to U.S.

Diagnosis

• E.U.-15 has a case of the low labor supply disease

• E.U.-15 also has a mild case of the low productivity disease

Is Europe Getting Sicker?

• Decade Productivity Growths

Answer

• Maybe there is a productivity growth problem, but probably not

• No doubt that Europe has the low hours disease

• But reforms are on the way, and Europe’s health will improve

European Productivity

• The European Union is a good system

• Has led to high productivity

• For 40 years prior to World War II, European productivity 53% of U.S. level

• Since 1990 about 90% of U.S. level

Hours per Week per Person 16-64

When Did the Sickness Develop?

• Europe didn’t have the low hours disease in the early 1970s

• Then 23.8 hours per person per week
• Now European hours 18.3

• U.S. hours increased from 23.5 to 25.4 in this period because of 1986 Tax Reforms

What Caused the Sickness in Europe?

• Western Europe increased marginal effective tax rate from 40% to 60%

• U.S. kept its tax rate at 40%

• A 60% tax rate means on margin if someone works more and produces 100€ worth of output, get to keep 40€

U.K. Is Not That Sick

• U.K. market hours only fell from 25 per working-age person per week in early 1970s to 23.3 today

• But …

What about Iceland?

• Tax system

• Flat rate individual income tax rate, 36%
• Consumption tax rate, 35%
• Value-added tax rate between 14% and 24.5%
• Part of property tax
• Most of excise duties
• Relatively modest payroll tax rate, 6%

Iceland: Predicted vs. Actual Labor Supply

• Average hours worked per person 1996-2005

• Predicted: 24.3
• Actual: 26

• Inconsistencies in measurement

• Foreign workers
• Number of part-time workers
• Size of underground economy bigger in U.S. and Europe

Is Scandinavia a Problem for the Theory?

• Discrepancy for Scandinavia is not a measurement issue

• With simple theory aggregate hours under predicted by 20-45 percent

• But this theory abstracts from

• Other factors that affect work incentives

Features of Scandinavian Welfare States

• Subsidized day care conditional on working

• Subsidized elderly care

• Some government employment not employment

• e.g., those in training programs

Findings

• Public expenditures on home good important for explaining labor supply in market and at home

• Accounting for public provision of day care and elderly care in Scandinavia closes half of gap in predicted market work

• Sweden, after its long secular decline relative to other advanced industrial countries, beginning in 1995 has been reforming, has become more prosperous

• Ragan (2005), Stockholm School of Economics

What Is the Cure? Tax Rate Cuts

What about Side Effects of Tax Cut?

• Won’t this reduce revenues that are needed to finance social programs?

• The answer is …

Answer

• No

• Why: Revenue will not fall

Iceland: Corporate Tax Rate Down, Revenue Relative to GDP Up

Cutting Taxes and Preserving the Welfare State

• Shift to some mandatory saving for retirement and nonextraordinary medical expenditures

• Avoid throwing away output

• France 25%
• Iceland 10%

Europe Will Cut Tax Rates and Will Boom

• Europe has no choice except to reform

• There will be healthy growth in Western Europe

• with 20% increase in output in 5 years
• and a catch-up to the United States

• Process already started

Spain Is Leading the Way

• Spain cut tax rates in 1998 and made other labor market reforms

• Let’s see how Spain has been doing

Dramatic Improvement in Hours

Why Isn’t This Cure Widely Known?

• Some History

• Macroeconomists found market hours respond strongly to incentives

• Microeconomists argued otherwise

Who is Right Matters for Evaluating Tax Policies

• Public finance people sided with macroeconomists

• Martin Feldstein and Glen Hubbard (former chairmen of the Council of Economic Advisors) in mid-1980s

• But were ignored

Congress Sided with Labor Economists

• U.S. Congress ruled that its budget office must assume the effect of tax rates on hours is zero

• Congress likes to tax and spend

• Congress does not like to impose dead-weight losses

• Dead-weight loss big if macroeconomists right, small if labor economists right

We Now Know So Much More

• We know theory predicts economic fluctuations of the nature observed if and only if this labor response is high

• (Kydland-Prescott Nobel Prize paper)

A Puzzle

• Microeconomists looking at individual behavior were finding one thing

• Macroeconomists looking at aggregate behavior were finding something different

• Why weren’t the two findings consistent?

Theory to the Rescue

• Microeconomists assumed that people varied the length of the workweek and not the number of weeks worked over the lifetime

• Europeans workers work 40 weeks a year while U.S. workers work 46 weeks a year

• Europeans retire earlier than Americans

Model of Life Cycle Labor Supply

• There are two margins of labor supply

• Length of working life
• Hours per employed person

• Rogerson and Wallenius (2007), Arizona State University

Taxes Reduce Both Margins

• Length of working life important margin

Puzzle Resolved

• Macroeconomists permit (and the new generation of labor economists permit) fraction of lifetime worked to vary

• Micro and macro observations are now in conformity

• Same response for all countries (including Japan, Australia, New Zealand, Japan, Chile, Greece and Ireland, as well as the G7 countries)

Welfare

• Nonmarket time is valuable

• Because of taxes, the value of time on margin is higher in the business sector than in the household sector

• Welfare gains of cutting tax rates are …

Tax Rates Can Be Cut Below U.S. Levels

• How: Shift from tax and transfers to retirement saving accounts

• Over 25 countries have them

• Singapore and U.S. have health savings accounts

U.S. Is Shifting

• Big shift in U.S. to savings for retirement

• Even federal government has shifted

• State and local governments have begun to shift

• Like Iceland, everyone will have their savings account

What about Transition Costs

• Of moving to a saving system?

• There are none

• Switching is a bookkeeping entry that makes some implicit government liabilities explicit

• Honest accounting is good

• Poverty rate would be reduced

Conclusions

• Iceland doing well, but could be doing better

• By moving in the direction of a saving system to finance nonextraordinary expenditures