Taxes, Hours and Employment

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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


Statistics for 2004 relative to U.S.


  • 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


  • 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


  • 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 …


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

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)


  • 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


  • Iceland doing well, but could be doing better

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

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