Why Do Americans Work So Much More Than Europeans?
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- Implications for Policy
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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
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, �
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.
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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. FEDERAL RESERVE BANK OF MINNEAPOLIS QR 10 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.
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.
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
FEDERAL RESERVE BANK OF MINNEAPOLIS QR 12 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 References Auerbach, Alan J., and Kotlikoff, Laurence J. 1987. Dynamic fiscal policy. Cam- bridge: Cambridge University Press. Baxter, Marianne, and King, Robert G. 1993. Fiscal policy in general equilibrium.
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