Income Taxation in a Life Cycle Model with Human Capital

I examine the effect of labor income taxation in life-cycle models where work experience builds human capital. In this case, the wage no longer equals the opportunity cost of time – which is, instead, the wage plus returns to work experience. This has a number of interesting consequences. First, the data appear consistent with much larger labor supply elasticities than most prior work suggests. Second, again contrary to conventional wisdom, permanent tax changes can have larger effects on current labor supply than temporary tax changes. Third, human capital amplifies the labor supply response to permanent tax changes in the long-run, as a permanent tax reduces the rate of human capital accumulation (reducing worker productivity). Fourth, for plausible parameter values, welfare losses from proportional income taxation are likely to be much larger than conventional wisdom suggests. Acknowledgements: This paper was presented as the Cowles Lecture at the 2011 North American Summer Meetings of the Econometric Society. Seminar participants at the University of Minnesota, the Australian National University, the University of Melbourne, the University of Zurich, the World Congress of the Econometric Society (Shanghai), the 2010 Australian Conference of Economists, the University of California at Berkeley, the 2011 SETA Conference (Melbourne), the Federal Reserve Bank of New York and Arizona State University (ASU) provided useful comments. I thank Susumu Imai and Nada Wasi for performing many of the simulation exercises reported here. Most of the work reported here was conducted while I was an Australian Federation Fellow at the University of Technology Sydney (UTS) and at the University of New South Wales (UNSW), or while I was a visiting research professor at Arizona State University (ASU). This research has been support by Australian Research Council grant FF0561843, by the AFTS Secretariat of the Australian Treasury and the ARC Centre of Excellence in Population Aging Research (grant CE110001029). But the views expressed are entirely my own.